Conceptual Framework for the Regulation of Rural Finance and Microfinance Institutions

The aim of a supportive regulatory framework is to build strong regulated and unregu­lated institutions of all types (a) to provide services on a sustainable basis under uniform, common, shared performance standards and (b) to encourage the regulatory authority to develop appropriate prudential regulations and staff capacity that are tailored to the institutions’ operational and risk profiles. This objective requires defining different tiers of financial institutions with different degrees of regulatory requirements. The requirements could vary from (a) simply registering as legal entities, to (b) preparing and publishing
periodic reports on operations and financial results, to (c) observing non-prudential rules of conduct in business operations, to (d) securing a proper license and being subject to prudential regulation by a regulatory authority, prudential supervision, or both by a cen­tral supervisory authority. Lower-tiers institutions serving the lower end of the market can enable non-bank microlenders to seek greater formalization without actual licensing.

image053As the rural finance and microfinance sector grows, adding a licensing tier that per­mits MFIs to legally mobilize savings and other commercial sources of funds can encourage capacity building and innovation that are aimed at self-sufficiency and greater outreach. Another approach that has been used is to open a special window for micro-lending as a product that enables commercial banks, as well as alternative specialized institutions, to benefit from different cost and regulatory structures. Licensing of rural and community banks can also facilitate the emergence of new types of MFIs that serve specific markets. However, the premature creation of special tiers with easy entry may result in weak insti­tutions, may affect the development of the commercial financial system, and may risk overwhelming inadequate supervisory resources.4

Thus, the licensing of MFIs should be designed to balance promotional and pruden­tial objectives. The main potential threats pertaining to deposit-taking MFIs are that (a) deposit-taking MFIs could collapse, thus adversely affecting the commercial system, and that (b) prudential regulation of deposit-taking MFIs could prove to be an administrative burden that distracts supervisors from adequately protecting the safety and soundness of the main financial system. The Consultative Group to Assist the Poorest (CGAP) Microfinance Consensus Guidelines (Christen, Lyman, and Rosenberg 2003) takes a bal­anced view, arguing that deposit taking on a small scale may essentially go unsuper – vised—especially where the deposits consist of only forced-savings components of the lending product, so that most depositors are net borrowers from the MFI at most times. This approach would leave the supervisory apparatus unencumbered from having to deal in-depth with a profusion of tiny MFIs.

A consensus on the framework for the regulation of rural finance and microfinance institutions has evolved on the basis of country experiences in recent years. This frame­work (summarized in table 7.2) identifies different categories and tiers of institutional providers of microfinance, and it specifies the thresholds of financial intermediation activities that trigger the need for progressively stronger types of regulation and supervi­sion. The legal and regulatory framework for banking and finance in many countries may not include lower tiers for rural finance and microfinance banks. Some countries may be in the process of establishing the legal and regulatory framework specifically to create new tiers for rural finance or microfinance banks, which usually have a limited geographical coverage specified by law. Regulation of microfinance activities and institutions may take three main forms: (a) simple registration as a legal entity; (b) non-prudential regula­tions that provide standards of business operations and oversight, such as operating and financial reports to be submitted, to protect the interests of clients or members; and (c) full prudential supervision. Global experience illustrates that the benefits from regulating microfinance may be limited when commercial banking standards are applied to MFIs without adequate consideration of microfinance methodologies.

Non-bank finance companies and other types of registered institutions providing rural finance and microfinance services are not subject to statutory prudential regulation and

Type of microfinance institution (MFI)

Activities that trigger regulation

Forms of external regulation

Recommended regulatory authority

Informal savings and credit groups funded by members fees and savings

None

None required

None required

Category A: Nongovernmental organizations (NGOs) funded by donor funds

Category A1: Funding only from grants

None, if total loans do not exceed donated funds, grants, and accumulated surplus

Registration as a nonprofit society, association, or trust

A registrar of societies or self­regulating body, if any

Category A2: Funding from donor grants and from commercial borrowings or securities issues

Generating liabilities through borrowings to fund microloan portfolio and operations

Registration as a legal corporate entity; authorization by a banking authority or securities commission

A registrar of companies, banking authority, or securities agency

Category B: Financial cooperatives and credit unions funded members’ money and savings

Accepting deposits from and making loans to members

Registration as a financial cooperative

A registrar of cooperatives or banking authority

Category C: Special-licensed banks and MFIs funded by the public’s money (deposits, investor capital, and commercial borrowings)

Accepting wholesale and retail public deposits for intermediation into loans and investments

Registration as a corporate legal entity; licensing as a finance company or bank (with full prudential requirements)

A registrar of cooperatives or banking authority

Note: This regulatory framework for the classification of MFIs was originally proposed by van Greuning, Gallardo, and Randhawa (1999) and modified by Randhawa (2003). Except for informal groups, MFIs are classified into four categories that are based on the structure of their liabilities (i. e., sources of funding). Cooperatives in category B have a long but inefficient history of regulation.

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If their deposit taking is small in scale and limited to their members, they should be given low regulatory priority. Category C should not include MFIs that require mandatory savings to secure loans as long as most customers are net borrowers most of the time. Formal banks with a microfinance department are not included in this regulatory framework because they are subject to prudential supervision, even if it is usually not adapted to the specific features of this segment of the financial system.

supervision by a central supervisory authority, because they do not mobilize retail deposits from the public and intermediate those deposits into loans and investments. Nevertheless, such institutions should observe and adhere to a set of rules and standards with respect to the conduct of their business operations to provide protection for their borrowing custom­ers and for third-party providers of wholesale commercial funds, even though commercial fund providers and institutional investors are presumed to be well informed and to be capable of any required due diligence.5 An overview of desirable standards for conduct of business is provided in box 7.2.

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