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Research Paper Series: LKYSPP10-003
Regulating Microfinance: A Suggested Framework*
Savita Shankar
Research Scholar
Lee Kuan Yew School of Public Policy
Savita.Shankar@nus.edu.sg
&
Professor Mukul G. Asher
Lee Kuan Yew School of Public Policy
National University of Singapore
469C Bukit Timah Road
Singapore 259772
sppasher@nus.edu.sg
2 January 2010
* Published in Economic & Political Weekly, Vol. 45 No. 1
Electronic copy available at: http://ssrn.com/abstract=1607704
comm en tary
Economi c & Politic al Weekly EPW january 2, 2010 vol xlv no 1 15
to more than the emissions reduction
from the voluntary commitments of the
developed nations.
Divisions in Developing World
But a significant weakness of the position
of the BASIC fou r (B raz il, South A fric a, I n-
dia and China) at Copenhagen is that
from the point of view of the small devel-
oping nations at the forefront of climate
change as well as the small island nations
the question of who bears the brunt of
emissions cuts may seem moot, especially
since global warming threatens their very
existence. At the summit, the developed
countries led by the United States suc-
ceeded in driving a wedge between the
major developing economies and the rest
of the G-77, counterposing the develop-
ment needs of a major part of the world’s
population with the vulnerability of the
small nations at the forefront of global
warming impacts.
While fighting for their justified share
of carbon space, it is clear that the major
developing economies need to acknowl-
edge that they have greater responsibili-
ties as distinct from the rest of G-77 to
avoid being trapped by the developed
countries. At the same time, any attempt
by the smaller developing nations to capi-
talise on this division between the devel-
oped nations and the major developing
nations, would legitimise the current tac-
tics of the global North that undermines
the very global environmental gover-
nance that is critical to their ability to face
up to the climate crisis. But both sections
collectively need to evolve an arrange-
ment that guarantees a relatively fair
share of the global carbon space within a
reasonably tight carbon budge.
Savita Shankar (savita.shankar@nus.edu.sg) is a
research scholar at the Lee Kuan Yew School of
Public Policy, National University of Singapore
and Mu kul G Asher (sppasher@nus.edu.sg)
teaches at the Lee Kuan Yew School
of Public Policy.
Regulating Microfinance:
A Suggested Framework
Savita Shanka r, Mukul G Asher
It is time to address regulatory
issues to enable the microfinance
sector to contribute more
effectively to the goal of financial
inclusion, and to provide an
environment in which all
stakeholders can participate
with confidence.
India with a population of around 300
million poor people has emerged as a
large potential market for the micro-
finance sector, which is attracting funding
from various sources. To enable the coun-
try to leverage this interest and use it to
progress towards the goal of financial in-
clusion, it is important to develop a regu-
latory structure for the sector, for a
number of reasons. First, regulation is
needed to enable microfinance institu-
tions (MFIs) to offer savings services, the
lack of which is a major shortcoming of
the sector. Second, with the entry of
c ommercially-oriented participants, the
need for supervision and consumer
protection is even more pressing. Third,
with MFIs broadening their range of serv-
ices to include services such as insurance
and pension products, coordinated regu-
lation of the sector is required. Finally,
given the diversity of legal forms of MFIs,
a uniform regulatory framework would
enable a l evel playing field and prevent
regulatory arbitrage.
Challenges of Regulation
The lending models used in microfinance
ha ve pec ulia riti es a nd hen ce its reg ula tion
poses cer tain unique c hal le nges.
First, MFIs may not pose systemic chal-
lenges in the sense that it is unlikely that
even the largest MFIs are “too big to fail”.
They however deal with low-income
gro ups leas t l ike ly to be ab le t o be ar dow n-
side risks. Hence in a democratic country,
politically MFIs may be “too sensitive to
fail ”. The implicit conti ngent li abil it ie s a re
on the State, making their effective regu-
lation in the interest of the government.
Second, while banks usually have to
make full provisions for loans without col-
lateral, such a measure is not possible in the
case of MFIs, as most of their loans are col-
lateral free. On-time repayments on micro-
finance loans, however, tend to be high,
though experience shows that once a loan is
overdue, the ultimate collection of the loan
is less likely, than in the case of loans that
are backed by collateral (Rosenberg 2008).
As a result, provisioning a lready delinquent
loans needs to be more aggressive for mi-
crocredit loans as compared to other loans.
Third, while bank failures may be con-
tagious due to the interdependent nature
of the payments system, the interdepend-
encies between group members in micro-
finan ce can lead t o a di fferent k ind of con-
tagion effect. Widespread defaults can
o ccur either if some members start con-
sistently defaulting or if there are rumours
of MFI failures. A n important ince ntive for
repayment of collateral free MFI loans is
the ability to obtain larger loans in the
f uture. Any event which makes the possi-
bility of future loans reduce considerably,
has the potential to trigger widespread
d efaults. A regulator of MFIs therefore has
to b e h ighl y s ensitive to these re alities.
Fourth, MFI customers are often first
t im e u se r s o f fi na nc i al se r vi ce s a n d us ua l l y
have low education. The responsibility on
Electronic copy available at: http://ssrn.com/abstract=1607704
comm en tary
january 2, 2010 vol xlv no 1 EPW Econo mic & Polit ical Weekly
16
the MFI to offer the right products which
suit their members’ needs as well as pro-
vide adequate financial education and
training to them is considerable. Regula-
tion needs to necessarily oversee this im-
portant element of MFI operations.
Fifth , m erely formulati ng regu lation re -
garding codes of conduct for MFIs an d pr o-
viding channels for dispute resolution re-
garding MFI practices is not sufficient.
Moreover, the channels need to be easily
accessible and MFI customers need to be
made aware of them.
Sixth, the cost that MFIs would incur in
complying with regulation needs to be
considered, as it may have an impact on
thei r lendi ng rates.
Regulation of any financial institution,
including an MFI, nee ds to enc ompass pru-
dential and non-prudential issues. The
first relates to issues regarding solvency of
the institution, important to maintain
confidence in the financial system and
protect depositors. The second includes all
other matters such as guidelines on
i nterest rates, truth-in-lending laws and
anti money laundering r ules .
The Consultative Group to Assist the
Poor’s (CGAP)1 guidelines on microfinance
regulation favour a clear distinction be-
t wee n t he s upe rv is ion of d epo sit or y (d ep osi t
accepting) and non-depository MFIs, as
the former require closer monitoring.
Housing the supervision of non-depository
MFIs separately helps avoid confusion
r egarding which MFIs are being monitored
closely. The guidelines suggest that
d eposit-taking MFIs should be supervised
by the authority which supervises com-
mercial banks, so as to leverage existing
supervis ory sk ills a nd re duce incentive for
regulatory arbitrage. The supervisory staff
needs however to be trained in the partic-
ular portfolio characteristics of MFIs.
Prudential Issues
These include minimum capital limits,
capital adequacy requirements and loan
loss provisions. A minimum capital limit is
usually set which is often used as a
r ationing device in order to keep the
number of MFIs to be supervised within
manageable limits (Rosenberg 2008).
Capital ade quacy requirements are based
on the premise that capital acts as a cush-
ion against p ossible losses for depositors
and creditors. Similarly, loan loss provi-
sions are required so as to build reserves
to p rovide for future losses. The peculiari-
ties of MFI portfolios discussed earlier
need to be t aken into account while set-
ting these requirements.
Non-Prudential Issues
Regulation encouraging transparent dis-
closure of interest rates, offering appro-
priate financial products, fair selling practi-
ces and met hods for collec ting lo ans come
under non-prudential regulation of MFIs.
Often interest rate caps are also sug-
gested as interest rates in microfinance
are observed to be higher than in the case
Call for Papers
International Conference on
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During March 19-20, 2010)
With the opening up of the nancial sector in India, new challenges have emerged for nancial market participants,
regulators as well as investors. In this dynamic environment of complex nancial products, increased market
competition, and progressive de-regulation, there is a need for all players in the nancial sector to develop
internal mechanisms for risk management, macroeconomic forecasting, corporate governance and related issues.
Quantitative methods such as time series analysis and forecasting, VaR, structural modeling, and simulation
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a common platform academic experts, as well as senior executives in the nancial sector to deliberate on a
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The Conference invites contributions from researchers, academicians, professionals and policymakers in
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submissions shall be peer reviewed. Selected papers would be invited for presentation. The Conference venue
is IBS campus, Hyderabad. The last date for submission of abstracts and full papers respectively are 20th
January, and 20th February, 2010. Abstracts and papers may be sent to Dr S Venkata Seshaiah, Organizing
Secretary, and Dean — Research, IBS Hyderabad, Survey No 156/157, Dontanpally Village,
Shankar pall i Mandal, RR Distri ct, Hyderabad- 501 504, Mo b. 99483 94557. You may send the paper
to ibs.igidr@gmail.com or venkatas@ibsindia.org. Further details about the conference may be seen
from www.ibshyderabad.org/ICQMBFI.
comm en tary
Economi c & Politic al Weekly EPW january 2, 2010 vol xlv no 1 17
of most other loans. Transaction costs aris-
ing from doorstep delivery of the loan,
when computed as a percentage of the
small loan size do contribute to the high
rates charged. Capping the interest rate
can lead to undesirable outcomes such as
exclusion of needy customers whose pro-
files call for interest rates in excess of the
cap. Moreover, a uniform interest rate cap
could create incentives for MFIs to stay
away from difficult and new geographies,
where transaction costs are higher. Deter-
mining and enforcing appropriate interest
rate caps could also be difficult as finan-
cial products are inherently complex.
There is a possibility that MFIs may be
e ncouraged to repackage loan contracts
by varying repayment schedules, fees and
other aspects such that effective interest
rates remai n the sa me .
One of the most important non-pruden-
tial issues is transparent disclosure of in-
terest rates. Often, interest rates charged
by MFIs involve upfront fees and service
charges, making calculation of effective
interest rates complex. Moreover, some-
times rates are calculated on a flat basis
and not on a diminishing balance basis.
Such practices are also observed in India.
A study by Porteous (2006) of mature
m icrofinance markets highlighted the im-
portance of requiring MFIs to quote inter-
est rates in a uniform manner in contrib-
uting to reduction of rates over time. Non-
prudential microfinance regulation in
I ndia need s to addre ss thi s i ssue.
Proposed Model for Regulation
It is on ly recen tly that most countries h ave
started seriously addressing microfinance
reg ulation. Hence , t he possibi lity of lear n-
ing f rom t he ex perience of ot her cou nt ries
is limited.
The policy with regard to microfinance
in India has been largely positive and de-
velopmental and at the same t ime marked
by caution and prudence. While the policy
has brought the sector to its current state
of development, in order to enable the
s ector to grow further in an orderly man-
ner, certain major policy initiatives need
to b e t aken .
The most important missing link in the
countr y’s financ ia l inclusion efforts i s that
of adequate saving channels for the poor.
While commercial banks, regional rural
banks and post offices, have good geo-
graphical networks, they are often unable
to provide the doorstep collection of small
deposits on a reg ular, frequent basis as re-
quired by the low income groups. These
groups are usually unable to visit formal
financial institutions during specified
working hours without incurring consid-
erable transaction costs in terms of time
and money. MFI operations on the other
hand a re ta ilored to more effect ively meet
their requirements and hence they should
be permitted to provide savings services.
While the “business correspondent” m odel
attempts to increases savings avenues for
the poor, large MFIs which have the scale
required to provide these services in an
economic manner, have not been ade-
quate ly ince ntiv ised to participate in it.
The other important missing link in the
country is that of affordable remittance
and payments services. Mobile banking
provides the greatest scope for this to take
place. In Philippines, a typical transaction
through a bank branch which costs $2.50 is
estimated to cost only $0.50 when auto-
mated using a mobile phone (Asian Banker
2007). In Kenya, the success of M-PESA, the
mobile money scheme launched by
S afaricom, its largest mobile operator has
nearly 7 million users out of a total popula-
tion of 38 million (The Economist 200 9).
The benefits for customers include quicker
and cheaper transfer of money and a
means to save small a moun ts of money for
emerge ncie s. The huge cu stomer ba se an d
p owerful brand of the mobile company
enabled outreach to unbanked segments
of the population. As regulators in many
countries do not permit non-bank entities
to offer banking services, other models
have developed. For example, in Uganda,
a leading mobile company has partnered
with a bank to offer a similar service
(The Economist 2009).
It is proposed that to address these two
missing links, some of the large MFIs
should be selectively permitted to be
c onverted to a special category of MFI
banks with lower initial capital require-
ments. These MFI banks should be permi-
tted to offer savings as well as mobile
p ayment services.
Given the large geographic area of the
country, licences to collect deposits need
to be provided selectively to entities, so as
to enable effective regulation. Regulators
should assess an MFI thoroughly based on
financial, management and operational
criteria. These entities should also have
the capability to increase outreach sub-
stantia lly a nd re ap economies of sc ale a nd
scope, with the potential to lower costs of
microfinance services. Large MFIs who
have a satisfactory track record are possi-
ble likely candidates. After a licence is pro-
vided, continued supervision and moni-
tor ing of t he se entities is c alled for.
It m ay be de sirable to ex tend de posit i n-
surance to MFI bank depositors, though it
may also create moral hazard issues. In
any case, the contingent liability of the
savings collected is likely to be on the
State given India’s political economy char-
acteristics, making their regulation im-
portant for the government.
Permitting MFI banks to partner with
mobile companies to offer mobile bank-
ing ser vices has the potential to enable
access to remittance services to a large
number of unbanked customers. While
the banks have a relationship with these
customers and are best placed to service
them, the mobile companies have the
technology and expertise required. Such
collaborations can bring down transaction
costs considerably.
The creation of MFI banks amounts to
allowing entry to private well-governed
deposit-taking small banks as recom-
mended by the Raghuram Rajan Commit-
tee on Financial Sector Reforms (2008).
As suggested by the committee, these
bank s will be in closer touch with custom-
ers and will provide tailor made products
and ser vices to t hem.
As small banks tend to be geographi-
cally focused, the Rajan Committee sug-
gests offsetting their higher risk by im-
posing on them more stringent regula-
tions. Higher capital adequacy norms,
stricter prohibition on related party
transactions and lower allowable single
party transactions have been suggested.
While the last of the three may not be
applicable in the case of MFIs which
usually have large number of small
borrowers, the first two suggestions
should be considered in deve loping
regulatory norms for MFI banks. As
recommended by the com mittee, the
s upervisory capacity should be developed
comm en tary
january 2, 2010 vol xlv no 1 EPW Econo mic & Polit ical Weekly
18
to deliver the greater monitoring these
n ewer banks will require.
The Reserve Bank of India (RBI) would
be an appropriate choice for prudential
regulation of MFI b ank s, as i t is th e reg ula -
to r for b an ks i n Ind ia. T hi s ma y st retc h the
regulatory capacity of RBI but would
n evertheless be a worthwhile investment
for the country as in the long run it could
result in large-scale financial inclusion
and financial deepening. Training a team
of officials at RBI on various microfinance
models and the peculiarities of microfi-
nance regulation as well as the intricacies
of prudential regulation will be required.
The non-prudential regulation of MFIs
may b e c arr ied out by an i ndep ende nt reg-
ulator in the nature of an oversight board
(OB) reporting to the RBI, so as to not to
overstretch the regulatory capacity of RBI.
The board should be broad-based in
n ature consisting of representatives from
government, banks, MFIs, SHG federations,
Sa-Dhan, NGOs and consumer forums.
MFIs of all legal forms should be required
to register themselves with this regulator
and adhere to the uniform code of conduct
prescribed. The code should cover truth in
lending, transparency with regard to
charges, financial education, selling appro-
priate financial products, practices for
monitoring and collection as well as norms
for provisioning of loans.Channels for cus-
tomer complaints and dispute resolution
should also be provided and creative com-
munication should be used to explain their
availability to SHG and MFI members.
The OB should coordinate with other
financial sector regulators, for instance,
with IRDA and PFRDA, with regard to in-
surance and pension services. The mem-
bers of the OB should have the requisite
expertise as a group and access to public
and private sector experts. This can be ac-
complished through appropriate advisory
committees. The above recommendations
effectively amount to having two regula-
tors. For prudential supervision of MFI
banks, regulation by RBI is proposed. For
non-prudential supervision for the sector
as a whole, an independent OB reporting
to the RBI is suggested.
The creation of regulatory capacity for
prudential and non-prudential regula-
tion of the Indian microfinance sector
will be a major challenge, but is likely
to be a worthwhile investment for the
c ountry as in the long run, it could result
in large-scale fi nan cial inclusion and
fi nancial deepening.
Note
1 T he Consultative Group to Assist the Poor is an
internationa l consortium of public and private
d evelopment agencies.
References
Asian Banker (2007): “Upwardly Mobile”, Asian
B a n k e r , 1 3 Aug ust.
CGAP (2002): “Microfinance Consensus Guidelines
Viewed on 31 March 2009” (http://www2.cgap.
org/gm/document. 9.2787/Guideline_RegSup.pdf).
Porteous , D (2006): Competition and Microcredit
I nterest Rate s, Viewed on 18 September 2009
(htt p://www.cgap.org /).
Rajan, R (2008): A Hundr ed Small Step s, Dra ft Report
of the Committee on Financia l Sector Reforms
Viewed on 31 March 2009 (http://planning com-
mission.nic.i n/reports/genrep/report _fr.htm).
Rosenberg, R (2008): “How Should Governments
Regulate Microfinance?” in S Sundaresa n (ed.),
Microfinance Emerging Trends and Challenges
(Cor nwa ll: M PG Bo oks), p p 85-1 07.
The Economist (2009): “The Powe r of Mobile Money”,
Economist, 2 6 Sept embe r.
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