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Microfinance

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Microfinance - “the provision of financial services to low-income individuals and households, as well as micro, small and medium enterprises (MSMEs), using specially designed methodologies that will ensure sustainability for the lenders, and lead to improvement in the standard of life for the consumers, while ensuring a triple bottom-line of “developing the person; positively impacting lives; and leading to economic development of the region” as it facilitates large numbers of clients with relevant financial services at affordable prices” - provides an enormous potential to support the economic activities of the low income people and thus contributes to poverty alleviation.
Widespread experiences and research have shown the importance of savings and credit facilities for the low income people and MSMEs. This puts emphasis on the sound development of MFIs as vital ingredients for investment, employment and economic growth. There is therefore, need for new, innovative, and pro-poor modes of financing low-income households and MSMEs based on sound operating principles. Implying that, an appropriate policy, legal and regulatory framework to promote viable and sustainable systems of microfinance in a country must be developed (Omino, 2005).
The existing microfinance regulation in Kenya, (Microfinance Act 2006), while putting regulation and supervision of Deposit Taking Microfinance Institutions (DTIs) under Central Bank of Kenya (CBK), has, through Section 3(2) of the Act, empowered the Minister for Finance to make regulations specifying the Non-deposit taking microfinance business and prescribe measures for the conduct of the specified business (MF Act, 2006).
Economic Rationale for Financial Regulation
Preserving Financial Sector Soundness
The core objectives of financial regulation are to preserve the stability and soundness of the financial system and to protect the deposits of the public (Llewellyn, 1999). A primary reason for regulating and supervising traditional financial institutions is consumer protection for public depositors in financial institutions. There are two main approaches to financial regulation: firstly, to impose limits or constraints on the supervisees so as to deter them from engaging in certain activities that entail excessive risk, and secondly, to provide financial firms with a set of incentives that would induce them to align their private objectives to social goals. Thus, regulation is meant to define the rules and incentives by which market participants must behave, but without constituting a barrier for the natural development of the industry. It was further stated by Stiglitz (2001, pg.16-17) that “the challenge of financial regulation is to enhance competition, openness, and innovation in the financial sector while maintaining sound prudential oversight, appropriate incentives, and needed constraints”
Ensuring Institutional Soundness
Regulation should help in setting standards that when followed to the latter, will enhance financial institutions’ soundness and thus enable their growth and sustainability, leading to economic development in the country. According to the Banana Skins report (2009, pg 28), “the concern most frequently cited by respondents is that many countries still lack specific MF Regulation, which means that MFIs are either unregulated, or forced to conform to other, mainly commercial banking regulation. This is a particular issue for deposit taking, an activity that more
MFIs want to get into. The wrong regulation can affect the viability of the business model, undermine depositor and investor confidence and expose MFIs to political interference”. Moral hazard issues sometimes arise because the interests of financial institutions vis-à-vis the interests of consumers per se are not necessarily compatible. Depositors and investors may not be in a position to judge the soundness of a financial institution (the issue of asymmetric information) much less to influence the institution’s management (Stiglizt, 2001).
In one among four studies on Microfinance Tradeoffs, conducted by Robert Cull, Asli Demirgüç-Kunt and Jonathan Morduch in September 2009, which looked at Regulation, Competition, and Financing, using an updated MIX Market dataset, they examined the effect of regulatory supervision on the profitability of microfinance institutions (Cull et al. 2009). In particular, they investigated how regulated institutions manage the financial and administrative burdens of complying with regulation, looking at profits, business orientation, outreach, and the share of employees who work in the field. They also looked for evidence that regulation provides benefits by improving loan quality. They conducted econometric analyses of the dataset described above, and of a subset, the 154 institutions that both reported detailed financial information and were subject to regulatory supervision (Cull et al. 2009). They estimated the impact of prudential regulation on profitability and financial self-sufficiency, using, for the key repressors, three dummy variables that summarize whether an institution faces prudential supervision and the intensity of that supervision.
These dummy variables measured whether; (1) an MFI faces a regular reporting requirement to a regulatory authority; (2) the MFI faces onsite supervision; and (3) onsite supervision occurs at regular intervals. They controlled for the same variables as in an earlier 2007 study on contracts and added a measure of staff concentration and Premium6. They found that onsite supervision of microfinance institutions varies, even within the same country and among profit-oriented institutions. Whether an institution faces onsite supervision depends on its ownership structure, funding sources, activities, and organizational charter. In terms of trade-offs, they found that microfinance institutions subjected to more rigorous and regular supervision are as profitable as others, despite facing higher costs of supervision (Cull et al. 2009).
Some components of the supervisory microfinance are described as follows:
Information Sharing
The existence of information asymmetries defines the special nature of the financial industry and explains its heavier regulation compared to other industries (Arun, 2005; Stiglitz, 2001). In fact, the asymmetric distribution of information among the different stakeholders (shareholders, debtors, and depositors) raises the need to counterbalance their particular interests through regulation, and especially, to protect the interests of small depositors (Vogel et al, 2000; Jansson, 1997).
The National Loans Register (NLR)
According to Rashid Ahmed8, “the NLR was developed during the time of the MFRC as a public registry intended to keep information specific to the micro-lending industry. It included information on loans - enquiries, total granted and payments. It does not house other credit bureau information such as judgments and there are no rules about what loans may or may not be made. The decision to grant loans rests with the lenders based on their risk and credit policies. The MFRC owned and took overall responsibility to ensure that the rules on making inquiries on the register were complied with, while the private sector, running credit bureaus also ran this register”.

Responsible Lending and Service Provision
Regulations help to define the legal status of institutions, outlining the allowable and prohibited activities, as well as the scope of offering those services. This helps in creating an environment of responsible lending, for lending institutions, and other services.
Consumer Protection
In stressing the importance of consumer protection in microfinance, it has been noted that financial services can help poor people transform their lives. And if not designed and implemented properly, they can, in some cases do more harm than good, especially micro credit (McKee et, al. 2010).
Interest Rate Controls
Regulation is intended to guard against exorbitant interest rates and pricing of MFI services that would exploit the poor. It is usually the case that when faced with an interest rate ceiling, companies and NGOs providing financial services to poor people will often retreat from the market, grow more slowly, and/or reduce their work in rural areas, or other, more costly market segments because they cannot cover their operating costs.
So the differential components can be rearranged in the following manner:

Risk-Based Approach for Offsite and Onsite Supervision
The microfinance regulation and supervision specialist will assist the BPNG to develop an improved risk-based supervision approach to its off and onsite supervision of MFIs, SLSs, and MPBs. This approach would continue BPNG’s capital adequacy, asset quality, management, earnings, liquidity, human resources, internal controls, and systems (CAMELHIS) approach to risk analysis. However, each institution should be provided with a risk score, and on-site supervision should focus more closely on financial institutions showing weak overall scores. Supervision by other institutions would then focus more closely on specific areas of weakness. As such, supervision would become issue-oriented rather than a standard inspection routine, with off-site supervision playing the major (but not the only) role in initial detection of risk areas.
This will allow the BPNG to closely monitor the specific risks faced by MFIs and SLSs and adapt its supervision focus and frequency accordingly. Particular attention should be given to the ability of the MFI or SLS to assess and monitor these risks itself, particularly with respect to asset quality and loan loss provision management.
The microfinance regulation and supervision specialist will provide on-the-job training for offsite supervision staff of the MFI and SLS units to ensure that
(i) An appropriate and standardized MFI supervision report format is in place;
(ii) The filing system on MFIs and SLSs is well maintained;
(iii) Each offsite supervisor makes strengths–weaknesses–opportunities–threats and trend analysis of the MFI or SLS he or she is responsible for;
(iv)Early warning signals are established and are being reported upon by the offsite supervisor if the situation of a particular MFI so requires; such signals will highlight to the onsite supervision section that the performance of a particular MFI shows worrying issues that bear particular risks for the organization and (potentially) the sector;
(v) A rating figure is given to each institution, from 1 (strong) to 5 (weak), based on an agreed set of criteria based upon the CAMEL-HIS or similar system; the rating will be based on offsite reporting and last onsite inspection;
(vi)Reports are prepared quickly following submission by the individual MFI or SLS;
(vii) Finalized offsite report data are sent to database management for updating; and
(viii) Adequate collaboration with onsite inspection is maintained to constantly improve the supervisory system.

Onsite inspections will focus on the investigation of issues highlighted in offsite supervision, and in following up problems addressed in previous on-site inspections. However, ongoing attention should also be paid to checking compliance with laws and regulations, checking data provided in offsite reports, and assessing the organizational and operational quality of MFIs and SLSs. It requires thorough preparation, organization, and planning.
The microfinance regulation and supervision specialist will review and recommend provisions where necessary to the onsite supervision procedures and ensure onsite inspectors are capable of
(i) Preparing the annual onsite inspection plan;
(ii) Organizing and preparing for individual inspections;
(iii) Chairing the inspections (or co-presiding when the unit chief takes part);
(iv)Undertaking a review of governance, management, and financial position based upon the CAMEL-HIS (or similar) approach of financial institution analysis;
(v) Preparing findings and proposing recommendations to present and discuss in a debriefing session in the MFI or SLS supervision unit;
(vi)Discussing findings and proposed recommendations with the MFI or SLS;
(vii) Finalizing the reports;
(viii) Preparing and sending an executive summary of the report to the BPNG Supervision Department; and
(ix) Submitting reports to the database (and to the individual MFI and SLS files).
The microfinance regulation and supervision specialist will assist the BPNG Supervision Department to develop offsite and onsite supervision manuals that reflect the improved supervision practices.

Challenges
The challenge supervisors’ face, which is sometimes complicated by a multitude of legal initiatives in this area, is how to accommodate or reasonably encourage microfinance within a framework of generally accepted norms and prudential standards for the financial services industry. In general, a framework that does not adequately address the features and risks of microfinance would not effectively serve these institutions or the people who depend upon them. Therefore, bank supervisors should ensure that the supervisory framework in place is such that would result in innovative, rapid and balance growth of the industry as well as consistent with accepted banking practices. The issue of savings/deposits is central to the regulation and supervision of microfinance. Supervisory authorities are supposed to ensure that the poor clients do not lose their savings in failing institutions.
A new challenge for developing an appropriate regulatory and supervisory framework for microfinance lies in the great diversity of institutions that offer microfinance services. A comprehensive framework significantly based on micro lending as an activity should, therefore, be developed and made applicable to all supervised institutions that offer this service, regardless of whether they are licensed as a bank or new institutional form created specifically for microfinance. The regulation should be defined to include standards for portfolio classification, loan documentation, loan loss provisioning and write-offs for microfinance operations.
It is instructive to note that the characteristics of microfinance clients are distinct, the credit methodology different and, in many cases the ownership structure of the institutions is not the same as that typically found in conventional financial institutions. These and other factors give rise to a unique risk profile that needs to be addressed through the regulatory framework and supervisory practices. In this regard, a risk based supervision shall be implemented which would focus mainly on (a) governance and ownership structure (b) lending methodology (c) borrower characteristics (d) appropriate management information system (e) internal control mechanisms and procedures.
A simple and rational regulatory and supervisory framework which would achieve a balanced growth, promote transparency, control risks faced by the institutions engaged in microfinance, eliminate barriers and unnecessary requirements has therefore, been developed and would be implemented for the sector.

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