Micro lending through microfinance institutions (MFIs) has become a popular vehicle for financing the poor. However, the dangers linked with unbridled growth and expansion of microfinance in developing countries including Bangladesh has propelled financial regulators to contemplate framing policies for this sector, or to include it under the framework of regulated financial institutions. Despite this, questions remain as to whether regulation is helpful or harmful in promoting microlending and what should be the appropriate time for such regulation.

Experts in the field observe that the regulatory environment for microfinance institutions (MFIs) is 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, to encourage MFIs to meet certain minimum performance and reporting standards and to improve their performance over time it is appropriate to have some kind of framework (Berenbach and Churchill, 1997).

The experience of countries dealing with microfinance has shown that in order to achieve sustainability, the better-performing MFIs adapted their operating methods to serve their target markets more effectively. This led to the development of innovative delivery methods and an extension of the financial services market, and MFIs appeared as a window of hope for finance to the collateral-less poor. Most MFIs began as NGOs with social objectives rather than profit making and this gave them the scope of continuing operations unregulated as long as they delivered social benefits. Since the MFIs generally did not resort to deposit-taking like conventional banking, they looked towards donor funds as a source of finance. But the rapid growth in their size as well as clientele coupled with the absence of regulation exposed these institutions to certain risks including market risk, and thus they became a focal point for regulation. The issue therefore, was: i) what is the appropriate rationale for regulating financial institutions, and ii) are existing regulation processes sufficient to regulate MFIs? These are addressed below.

Kinds of regulation

Firstly, financial regulation and supervision is intended to serve macroeconomic goals by ensuring the solvency and financial soundness of financial institutions in an economy. A primary objective of regulation is to provide the client (in particular those making deposits) protection against excessive risks that may arise from failure, fraud, or opportunistic behaviour on the part of the institution providing financial services. Objectives of long run sustainability as well as profit-making objectives can lure financial intermediaries into investing in excessively risky loans at high interest rates, thereby putting deposits at risk. This is so because if the risky loans turn out well the owners of the financial institution benefit and take the profits, but in case of loss from those loans the institution simply goes bankrupt and the owners are able to walk away from the losses due to their having a limited exposure to the potential losses. This is referred to as moral hazard. It arises when a person holding an asset belonging to another person is tempted into risking the value of that asset because he does not bear the full consequence of any loss. In the case of MFIs, particularly those where neither the Executive Committees nor the Board of Directors have any substantial investment in the institution, there is a clear moral hazard. The risk to the depositor's savings is greater when they do not have access to the withdrawal of those savings when they perceive that they are at risk.

Secondly, regulation can be prudential or non-prudential. Regulation is "prudential" when it is aimed specifically at protecting the financial system as a whole as well as protecting the safety of deposits in individual institutions. When a deposit-taking institution becomes insolvent, it cannot repay its depositors. If it is a large institution, its failure can undermine confidence so much so that there is a run on deposits. Therefore, prudential regulation involves the government authority - generally, the central bank - in attempting to protect the financial soundness of the regulated institutions. "Non-prudential" rules, on the other hand, encompass regulations about the institution's business operations, and as such do not have the ultimate aim of protecting the entire financial system. For instance, the concern may be only to keep persons with bad records from owning or controlling MFIs. In such cases, the central bank does not have to take on the task of monitoring the financial soundness of MFIs. Registration and disclosure of the individuals owning and/or controlling any MFI, and devising a 'fit and proper' screening for such individuals may be sufficient.

Principles for regulation of MFIs

Accepting the fact that regulation is necessary to improve the performance of MFIs and encouraging formation of new ones, the logical common question that crops up is: on what principles should such regulation be based? The Consultative Group to Assist the Poorest (CGAP), a conglomeration of 29 donor agencies that support microfinance, elaborated some guiding principles for microfinance. CGAP (2002) suggests use of non-prudential regulation to address issues such as granting permission to operate MFIs, protection of consumers, prevention of fraud and financial crimes, policies with respect to interest rates, management and sources of capital. For instance, such regulation can be used to deal with consumer protection issues such as i) the indebtedness trap - giving rise to loan defaults through granting of loans without properly evaluating the loanee's repayment capability and ii) exploitation through charging excessively high interest rates. Use of prudential supervision, on the other hand, should be based on major factors such as sources of funding and cost-benefit analysis. If the MFI is funded from donor grants, it does not call for prudential regulation. Again, many MFIs require cash deposit of a relatively small amount from borrowers before sanctioning a loan, which can be looked as a form of collateral. In such cases the borrowers owe much less to the MFI than the MFI owes them. If the MFI goes bankrupt, the borrowers can protect themselves simply by stopping repayment. However, if members' share deposits and savings is the main source of funds for the microlending that is provided by financial cooperatives, and if the financial cooperative becomes large enough to endanger the financial system, then prudential supervision of some form may be necessary.

Other regulatory controls for MFIs

In some countries, MFIs face additional regulatory controls that are not of a prudential nature. For instance, in Bangladesh all NGOs that receive foreign donations are required to be registered with the NGO Affairs Bureau and give details of foreign donations. They are required to seek approval each time they receive a foreign donation, and provide detailed budget of how the funds are to be used. This information is also passed on to relevant ministries. Through this process, the NGO Affairs Bureau and the relevant ministries have sufficient powers to regulate the activities of MFIs.

In India, all NGOs receiving grants from foreign sources are required to register with the Ministry of Home Affairs and report on a regular basis. However, if the entire amount of a grant is not 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, approval from the Ministry of Finance is needed before any loan can be received from foreign sources. In Malaysia and Thailand, it is quite difficult for an MFI to meet the legal requirements to establish a microfinance program. Under the Malaysian law, only specified institutions such as banks, cooperative societies and licensed moneylenders are permitted to lend money on consideration that a larger sum will be eventually repaid to the clients. 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. In Nepal, the central bank has granted limited banking authority to a number of MFIs. MFIs that have not been granted limited banking authority are not subject to any regulation by the central bank. The degree of regulation for licensed non-bank MFIs is much lower than it is for banks.

Setting up separate regulatory body

Regulation and supervision of MFIs is an expensive affair because of the widespread location of these institutions in remote corners of the country, small asset base and the shortage of expertise in the regulating authority in handling microfinance issues. Due to these considerations, some countries such as Bangladesh and the Philippines have been debating for a long time whether to establish a separate registration process for MFIs. A prime beneficial effect of establishing a regulatory framework that specifically caters for the needs of MFIs is that it could ensure that all MFIs in the country face the same requirements. Since MFIs operate as NGOs on a small scale which does not affect the country's financial system, it is quite easy for them (NGOs) to obtain registration in most countries under the general provisions applying to NGOs and cooperatives. The only exceptions to this appear to be Malaysia and Thailand. The relatively lax attitude can give the opportunity to unscrupulous operators to come in and take advantage of clients. In Bangladesh for instance, examples of fraud by MFIs is not uncommon. 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 the unstructured regime has led to some problems, with some NGOs reportedly engaging in activities of a controversial nature. While such cases are not all that widespread, they have affected a number of poor clients, who have lost their money. Moreover, such fraud has the potential for undermining the confidence of borrowers in the vast majority of MFIs that are operating legitimately. Prevention of such abuses provides the justification for tightening up the regulatory framework and monitoring their activities.

On the other hand, in some cases MFIs are subject to unnecessary and burdensome rules and regulations, and the logic behind such rules is not always transparent. This happens most often in the case of cooperative societies, especially in South Asia.

MFI Regulation in Bangladesh

Microfinance is looked upon as a poverty alleviation tool in rural Bangladesh, which is one reason for the relaxed attitude towards monitoring MFI activities. Until recently, NGO-MFIs as financial institutions remained outside any formal supervisory or monitoring system. Grameen Bank is the only formal financial institution established in 1983 under a special law. An important part of the environment in Bangladesh is the Palli Karma Sahayak Foundation (PKSF), the government-sponsored apex institution created in 1990 to on-lend funds from government and international agencies on highly concessional terms to NGOs engaged in microfinance. PKSF plays a quasi-regulatory role in holding NGO-MFIs to certain performance criteria as a condition for its credits.

The phenomenal growth of this sector in Bangladesh after 1990 in terms of outreach pointed to the need for a set of guidelines and rules for MFIs if the targeted objectives of poverty alleviation were to be met. Initially, a Microfinance Research and Reference Unit (MRRU) was set up in 2000 at Bangladesh Bank, which prepared a set of guidelines which were implemented by the Unit. Subsequently, on the basis of the suggestions of the MMRU, the Microcredit Regulatory Act, 2006, was passed under which a separate regulatory authority for microcredit, Microcredit Regulatory Authority headed by the Bangladesh Bank's Governor was established. The law made it mandatory for MFIs to obtain license for carrying out microfinance operations. The MRA has been empowered to chalk out guidelines relating to microcredit operations, internal and external audit of accounts, collection of deposits and use of earned profit, among others. The MRRU has been changed into a Secretariat of the MRA.

Internal Control for MFIs

Many MFIs apply a system of internal control, which is a set of integrated methods and procedures translated into regular and periodic activities that preserves safety of asset (e.g. loan portfolio, cash and other physical assets etc), improves client service, ensures reliability of financial information and staff adherence to management policies and guidelines. Internal control, through detection of errors and irregularities, is more likely to ensure accountability and prevent occurrence of errors and irregularities (P.Mahmud, Dy. Managing Director, PKSF). Management must ensure that a proper internal control structure is instituted, reviewed, and updated to keep it effective. According to Mahmud, there are five basic steps in the design of an internal control system: i) describing the objective of the internal control system by using the performance standards benchmark; ii) including a flow chart of operations, organizational structure and procedures; iii) identifying tasks that need crosschecks or verifications to prevent error or fraud; iv) creating an annual work plan delegating assignments among staff and v) maintaining detailed control documents that are cross-checked by an assigned person or team.

Benefits and costs of regulation

Regulation of MFIs is not an unmixed blessing. Supervision of MFIs is usually more expensive than supervision of commercial banks due to factors such as MFIs' generally smaller asset base, larger number of accounts and decentralized operations. Moreover, most central banks do not have a unit responsible for microfinance or do not have sound knowledge and understanding of the requirements of MFIs. It is also argued that the existing system of regulation and supervision used by the authorities would likely stifle MFIs and discourage innovation at the base level. Experience of some countries shows that the absence of a regulatory framework has allowed some MFIs to develop cost-effective and innovative methods for reaching poor clients on a sustainable basis.

In Ethiopia all MFIs must be 100% Ethiopian-owned and obtain a license from the National Bank of Ethiopia (NBE). Licensed MFIs can accept savings, demand, and time deposits and manage funds for the purpose of on-lending them to peasant farmers and microentrepreneurs. Only licensed MFIs may accept concessional credits or assistance from foreign organizations. It has been observed that since the passing of the law in 1996, the framework has been generally helpful, but has also created some problems threatening sustainability of the market. It is alleged that the ceilings on loan size and term are apparently maladapted to many farmers' needs although there is demand for bigger and longer term credits; thus farmers' needs are not met. The prohibition of foreign ownership and ministerial control on donor funding appear to have deterred involvement in the sector by foreign donors and international NGOs (Shiferaw and Amha, 2001).

In the Philippines, rural banks must be wholly owned by Filipino individuals or entities, a requirement (as in the case of Ethiopian MFIs) that appears to have no economic rationale. One recent analysis (Gomez et al 2000) suggests that, while the rules applicable to rural banks in the Philippines allow microfinance, prudential supervision practices in fact discourage it. The central bank (BSP) has in practice set a ceiling of 30% on unsecured loans, and supervisors do not recognize microfinance mechanisms (such as group guarantees) as valid security. The constraints imposed by the regulatory regime, has slowed down MFI operations, and the arrears rate for rural banks rose from 14% in 1996 to 19.8% by 1999. (Gomez et al 2000).

Again, since prudential regulation is concerned with depositors' safety it may not be appropriate for credit-only MFIs that fund themselves from donors or commercial loans. Such MFIs may require relatively light non-prudential regulation. Some researchers suggest that some deposit-taking organizations also may be exempted from such regulation, such as community-based organizations that mobilize deposits only from members and in which members have direct personal control and knowledge of operations, or organizations that mobilize only mandatory deposits to secure loan repayment. Also, such community-based deposit-taking organizations are so small or remote that effective prudential supervision would be too expensive.

From the above it can be concluded that for regulation and supervision to be effective in providing an enabling environment for MFIs and yet not hinder their operations, it is important to consider the nature of the regulation as well as the timeliness of such intervention. Since prudential regulation is concerned with depositors' safety it may not be appropriate for credit-only MFIs that fund themselves from donors or commercial loans. Such MFIs may require relatively light non-prudential regulation. The maturity period of an MFI is a factor that merits reckoning. New MFI entrants and NGOs that plan to expand their service area and client base might well be subjected to relaxed entry standards under provisional registration. At a later stage in the life of an MFI, expanded services and client bases would justify stricter rules. MFIs requiring members to make a deposit to get a loan should generally be free from prudential regulation and supervision. Such deposits are simply a part of the contract to get a loan, and most often the clients are net debtors to the MFI. Staff involved in MFI regulation should have professional understanding and experience in microfinance. Finally, MFIs that do not meet basic operational standards are not likely to reach large numbers of poor clients on a sustainable basis. The task is therefore to find cost-effective ways of improving the standards of MFIs operations while at the same time avoiding restrictions that impair their efficiency or effectiveness and meanwhile encouraging them to be innovative.

Md. Ghulam Murtaza, former General Manager of Research, Bangladesh Bank, is a freelance consultant.