5.1 Background

While most institutions engaged in microfinance are specialist microfinance institutions (MFIs) registered as societies, non-profit companies or similar bodies, there is also considerable scope for regulated banks to become involved in microfinance.¹

In the past, most banks have tended to steer clear of microfinance, because they have regarded it as too risky and expensive, and it is clear that traditional banking methods and procedures are inappropriate for microfinance. As noted by Baydas, Graham and Valenzuela (1997), banks need to resolve a number of critical issues relating to commitment, organisational design, financial technology, human resources and cost-effectiveness if they are to enter the microfinance market successfully. Nevertheless, Baydas et al. note that if banks can learn from specialist MFIs and adjust their methods, they actually have a number of advantages over specialist MFIs that may put them in a very good position to establish microfinance programs:

• As regulated institutions, they are subject to a variety of standards which help to ensure prudent management.

• Many have physical infrastructure, including a large network of branches, from which they can reach out to large numbers of microfinance clients.

• They have their own sources of funds, such as deposits and equity capital, and hence do not have to rely on scarce and volatile donor resources.

• Their ownership structures encourage sound governance and profitability.²

The relationship between microfinance and the regulated banking system flows in both directions. In most countries, only regulated banks are permitted to raise deposits from the general public. Given the strong fiduciary relationship between deposit-taking institutions and their clients, this is appropriate. Some specialist MFIs may wish to establish regulated banks, so that they can raise deposits from the general public and, more generally, increase their credibility with investors and depositors. Offering full deposit services enables them to offer a broader range of financial services to the poor, with some studies suggesting that savings facilities are just as important to the poor as credit. Moreover, a bigger deposit base gives MFIs access to an additional source of funds, enabling them to expand their operations. A number of specialist MFIs in countries included in this study, including the Bangladesh Rural Advancement Committee in Bangladesh, the Aga Khan Rural Support Programme in Pakistan, TSPI Development Corporation in the Philippines, and the Federation of Thrift and Credit Cooperative Societies in Sri Lanka, are currently seeking to establish banks. On the other hand, it is not necessary or desirable for all specialist MFIs to establish regulated banks. Establishing a regulated bank raises a number of complex issues, and may lead to a change of focus away from the original objectives of the institution. It may not be an appropriate path for all MFIs to follow.

From the other side, some traditional banks may wish to become involved in microfinance. As noted above, banks have a number of advantages that make them well placed to move into the microfinance sector. Where they adopt appropriate operational procedures, microfinance can be a profitable activity. The involvement of regulated banks in microfinance is most common in Indonesia, where there is a large number of banks providing financial services in the rural areas, including to poor clients. While Bank Rakyat Indonesia is the largest and most famous of these, there are also many small banks operating in more localised areas. To a lesser extent, regulated banks are also becoming involved in microfinance in the Philippines, and in a number of the other countries included in this study. Banks may be involved in microfinance either through direct lending to the poor, or through linkages with specialist MFIs.

The extent to which regulated banks become involved in microfinance depends critically on the policy environment. As noted in chapter 3, in some countries the government operates specific microfinance programs in which funds are channelled through the banks to borrowers who meet certain criteria. Most countries also continue to impose various directed credit requirements, whereby banks are required to lend a certain proportion of their loan portfolio to particular sectors, which may include the poor. Hence, regulated banks may become involved in microfinance as a result of specific government requirements.

Banks may also become involved in microfinance as a matter of choice, because they see it as a profitable activity. This depends importantly on the regulatory and prudential framework. In many ways, the regulatory and prudential framework is more critical for regulated banks than it is for specialist MFIs. As noted by Baydas et al:

Non-bank microlending NGOs can operate in a repressed financial market environment since they are not subject to the regulatory interest rate ceilings, high reserve requirements and selective (i.e. targeted) credit policies characteristic of these markets. Commercial banks, however, cannot escape these regulations that, in the end, reduce their profit margins. Rarely have commercial banks considered microfinance initiatives while operating under a regime of financial repression (pp.8–9).

This chapter considers a number of matters relating to the regulatory framework that are particularly relevant to the scope for banks to engage in microfinance. Section 5.2 looks at issues of licensing and minimum capital requirements, while section 5.3 deals with regulations relating to interest rates. A range of issues relating to prudential regulation and supervision are considered in section 5.4, while section 5.5 summarises the chapter and provides recommendations.

One critical factor affecting the extent to which regulated banks will become involved in microfinance is the scope for the establishment of small banks. Baydas et al. found that microfinance programs rarely have a secure position in large banks. Microfinance programs generally do not rank highly among the operational divisions within the bank, and the future of programs depends strongly on the support of a few important shareholders or bank officers. While some large banks such as Bank Rakyat Indonesia have been able to extend the range of their commercial banking functions successfully and profitably into the domain of microfinance, this is the exception rather than the rule.

Smaller banks, by contrast, operate in more localised areas and are more likely to serve niche markets. Baydas et al. found that where smaller banks are involved in microfinance, they tend to have a larger percentage of their portfolio in microfinance and there is a stronger institutional commitment to it, as compared to larger banks. It is also easier to establish an institutional culture geared towards servicing a lower income clientele with specialised products.

The scope for establishing small banks is also of critical importance to specialist MFIs wishing to establish regulated banks. Clearly, such institutions are unlikely to be able to muster the capital to establish a commercial bank of national significance offering the full range of financial services. Unless there is provision to establish smaller banks, they will not be able to become regulated financial institutions and offer full deposit services. For these reasons, if regulated banks are to play an active role in microfinance, it is essential that there be some mechanism to enable small banks to be licensed. In large part, this means that minimum capital requirements for the establishment of a new bank should be realistic for a small bank operating at a local level. It also means that there should not be other restrictions preventing the establishment of small banks. Jansson and Wenner (1997) note that a further issue is whether NGOs establishing banks should be permitted to use the net present value of loan portfolios as capital.

Does relaxing minimum capital requirements increase prudential risks? Chaves and Gonzalez-Vega (1994, p.64) distinguish clearly between capital adequacy ratios and minimum capital requirements:

Capital adequacy regulations in the form of some minimum solvency ratio create good incentives. This makes for sound regulation. But capital adequacy requirements as an absolute minimum amount of equity to enter the industry are, conceptually, anticompetitive. The only justification for this latter type of regulation is a pragmatic one that has to do with the difficulty of supervising large numbers of intermediaries with small scale operations.

Following this line of argument, the major cost of permitting the establishment of small banks will be the additional cost to the central bank of regulating and supervising them. While this cost may be not insignificant, it would appear a relatively small price to pay if the result is to increase significantly the outreach of financial services in the rural areas, including to poor clients.

CGAP (1996) and Berenbach and Churchill (1997) are less emphatic. They note that the more capital a financial institution has, the better able it is to sustain losses. Moreover, the more money owners of financial institutions have at stake, the greater the incentive to avoid high-risk decisions. They point to particular risks in the case of NGOs-turned-banks, where much of the capital may come from investors who are not primarily motivated by commercial concerns, and so have less incentive than other investors to avoid risky behaviour. Nevertheless, central banks may minimise these risks by looking at the source of capital and proposed ownership structure, limiting any one shareholder to a fixed percentage of the share capital, and scrutinising the management of the proposed bank.

Of the nine countries included in this study, only two have a permissive policy environment for the establishment of small banks.³ For Indonesia, the category of rural banks (known by their Indonesian acronym BPR), was mentioned in chapter 3. Under the Banking Act of 1992, the government of Indonesia determined that there should be only two categories of banks in Indonesia, commercial banks and rural banks. The former provide general banking services with access to the payments system, while the latter may accept deposits only in the form of time deposits, savings or other similar forms. Rural banks, which may be structured in such forms as regional government enterprises, cooperatives or limited liability companies are entitled to extend credits and may also place funds in central bank money market instruments or with other banks.

Both categories of banks are subject to the supervision of Bank Indonesia, the central bank. In principle, both are subject to broadly the same prudential and regulatory regime, with regard to such requirements as capital adequacy ratio, legal lending limit (related party transactions), loan to deposit ratio, debt provisioning and bank ratings according to CAMEL factors. Rural banks are quite restricted in regard to the geographic area of their operations, with their expansion being confined to adjacent municipalities or subdistricts. Despite their name, ‘rural’ banks may also be established in urban areas. However, rural banks are somewhat more lightly regulated than commercial banks in terms of the requirements for qualifications of directors (although at least 50 per cent of nominees for a rural bank board must have not less than one year’s experience in banking operations).

The principal difference relates to the minimum capital requirements for the two types of bank. Unlike commercial banks, a rural bank may be established with as little as Rp50 million ($21,300) in capital. Such banks are frequently very modest operations and their client bases can extend well down the income distribution to include low-income people and microentrepreneurs. They are playing an increasingly important role in the program established by Bank Indonesia to create linkages between banks and NGOs for the provision of credit to the poor. Some are moving quite proactively to create self-help groups among poor clients to minimise the transaction costs of dealing with this class of very small customer. In an environment where NGOs appear not to flourish, they are beginning to play a significant role in microfinance. It should be noted, however, that the recent financial crisis has led to the closure of a number of rural banks and may also lead to a tightening of the requirements for the establishment of rural banks.

There is also considerable scope to establish small banks in the Philippines. While the minimum capital requirement for a commercial bank is Ps2 billion ($76.3 million), it is possible to establish thrift banks and rural banks with much lower capital. The requirement for a thrift bank is Ps250 million ($9.5 million) if the head office is in Metro Manila, and Ps40 million ($1.5 million) if the head office is outside Metro Manila. In the case of rural banks, the minimum capital requirement varies from Ps20 million ($0.8 million) down to Ps2 million ($80,000), depending on the location of the head office. While thrift banks and rural banks are more restricted in their operations than commercial banks, particularly with respect to their areas of operation, they are permitted to provide the full range of deposit services. This policy environment has facilitated the establishment of a large number of small banks, with some 108 thrift banks and 805 rural banks (the latter including some 47 cooperative rural banks) under the supervision of the central bank. The cooperative rural banks have been singled out for praise by the World Bank for their capacity to provide microfinance services profitably.

In the other seven countries, there is much less scope to establish small banks. In all cases, the minimum capital requirement to establish a commercial bank is high, ranging from $4.8 million in Bangladesh to $29.6 million in Thailand. This would generally be too high for someone wishing to establish a small localised bank. Moreover, even meeting the minimum capital and other requirements for the establishment of a commercial bank does not mean that it is possible to obtain a licence. To establish a commercial bank in Pakistan, it is necessary to open a branch in each of the four provinces and in the disputed territory of Kashmir. In Bangladesh, Malaysia and Thailand, the central bank is actively trying to restrict the number of commercial banks, and it is unlikely that any new bank would be licensed even if it met all the criteria.

In these four countries (that is, Bangladesh, Malaysia, Pakistan and Thailand), the retail banking system is essentially limited to commercial banks and state development banks, with no network of small regulated banks. No regulated banks other than commercial banks are permitted to offer full deposit services. Hence, there is effectively very little scope to establish a small bank offering full deposit and loan services. While there may be some scope to be licensed as some other type of bank (for example, as an investment bank in Pakistan, the route currently being used by the Aga Khan Rural Support Program to establish a bank), this is clearly a very imperfect solution that permits only a limited range of deposit services.

In Nepal, the banking system has traditionally consisted of commercial banks and state development banks. However, since 1994, five regional rural development banks have been established to lend to ‘deprived’ sections of society using the Grameen Bank model. These banks are owned as to 75 per cent by the government and central bank, with the balance being subscribed by other banks and financial institutions. While their initial performance has been promising, it was reported that they are increasingly being plagued by political pressure and interference with their operations. Following passage of the Development Bank Act 1996, it is also possible for private interests to establish development banks mandated to focus on low-income families. The minimum capital requirement is Rs10 million ($180,000), and it is understood that a private development bank is to be licensed shortly.

In India and Sri Lanka, there has long been a network of small banks, with the regulated banking system including commercial banks, state development banks, regional rural development banks and, in the case of India, cooperative banks.⁴ Regional rural development banks and cooperative banks operate at the regional level, and to some limited extent are involved in microfinance. However, they are essentially owned and/or controlled by the government, and in most cases their performance has been poor. There is no scope for private shareholders to establish new regional rural development banks. In India, there may be some limited scope to establish new urban cooperative banks. This is the route taken by one prominent MFI, SEWA Bank, but it is not clear if it would be open to other institutions.

In both India and Sri Lanka, there have been some recent initiatives to encourage the establishment of smaller banks. In India, the Reserve Bank has created special provisions for the establishment of local area banks with a minimum capital requirement of Rs50 million ($1.4 million). They are permitted to offer the full range of banking services, but their operations are limited to three geographically contiguous districts. Similarly, in Sri Lanka, the government has recently made it easier for specialised banks to be licensed, with a minimum capital requirement of Rs100 million ($1.8 million). While these provisions make it easier to establish smaller banks, the minimum capital requirements are still quite high.

One critical constraint which may prevent regulated banks from lending directly to the poor relates to interest rates. Microfinance is an inherently costly activity. Effective microfinance programs require intensive inputs in motivating and training borrowers and in follow-up, with regular monitoring and frequent loan repayments. Programs must go to where the borrowers are, rather than being located in regional centres. All of these factors add to costs. And loan amounts are small, implying low interest income per loan. To be sustainable, microfinance programs must therefore charge higher rates of interest than those charged on other loans. This is true regardless of whether programs are undertaken by specialised MFIs or regulated banks. The Grameen Bank, the largest and one of the most efficient microfinance programs in the world, charges an effective interest rate of 20 per cent per annum, and most smaller programs need to charge considerably more than this to be sustainable. Even if regulated banks adopt the techniques of specialist MFIs, they need to charge higher interest rates on their microfinance loans than on their other loans if their microfinance programs are to be sustainable.

Four of the countries included in the study impose interest rate ceilings on small loans by banks. In Bangladesh, interest rate ceilings apply to bank loans for small-scale cottage industries (12 per cent) and agriculture (14 per cent). In India, commercial bank loans below Rs25,000 ($690) are subject to a ceiling of 12 per cent, while loans between Rs25,000 ($690) and Rs200,000 ($5,560) are subject to a ceiling of 13.5 per cent (these ceilings only apply to loans by commercial banks, and do not apply to loans by regional rural banks or cooperative banks). In Malaysia, bank loans are subject to a general ceiling equal to the base lending rate plus 4 percentage points, with lower ceilings for some specific categories of loans. In Nepal, the maximum mark-up between deposit rates and loan rates is 6 percentage points. All of these requirements effectively preclude regulated banks from lending direct to poor borrowers on a sustainable basis. It is not surprising that in all of these countries, regulated banks tend only to lend to poor borrowers where they are required to by law or where they can access special government funds. This is also the case in Pakistan, where there is no formal interest rate ceiling but where banks generally charge small borrowers at the minimum rate of 14 per cent because of perceived social pressures.

The remaining four countries, Indonesia, Philippines, Sri Lanka and Thailand, have no interest rate ceilings, with banks free to determine their own interest rates in line with costs and market conditions. In two of these countries, most especially Indonesia and to a lesser extent the Philippines, regulated banks are involved in microfinance to a significant extent. Clearly, deregulated interest rates are an important factor in encouraging them to become involved in the microfinance sector. It is understood that rural banks in Indonesia charge interest rates up to 3 to 4 per cent per month, while Goodwin-Groen (forthcoming) notes that in the Philippines, rural banks charge interest rates of around 34 per cent annually.

Another factor which may discourage banks from becoming involved in microfinance is high reserve requirements. In many developing countries, regulatory authorities have used reserve requirements to limit monetary expansion in the banking system and thereby control inflation. The higher the reserve requirement, the less the deposit base available for on-lending and the less likely are banks to engage in microfinance.

In the past, a number of countries in Asia have maintained high reserve requirements. However, these have been reduced significantly in recent years as they have deregulated their banking systems. Of the countries included in the study, Malaysia has the highest reserve requirement, with banks required to hold cash reserves with the central bank equal to 13.5 per cent of deposit liabilities. In the Philippines, the reserve requirement for commercial banks is 13 per cent, but requirements are lower for thrift banks and rural banks, with savings and time deposits treated more leniently than demand deposits. Similarly in India, the reserve requirement is currently 10 per cent for commercial banks, but only 3 per cent for other banks. All other countries have reserve requirements of less than 10 per cent. Hence, for the countries in the study, reserve requirements appear to be set primarily on prudential rather than macroeconomic grounds, and do not appear to be a constraint to the development of microfinance.

Chaves and Gonzalez-Vega (1994) and CGAP (1996) comment that small banks are likely to be exposed to high levels of liquidity risk, particularly seasonal liquidity risk. They suggest that it may sometimes be prudent to set relatively high liquidity standards. Similarly, Christen (1997) notes that liquidity management is an extremely important area, and one in which MFIs tend to be weak. On the other hand, he points out that what may be an appropriate liquidity ratio depends very much on the particular circumstances facing the institution concerned, such as seasonal factors and plans for expansion. He argues that this makes liquidity management less susceptible to regulation and supervision than some other areas. For the countries included in the study, statutory liquidity requirements (over and above reserve requirements) range from zero in Thailand to 25 per cent in India and Pakistan.

In terms of capital adequacy ratios, the Basle Accord recommends that banks should maintain capital at least equal to 8 per cent of risk-weighted assets, equivalent to a gearing multiple of slightly over 12:1. Most of the countries in this study have adopted this standard. Thailand and the Philippines have adopted slightly higher standards of 8.5 and 10 per cent of risk-weighted assets respectively, whereas in Pakistan banks must maintain capital equal to at least 7.5 per cent of time and deposit liabilities, a slightly lower standard than that recommended by the Basle Accord.

Most commentators suggest that the capital adequacy ratio should be higher for small and microfinance banks than for commercial banks. There are a number of reasons for this. First, as noted above, in the case of banks established out of the NGO movement, much of the capital may come from investors who are not primarily motivated by commercial concerns.⁵ Such investors may have priorities other than rigorously safeguarding their capital. Second, such banks will generally be restricted to certain geographic areas or client groups, leading to less diversified portfolios than other banks. Third, because such banks operate with relatively high costs and high interest rates on loans, a given percentage of non-performing loans will decapitalise them faster than commercial banks. Fourth, banking regulators have little experience with small banks. Some have suggested capital adequacy ratios of 20 per cent or higher, at least initially, while others have suggested more modest figures such as 12 per cent.

Loan classification and provisioning is another problematic area for banks specialising in microfinance. While microfinance portfolios often show lower delinquency than commercial bank portfolios, delinquency tends to be more volatile. For this reason, CGAP (1996) suggests that microfinance banks should provision their overdue loans (based on time overdue) more aggressively than conventional banks. On the other hand, some regulations for loan provisioning require high provisions for unsecured loans, even where such loans are not overdue. Clearly, such regulations are inappropriate for microfinance banks. CGAP suggests that regulators should be flexible in considering alternative indicators of asset quality, such as historical performance of portfolios, statistical sampling of arrears, and the adequacy of management information systems and policies for dealing with arrears.

What provisioning requirements are appropriate for microfinance banks? One approach would be for regulators to use the same provisions that CGAP (1997a) has proposed for MFIs, as follows.:

These are stricter, in terms of the provision required for loans with a given length of time in arrears, than those applying to commercial banks under the Basle Accord, but are not quite as strict as those used in the ACCION CAMEL instrument for MFIs. The provisioning requirements in the Basle Accord have been adopted by most of the countries in this study. Some countries, including the Philippines and Thailand, require higher provisions for unsecured loans than for secured loans that are the same length of time in arrears.

Berenbach and Churchill (1997) argue that reporting formats used for large commercial banks may not be appropriate for small microfinance banks. They comment that reporting formats were originally conceived for banks with fewer, larger transactions, while microfinance banks are more concerned with aggregate indicators. Since their portfolios consist of thousands of small loans, it is not necessary nor realistic to monitor the performance of each individual loan, and portfolio reporting formats should be appropriate to the volume, loan size and term of microfinance loans.

For those countries in the study that have small regulated banks (India, Indonesia and the Philippines), reporting requirements are broadly similar for all categories of banks. Nevertheless, small banks did not comment that these requirements were overly difficult for them to fulfil. For instance, one urban cooperative bank in India that is heavily involved in microfinance commented that it found the reporting requirements rigorous but realistic. It may also be the case that, in practice, small banks are not supervised as rigorously as larger ones. In Indonesia, for instance, the current financial crisis has given rise to suggestions that some rural banks have not been adequately supervised.

Berenbach and Churchill (1997) noted a number of other problems that may apply when standard banking regulation and supervision is applied to small banks or banks with substantial microfinance portfolios.

In many countries, bank regulations limit the percentage of the portfolio that may be extended as unsecured loans. Clearly, regulations of this nature will limit the share of a bank’s portfolio that can be devoted to microfinance. Nevertheless, such regulations do not appear to be a constraint in the countries included in this study. The only country to impose restrictions on unsecured lending by banks is Pakistan, which only permits banks to make unsecured loans up to Rs100,000 ($2,850) in the case of loans of less than three years for trade, commerce or business, and Rs25,000 ($710) for other loans. These ceilings are high enough to enable the banks to engage in direct lending to the poor without security, should they wish to do so.

Sometimes regulations concerning loan documentation are not appropriate for microloans. It is not clear if this is a constraint in the countries included in this study. None of the central banks reported any regulations of this nature, leaving the question of loan documentation to the discretion of individual banks.

Supervision methods used by bank regulators may not be appropriate for microfinance portfolios. Berenbach and Churchill noted that bank examiners usually review 30 per cent of a bank’s loans. Clearly, this is not feasible in the case of microloans, and such procedures would need to be adjusted. Christen (1997) also suggests that supervisors need to adopt a different mindset when dealing with microfinance banks. The instinctive reaction of regulators to increased loan delinquency and management weakness may be to suggest greater administrative controls, essentially meaning greater hierarchy and bureaucracy, but this is likely to be inappropriate in the case of microfinance banks.

In some countries banking regulators must approve the opening of new branches, or branches may have limited flexibility regarding services and opening hours. Berenbach and Churchill comment that in some cases regulators have queried the location of branches in poor, remote communities that are perceived as unsafe, but these are precisely the areas where banks providing microfinance services should set up branches. Another issue is that banks with large microfinance portfolios will inevitably have higher ratios of operational costs to average portfolio than other banks. When conducting the standard CAMEL rating, regulators should therefore compare microfinance banks with other banks with similar loan portfolios.

Most institutions engaged in microfinance are specialist microfinance institutions (MFIs) registered as societies, non-profit companies or similar bodies. However, there is also considerable scope for regulated banks to become involved in microfinance. Some specialist MFIs may wish to establish regulated banks, so that they can raise deposits from the general public, and more generally increase their credibility with investors and depositors. And some traditional banks may wish to become involved in microfinance. However, the extent to which regulated banks become involved in microfinance depends critically on the policy environment.

Licensing and minimum capital requirements

One critical factor affecting the extent to which regulated banks will become involved in microfinance is the scope for the establishment of small banks. Microfinance programs in large banks rarely have a secure position within the bank, although the unit desa system of Bank Rakyat Indonesia is a major exception to this. The particular combination of supportive policy and regulatory environment and political leadership which underlies the success of Bank Rakyat Indonesia deserves close study throughout the region.

Smaller banks, by contrast, operate in more localised areas and are more likely to be involved in microfinance. Of the nine countries included in this study, only Indonesia and the Philippines have a permissive policy environment for the establishment of small banks. In these two countries, there is considerable microfinance activity by small banks operating at the local level. In the other seven countries, there is much less scope to establish small banks. In Bangladesh, Malaysia, Pakistan and Thailand there is no network of small regulated banks. In India and Sri Lanka there is a network of regional rural development banks which are involved in microfinance to some extent, but they are essentially controlled by the government and in most cases their performance has been poor. In Nepal the government has recently established regional rural development banks with a specific microfinance mandate, but they are subject to increasing political pressure.

If regulated banks are to play an active role in microfinance, it is important that there be some mechanism to enable small banks to be licensed. Governments should ensure that the minimum capital requirements for establishing a bank are realistic for small banks operating at the local level, and that there are no other restrictions affecting the establishment of small banks.

Four of the countries included in the study impose interest rate ceilings on small loans by banks. Such ceilings may prevent banks from lending directly to the poor. Microfinance is an inherently costly activity, and if it is to be sustainable, interest rates on microloans must be higher than on other loans. Interest rate ceilings on small loans should be removed, or at the very least set at levels that are sufficient to enable banks to operate microfinance programs sustainably.

High reserve requirements may also discourage banks from becoming involved in microfinance. For the countries in the study, however, reserve requirements appear to be set primarily on prudential rather than macroeconomic grounds, and do not appear to constitute a barrier to microfinance. While microfinance may give rise to liquidity risk, it is not clear that small banks should face higher statutory liquidity requirements than large banks.

The Basle Accord recommends that banks should maintain a capital adequacy ratio of at least 8 per cent of risk-weighted assets. However, required capital adequacy ratios should be higher for small microfinance banks than for standard commercial banks, reflecting higher risk and other factors. Some commentators have suggested capital adequacy ratios of 20 per cent or higher, at least initially, while others have suggested more modest figures such as 12 per cent.

Microfinance banks should provision their overdue loans, based on time overdue, more aggressively than conventional banks because of the greater volatility of delinquency. On the other hand, provisioning requirements must take account of the fact that microfinance loans are generally unsecured. Regulators should be flexible in accepting additional indicators of asset quality, such as historical performance of portfolios, statistical sampling of arrears, and adequacy of management information systems in their evaluation of risk.

There are a number of other prudential standards sometimes applied to commercial banks that may not be appropriate for microfinance banks. These include reporting requirements, limits on unsecured loans, requirements concerning loan documentation, supervision methods, and branching restrictions. While the study did not identify any specific impediments in these areas, regulators should review their policies and remove any unnecessary restrictions facing microfinance banks.