"I ,"" ,' V

Should Principles of
Regulation and
Prudential
Supervision Be
Different for
Microenterprise
Finance
Organizations?

GEMINI Working Paper No. 38

GROWTH and EQUITY through MICROENTERPAISE INVESTMENTS and INSTITUTIONS

7250 Woodmont Avenue, Suite 200, Bethesda, Maryland 20814

DEVELOPMENT ALTERNATIVES, INC. e Michigan State University * ACCION International.

Management Systems International, Inc. * Opportunity International e Technoserve * World Education
 Should Principles of Regulation and

Prudential Supervision Be Different for

Microenterprise Finance Organizations?

by

Rodrigo A. Chaves

and

Claudio Gonzalez-Vega

April 1993

This work was supported by the U.S. Agency for International Development through a buy-in to the
Growth and Equity through Microenterprise Investments and Institutions (GEMINI) Project, contract
number DHR-5448-C-00-9080-00.
 i

ACKNOWLEDGMENTS

This paper was written for the Growth and Equity through Microenterprise Investments and
Institutions (GEMINI) Project of the U.S. Agency fo' International Development, under contract with
Development Alternatives, Inc. The authors are grateful for the enthusiastic initiative of and support
r,.eived from Elisabeth Rhyne and Maria Otero in the development of this effort. The opinions
expressed are those of the authors and not necessfi'ily those of the sponsoring organizations.

The authors are, respectively, a Graduate Research Associate and a Professor of Agricultural
Economics and of Economics at Ohio State Uriversity. Both have been associated with the Rural Finance
Program funded by the A.I.D. through the Financial Intermediaries Resource Management Cooperative
Agreement with Ohio State University.
 TABLE OF CONTENTS

Page

ABSTRACT v

INTRODUCTION 1

REGULATION, FINANCIAL REPRESSION,

SUPERVISION, AND INTERNAL CONTROL

1

DEPOSITORY FINANCIAL INTERMEDIARIES AND

THE RATIONALE FOR THEIR REGULATION 4

PRINCIPLES FOR THE REGULATION OF

DEPOSITORY FINANCIAL INTERMEDIARIES

9

FREQUENTLY ADOPTED INSTRUMENTS OF PRUDENTIAL REGULATION 12

PRINCIPLES FOR THE PRUDENTIAL SUPERVISION OF DEPOSITORY

FINANCIAL INTERMEDIARIES 17

THE METHODOLOGY OF SUPERVISION 19

RISKS OF FINANCIAL INTERMEDIATION 20

REGULATION OF MICROENTERPRISE FINANCE ORGANIZATIONS 21

REFERENCES 25
 V

ABSTRACT

This paper discusses general principles of financial intermediary regulation and prudential
supervision and evaluates how these issues are relevant for microenterprise finance organizations.

Regulation, financial repression, prudential regulation, financial intermediary supervision, and

internal control are defined; a clear distinction among these concepts is critical for the analysis. The
rationale for the regulation of depository financial institutions is provided next. The importance of a well­
functioning payments system is not a sufficient reason for government regulation of financial markets.
Opportunistic behavior on the part of depository institutions that results in excessive risks and instability,
asymmetric information and moral hazard, and associated negative externalities is at the core of the
rationale for regulation. Consumer protection issues in the presence of market failure and conditions for
the successful enforcement of financial contracts are emphasized.

Regulation is desirable because, in financial markets, preventive action is more cost-effective than
remedial interventions. There are no standardized rules for optimum regulation. The authors propose
seven regulatory commandments, including competitive neutrality, minimum cost, specific objectives,
incentive compatibility, and flexibility. Recognition of idiosyncratic risks is critical. Among frequently
adopted instniments of prudential regulation are the role of lender of last resort, deposit insurance,
licensing, capital adequacy requirements, prohibition of loans to insiders, diversification rules, admissible
activities, and enforcement powers. Preventive regulation is distinguished from protective regulation.
Five supervision commandments are also proposed,

Off-site and on-site methodologies for supervision are evaluated. Typical risks (for example,
credit, interest rate, liquidity, and fraud) are described. Unique risks such as subsidy dependence and
donor intrusion are added to traditional risks. Difficulties of generalization for microenterprise finance
organizations are discussed.
 INTRODUCTION

This paper discusses general principles of financial intermediary regulation and prudential
supervision and evaluates how these issues are relevant for microenterprise finance organizations. It
presents the state of the art as captured by the literature on regulation and supervision of depository
institutions, it interprets and further develops the necessary conceptual framework, and translates it for
microenterprise finance agencies.

Some definitions are provided first, followed by a discussion of the rationale for the regulation
and supervision of deposit-taking organizations. Generally accepted principles of sound regulation and
supervision are examined next. The most frequently adopted regulatory policies and instruments are
briefly described. Finally, some insights are offered about whether the differences between traditional
financial intermediaries and microenterprise finance organizations are significant enough to make it
necessary to regulate and supervise the laer in a different manner.

REGULATION, FINANCIAL REPRESSION,

SUPERVISION, AND INTERNAL CONTROL

Although the way one defines regulation usually depends on the context of the analysis, it is
useful to first consider this term in its most ample sense. From this perspective, regulation refers to a
set of enforceable rules that restrict or direct the actions of market participants, altering, as a result, the
outcomes of those actions. In this sense, regulation may be performed by the market itself, without
government intervention or participation of other external forces.

Efficient markets regulate thi actions of agents by rewarding or penalizing them when, for
example, they assume correct or inappropriate combinations of risk and expected returns or when they
acquire reputations that lead other agents to transact or not with them. In principle, an efficient market
guarantees that agents that make incorrect choices eventually go bankrupt and, as a result, have to exit
the market.

This broad perspective is useful because such an ability of markets to regulate actions and enforce
contracts should be taken into account in the design of government regulation. The more regulation by
governments imitates regulation by efficient markets, the more effective it will be. That is, optimal
regulation seeks to replicate perfect-market mechanisms (Klein and Leffler, 1981).

More narrowly defined for our purposes, regulation refers to the adoption of putlic policies that
affect market outcomes through the exercise of government power. Enforceable public regulation
substitutes the mandates of the government for market economic incentives. In this context, financial
regulation becomes the imposition of a set of enforceable rules that affect the behavior of agents in
financial markets.

The replacement of market incentives with government rules, with restrictions on certain types
of behavior that would be adopted in the absence of the regulations, may have beneficial or harmful
effects on the performance of the economy. Because financial markets have been among the most
 2

regulated economic activities in every country in the world, it is easy to observe examples of beneficial
and harmful regulations on the basis of their effects on market efficiency.'

We refer to financial repression as those forms of regulation that distort financial markets and
reduce the efficiency of their performance (Shaw, 1973; McKinnon, 1973). Financial repression
encompasses a set of government-imposed rules whose purpose is to tax or subsidize financial transactions
and otherwise distort the flows of funds and resource allocations away from what would occur when
agents act on the basis of price signals (that is, risk-adjusted returns).

Main examples of these distortions are credit subsidies, through loans granted at below-market
interest rates, mandatory credit allocations that target loans for particular sectors of the population, and
other usury restrictions. Other important tools of financial repression are confiscatory reserve
requirements, the inflation tax, the overvaluation of the domestic currency, and excessive restrictions on
entry to the market. The negative consequences of financial repression have been amply documented
elsewhere (Fry, 1988; Adams, Graham, and Von Pischke, 1984).

Frequently, some of the most repressive regulations have been adopted with the best of intentions.
However, legitimate objectives are not enough to achieve the desired results - the choice of means also
matters. Inconsistent means and objectives constitute a recipe for failure. For instance, excessive
barriers to entry into the financial industry are frequently raised with the ostensible purpose of promoting
a safe and resilient system. The contradiction between the objective and the instrument chosen for the
regulation is clear when one takes into account that barriers to entry may prevent the failure of existing
organizations, regardless of how inefficient they may be, by shielding them from the competition of new,
more efficient intermediaries. Potentially less efficient organizations are thus protected from competition
from precise!y the types of intermediaries the policy set out to promote in the first place.

The widespread repression of financial markets and the observed negative consequences from
repression suggest thiat inappropriate regulation may frequently be more dangerous than no regulation at
all. What really matters are the effects of the regulations, not their objectives. Too often the good
intentions of poorly designed regulations are eclipsed by their more powerful unintended evils.

In contrast, prudential financial regulation (or, simply, prudential regulation) refers to the set of
general principles or legal rales that contribute to and pursue as their objective the stable and efficient
performance of financial institutions and markets. These rules represent bounds and constraints placed
on the actions of financial intermediaries to ensure the safety and soundness of the system.

Government regulation should serve three basic policy goals. The first one, macroeconomic in
nature, is to ensure the solvency and financial soundness of all intermediaries, in order to protect the
stability of the country's payments system.' The second objective is to provide consumer protection
against undue risks of losses that may arise from failure, fraud, or opportunistic behavior of the suppliers

' Although this paper emphasizes the effects of regulation on market efficiency, beneficial and
harmful outcomes may be identified with respect to stability, equitable distributions, and other policy
objectives, as well.
2 The basic assumption is that an efficient payments system is a key determinant of proceses of
economic growth and of efficiency in resource allocation. Low-cost operation of the payments system
is based on the public's trust, which, in turn, depends on perceptions about the stability and the solvency
of institutions that manage the system.
 3

of financial services. The third goal of financial regulation is to promote the efficient performance of
institutions and markets and the proper working of competitive market forces. Non-distorting financial
regulation should be general (that is, neutral) in the nature of its mandates and should induce all market
participants to adhere to standard rules.

Achievement of the first two objectives of prudential financial regulation is simultaneous. When
the authorities provide consumers (for example, depositors) with reasonable protection, the stability of
the payments system is guaranteed.' The objective of promoting efficiency implies, on the other hand,
increased competition and the possibility that inefficient firms will exit the market. This means, in turn,
that some consumers may be exposed to deposit losses and that some degree of instability may arise.
These seeningly conflicting objectives must be balanced. The practical problem is to develop a system
that allows the market mechanism to work, while keeping the system safe. This is not a trivial task.

Financial intermediary supervision, in contrast to regulation, consists of examination and

monitoring mechanisms through which the authorities verify compliance with and enforce financial
repression or prudential financial regulation. Supervision refers to specific procedures adopted to
determine the risks faced by an intermediary and, in general, to review regulatory compliance.
Supervision of compliance with rules that promote stability and efficiency is desirable and is a key
component of financial progress. Supervision of compliance with rules that tax and distort the system
is repressive supervision.

It is possible to observe highly efficient supervision efforts directed at enforcing the restrictions
implicit in financial repression packages. This type of supervision is usually damaging. When the
supervision of the financial system is used to enforce financial repression, the more effective the enforcing
mechanisms (that is, the more likely they are to deter regulatory avoidance), the greater the potential
damage of the repression. We focus, instead, on the dimensions of financial intermediary supervision
that seek the enforcement of legitimate financial regulation (that is, prudential supervision).

Finally, internal coiitrol refers to the activities undertaken by the owners of a financial institution
to prevent, detect, and punish fraudulent behavior of the organization's personnel and to ensure that the
financial policies adopted by the owners are properly implemented. In general, internal control activities
are in the interest of the intermediary's owners and normally should not be an overriding concern for the
supervisory authorities. In several types of microenterprise finance organizations, however, particular
ownership arrangements may imply a special concern with internal control issues.

It is important for the analysis to keep clear the distinctions of regulation, supervision, and
internal control,because each leads to separate policy issues. In most cases, regulation requires a legal
framework. However, once the appropriate regulation is in place, supervision may be more discretionary
in nature. Although these activities are complementary (for example, regulation without supervision
would be useless), unless they are analyzed separately it would not be possible to improve the design of
each dimension. One should be able to identify the virtues and defects of each set of activities in order
to focus any corrective actions.

' Some mechanisms of consumer protection, such as deposit insurance, may induce financial
intermediaries to assume higher risks than otherwise and may force the authorities to bail the
intermediaries out. Stability is preserved, but at a high cost to the taxpayer, as in the recent problems
of U.S. savings and loans institutions.
 4

DEPOSITORY FINANCIAL INTERMEDIARIES AND

THE RATIONALE FOR THEIR REGULATION

Formal financial markets in the developed world are incredibly diverse in the types of services
offered, instruments available, and organizations that provide them.4 Services range from traditional
checking accounts to derivatives trading (for example, options in futures markets); organizational types
range from small-town banks and credit unions to the Chicago Board of Trade and similar institutions.
For the purposes of this paper, we focus on the regulation of depository financial organizations. These
are the most common formal financial institutions in the developing world.

Depository intermediaries may be distinguished from other financial institutions by three

characteristics. On the liabilities side of their business, depository institutions issue fixed-value claims,
more commonly deposits, to their customers. They are also characterized by large amounts ol debt, in
the form of deposits, compared with equity claims. On the assets side, depository institutions hold a
substantial portion of their por.folios in non-marketable and risky securities, particularly in business and
personal loans.

These features of depository intermediaries, combined with the nature of a deposit contract and
the intrinsic complexities and imperfections of financial markets, are what make the regulation and
supervision of depository intermediaries necessary. Given that there is always uncertainty about the
fulfillment of financial obligations, since they are promises to deliver at a future date, imperfections in
financial markets arise from asymmetries of information among agents about the likelihood of the
transactions being completed. It seems that most, if not all, valid arguments in favor of the regulation
of financial markets can ultimately be traced to combinations of these elements.

Traditional justificat;ons for regulation have claimed that depository financial intermediaries (for
example, banks) are special because they are the holders of deposits from the public, the primary
allocators of credit in the economy, the managers of the payments system, and the main providers of
portfolio management and risk-sharing services. 5 Depository financial intermediaries are particularly
important in developing countries, where other dimensions of financial markets are undeveloped or
completely absent."

" Substantial variation may be found, as well, in tie informal financial markets of the developing
world (Adams and Fitchett, 1992).

5 We ignore arguments in favor of regulation that are frequently the result of rent-seeking behavior
on the part of the industry itself or some other vested interest (Stigler, 1971). We focus on the safety
of the banks, disregarding aspects of monetary control as well. There is increasing agreement in the
literature that public regulation of depository organizatiorts is not needed to protect the purchasing power
of money. Rather, we examine arguments for government intervention that we believe have some merit,
and we focus on the safety of depository organizations.
6 In economies with low per capita incomes, open markets for common stocks, bonds, mortgages,
or even commercial bills are typically insignificant. Instead, private financial savings are largely currency
and deposits (McKinnon, 1989). Banks thus become the principal formal source of funds (not owned by
the producer) for the firm or household. This is not an imperfection but, rather, a reflection of the cost
of information and of the importance of economies of scale, density, and economies of scope in the
delivery of financial services.
 5

Given the crucial services provided by depository intermediaries, their failure as a system would
impose high costs on the economy. Breakdowns and other inefficiencies of the payments system would
sharply increase transaction costs and cause a severe dislocation of productive activity, and attempts to
prevent bank failures may impose high financial losses for the government if it has to bail out
intermediaries having solvency problems. Dramatic examples of economy-wide crises of the financial
system are the 1907 dislocation of the U.S. banking system and similar problems during the Great
Depression of the 1930s. A more recent example has been the bailout, at government (and taxpayer)
expense, of many firms in the savings and loans industry. In the developing world, the bailout of major
banks took place in Chile, Uruguay, and other countries in the early 1980s (Brock, 1992).

There is no question that depository intermediaries perform an array of important services and
that the system's failure would have major negative effects on the rest of the economy. These
characteristics are shared, however, by industries that have not been as heavily regulated (for example,
traisportation or information). Government regulation and supervision of the financial system must be
justified beyond the simple argument that banks are special.

The correct underlying reason for the regulation of depository intermediaries springs from the
nature of the contracts between depositors and the owners of the financial organizations. These contracts
are special because they provide ample occasion for opportunistic behavior on the part of the depository
institution.7 One consequence of 4his behavior is a degree of instability in financial markets that is higher
than optimal. In short, legitimate reasons tbr regulation are related to consumer protection issues and
respond to higher-than-normal levels of instability in the industry. Without regulation, an unduly high
proportion of financial intermediaries would be likely to assume excessive risks.

The nature of deposits and similar financial contracts is that the borrower (for example, the
depository institution, such as a bank) is required to pay a contracted fixed amount to the lender (for
example, a depositor), usually at specified intervals, unless the borrower goes bankrupt. In the absence
of regulation (for example, no capital requirements), a bankrupt borrower pays less than has been
contracted - and perhaps nothing.

After depositors have supplied the funds for a stated objective, bank managers and equity holders
may be encouraged to take greater risks, because they are able to keep the extra rewards while depositors
bear the additional risk. Given the nature of fixed-interest-rate deposits, the owners of the depository
institution keep any extraordinary profits if the bets turn out well, but can go bankrupt and walk away
from lost bets.8 In short, in the absence of government regulation, the depository intermediary is the
beneficiary of an unfair bet against its depositors or the government. The bank gets to keep all
extraordinary profits, while not having to pay all of the costs, private and social, that arise from lending
practices that are risky.

' Opportunistic behavior occurs when an agent takes undue advantage of resources committed by
another party that cannot withdraw the resources before the end of the contract.
' The problem is identical when a lender (for example, a bank) charges a fixed interest rate to a
borrower, who may be inclined to assume additional risks and keep the extra returns if things go well
or to default if things go wrong (Stiglitz and Weiss, 1981). The absepce of capital requirements is
equivalent to the absence of collateral.
 6

This problem of moral hazard is also present between the bank, when acting as a lender, and its
borrowers.' The same opportunity exists for the borrower to impose an unfair bet upon the bank. This
is precisely the reason why bank,, do regulate (that is, impose requirements upon) their borrowers. This
is an example of regulation through the market. These requirements are voluntarily agreed loan
covenants designed to ensure - or at least increase the probability - that bankruptcy does not ensue.

Examples of loan covenants are restrictions on dividend payments by the borrowing firm,
requirement of a minimum equity investment in the project, and all forms of collateral. In other instances
(for example, for small borrowers), regulation through the market takes the form of collateral substitutes,
such as interlinked transactions or the value of the borrower's reputation. These rules create incentives
for the borrower to behave in ways that reduce the probability of bankruptcy. In this way, the lender
decreases the level of its risk exposure.

A market solution to the problem of discouraging opportunistic behavior by banks does not seem
very plausible, however.'0 Although banks find it profitable to invest large amounts of resources in
estimating the probability that a borrower will repay a loan according to the contract (loan screening) and
in enforcing the loan covenants described (loan collection), individual depositors may find that similar
efforts to estimate the bank's probability of repayment are just too expensive relative to their investments
(deposits). The market failure that results from the asymmetry of information between banks and
depositors and the associated moral hazard on the part of the bank may be significant enough to warrant
government intervention. The difficult question is how best to intervene."

The possibility of opportunistic behavior is the source of several concerns. First, if the market
fails, there may be important efficiency losses for the economy. Alternatively, if consumers are naive,
then issues of consumer protection arise. 2 The practical consequence of any of these possibilities ­
consumer protection and the correction of market failure -- is that regulation is warranted.

For microenterprise finance organizations (MFOs), concern with consumer protection increases
if considerations of equity are incorporated into the analysis. It is reasonable to assume that depositors
in MFOs fall into the lower-income percentiles of people in developing countries who possess financ -1
assets. Losses from insolvency or from fraud would affect segments of the population with lower
endowments of wealth and income.

9 Moral hazard occurs when a party in a contract imposes additional risks on the other party, beyond
those specified in the contract, and the other party does not have control over those risks but has to pay
the consequences.
'o For expository purposes, the term "bank" will be used to denote any formal depository
intermediary.

" In some instances, the social costs of these interventions may still be too high compared with .eir
expected benefits. Existence of a cause may not be sufficient reason to intervene. A cost-benefit analysis
is required. For example, if it would cost one million dollars to supervise hundreds of small
intermediaries whose total assets amount to one half million, it would be better to leave the market alone.
2 Naive or financially unsophisticated depositors may find it difficult to measure with any degree
of accuracy the risks of depositing with a particular intermediary, even if they have access to the data
needed. Such an evaluation may be too expensive for small savers and microentrepreneurs.
 7

A second concern that originates from opportunistic or morally hazardous behavior relates to the
associated negative externalities. A negative externality arises because the total societal costs of such
behavior are greater than the private costs faced by the depositors and the owners of a failed depository
intermediary. That is, the parties directly involved - owners and depositors - do not bear the full costs
of their actions. Rather, these costs spill over to other agents in the market and to the economy as a
whole.

There are several ways these spillover effects can take place. It should be noted first that
excessive risk taking does not always result in the bankruptcy or insolvency of a bank; sometimes bets
and lotteries do pay. Nevertheless, even in those cases when a bank takes high levels of risk that do
result in high returns rather than in insolvency, there might still be negative effects for the stability of
the system. This would be the case for an intermediary that concentrates its lending portfolio in very
risky clients who, as expected, would be willing to pay a high rate of interest on loans. This depository
intermediary would, in turn, be willing to pay marginally higher rates of interest on its deposits or,
equivalently, incur other promotional expenses (for example, to reduce transaction costs for depositors).
In a competitive market, other intermediaries would be forced to match the increased deposit rates. This
price race might take place to a point where all banks would be forced to lend to increasing numbers of
high-risk clients. The intermediary that initiated the process may have good luck -- its risky activities
may earn it a high return, at the same time forcing its competitors to assume higher levels of risk - (but
the general assumption of higher risk increases the probability of insolvency for the system as a whole.

Another way negative externality takes place is recognized in the history of financial institutions.
The failure of an intermediary may cause a panic or run on the deposits of other intermediaries that
otherwise have healthy financiAl situations. Runs on deposits are sudden, massive, unexpected
withdrawals that endanger prudent and imprudent institutions alike. Even educated depositors who have
informed themselves about the financial health of the intermediaries where they have entrusted their funds
may find it rational to rush to withdraw their deposits. This is because individual depositors are not able
to foresee the behavior of other depositors and it is rational for the well-informed depositor of a sound
bank to withdraw funds when it is believed that others are doing so or are about to do so. This is an
example of the prisoner's dilemma applied to financial markets."3 A welfare-increasing cooperative
agreement not to withdraw all deposits at once is not enforceable or credible among depositors.

The case for prudential financial regulation is almost complete. However, the question remains
of why it is necessary before the fact to restrict potentially opportunistic behavior and other forms of
mismanagement by depository institutions, rather than to punish them after the fact, as is the case with
most transactions in the economy. That is, why is it necessary or better to implement preventive
regulation of depository intermediaries, as opposed to remedially resorting to common law tort suit
criminal law prosecution?

Common law is a remedial option in the sense that it represents a recourse for depositors when
the intermediary fails to meet the terms of the deposit contract. Regulation is a preventive action in that
it limits the range of permissible actions for the intermediary and specifies prohibited activities. The
choice of weights between prevention (in the form of regulation) and remedy (criminal prosecution and
tort liability) must be faced every time any framework to govern an economic activity is established. The
optimal combination is not the same across different types of economic activity. The elements to decide
between regulation and common law are:

s The prisoner's dilemma arises when players who would find it in their advantage to cooperate
choose strategies with lower pay-offs because of lack of credible commitments to cooperationr
 8

0 The size of the assets held by those who may commit the crime, relative to the size of the
damages (such as amount of deposits lost). The smaller the amount of the assets held by the
offender, the more should one rely on prevention. The combination of the limited liability, high
levels of financial leverage, and capital specificity of depository intermediaries implies that thf,
amount that owners stand to lose is rather small. 4 This supports the case for regulation. Oniy
the protection of the consumer against related damages has been considered here; the case for
regulation becomes stronger when the costs from instability of the system are included as well.

0 The possibility of suing (successful contract enforcement). The lower the likelihood that remedial
action will be taken or granted by a court of justice, the more the system should rely on
regulation. A first dimension of this problem results from the widespread harm caused by
opportunistic behavior on the part of an intermediary. There will usually be a multitude of
comparatively small depositors, while the costs of collective action may be too high (Olson.
1965). Many individual depositors with small balances may not induce suit or may simply ride
free on tue efforts of others. A second aspect of this problem is that the causality of morally
hazardous behavior in bank failures may be difficult to establish in a court of law. 5 The low
probability of adequate contract enforcement supports the case for regulation as well (Shavell,
1984).

Any system is unlikely to be entirely preventive or entirely remedial. However, the smaller its
equity relative to the intermediary's debt, the more specific the organization's capital is, the larger the
number of depositors and the smaller their individual stakes, and the lower the transaction costs of
monitoring relative to punishing (that is, the likelihood of successful contract enforcement), the nearer
a system should be to the preventive end of the scale. 16

From the point of view of consumer protection, when these general criteria for prudential
regulation are applied to MFOs, the argument for a solution closer to the preventive end of the scale is
even stronger. It may even imply that some MFOs should be regulated more closely than other types
of depository intermediaries. This is because, in some MFOs, those in control do not own the capital
of the organization, and any negligent action on their part leading to the loss of deposits would be
punished, at most, with the loss of their jobs.

The fact that MFOs are located mostly in developing countries may further imply that remedial
action may be too costly or simply impossible for depositors. In several developing countries, the inputs

"' We argue that a bank's capital is specific because it is always more valuable in the bank's
possession than elsewhere in the market. This is because bank capital is mostly bank loans and brand
name. Loans have a significant component of management's private information, while brand name is
worthless once the bank is banlaupt.

," In developing countries, the court system may be prohibitively expensive, corrupt, or inefficient,
further reducing the probability for successful contract enforcement. Financial intermediaties also face
these problems in their role as lenders.
From a macroeconomic perspective, if individual depositors perceive that, to protect the payments
16
system, the government will be recponsible for the safety of their deposits, the authorities may be called
upon to engage in costly bailouts. This guarantee is usually not desirable, but if the government is
committed to it, then preventive regulation may be implemented to minimize the cost of the bailouts to
the government.
 9

and technology (laws, courts, and experience) for remedial action may not be available. This also may
be the case with any regulatory and supervisory structure. Under certain circumstances, it may be easier
to develop a regulatory framework than to adapt a whole judicial system to allow for remedial action.

PRINCIPLES FOR THE REGULATION OF

DEPOSITORY FINANCIAL INTERMEDIARIES

There is a case for the prudential regulation of depository intermediaries. Much of the debate
is not, however, about whether there should be regulation, but about how much regulation to implement
and of what kind.' 7 Economic theory has yet to offer standardized principles for the determination of
the optimal degree of regulation. Such a formula may not exist, because the optimal type and degree of
regulation may be very specific, in terms of time, location, and even the particular institutional structure
of the organizations to be regulated. The most that can be provided is a set of general principles or
regulatory commandments.

The following are principles that should be included among these regulatory commandments:

" Regulation should attempt to minimize disturbances to the existing competitive balance among
financial intermediaries. This principle of competitive neutrality requires, among other
things, that the regulatory 3nvironment provide all market players with a level playing field.
No particular type of intermediary should be granted an advantage simply as a result of the
name in its charter or from implicit perceptions - good or bad - about its clientele or
operations."8 Financial institutions operating under the same or different charters should be
able to find their comparative advantages in serving all possible market niches.

* The negative effects of regulation upon efficiency in the financial system should be
minimized. Efficiency of a financial system is a multidimensional concept. The first
dimension is related to allocative efficiency. This requires that resources flow to the
organizations that off'.r the highest prospective risk-adjusted rates of return. Second,
operational efficiency refers to the consumption of real resources in the process of financial
intermediation. As few resources as possible should be spent (for low transactions costs).
Finally, dynamic efficiency is the ability of the interm,diaries to adapt over time to the needs
of the users of the system. Good regulation would minimize the costs, both direct (for
example, compliance costs) and indirect (for example, reduced competitiveness and
innovation), caused by external rules forced upon the system.

* The regulation of financial markets should not be used to promote the achievement of social
objectives (such as poverty alleviation) or to pr%.vide assistance to particular sectors of the
population or to priority industries. In most cases, regulation directed to achieve these
objectives falls into the category of financial repression, because it taxes the financial system
(or some of its participants) in order to subsidize other sectors of the economy. In practice,

17 For the moment we abstract from important political and institutional constraints that may imply
difficulties in establishing an adequate regulatory framework.
18 For example, in several countries, cooperative banks are subject to less strict capital adequacy
requirements than are equivalent intermediaries, for entirely political reasons.
 10

these regulations have failed to achieve their objectives but have imposed high costs on all
market participants. Worthy social and political objectives may be best achieved in
effectiveness and in cost through fiscal means (Gonzale7-Vega, '1976).

0 The purpose of regulation and supervision should not be to avoid bank failures at all costs.
Such a policy objective is not attainable, and to pursue it may induce severe negative effects.
T-here is no purpose in allowing inefficient organizations to continue to operate in the market.
If an intermediary does not adopt the proper strategies, does not have the flexibility to adapt
to changes in the environment, or does not react to competitive attacks from its rivals, or if
its owners are not able to avoid malfeasance or incompetence on the part of their staff, the
role of the regulator is to ensure that the owners of the incermediary replace the equity losses
or that they exit the industry without damaging their depositors' interests or the stability of
the market.

In effect, the policy of preventing or postponing bank failures has resulted in the reduction
of competition and in the inefficiency of entire financial systems, while exerting significant
pressures on the government's budget or on central bank operational losses. The objectives
of regulation and supervision should be to avoid bank failures and to minimize the negative
effects of failures that do take place. One way to achieve these objectives is to ensure that
those responsible for any failure - because of fraud or lack of financial ski!l - assume most
or all of the associated costs and that they are not able to transfer these costs to their
customers or to the government.

" Regulation must rely, as much as possible, on the self-interest of economic agents.
Government regulation should stimulate, as much as possible, the ability of the market to
enforce contracts. In short, regulations that are incentive compatible are optimal. 9

The main rationale for regulation springs from consumer protection concerns that arise from
the need to curb the attractiveness of excessive risk taking (that is, opportunistic behavior)
by depository intermediaries and from the negative externalities associated with such
behavior. There are two ways to counteract opportunistic behavior before it occurs. The
first way is to keep the discretionary powers of the intermediary within narrow and closely
superised limits. The second is to rely on the self-interest of the intermediary, by
introducing incentives that induce discretionary behavior consistent with the objective to
reduce excessive risk taking.

The second option relies on external and internal disciplinary agents (Holstrom and Tirole,
1990). Internal discipline would result, for instance, from a regulation that would require
banks to keep a minimum amount of capital (that is, a deductible). A sufficierndy large
deductible may induce a more prudent behavior on the part of management. External
discipline is achieved by competition in relevant markets (for example, a takeover by other
shareholders or the market to hire and fire agents).

* The regulatory framework should not be static; it must recognize that, inevitably, there will
be innovations adopted to avoid the original regulation. The regulatory environment should
evolve accordingly (that is, it should be flexible over time). Efforts to alter market solutions

19 There is incentive compatibility when, given enforceable constraints, the agent voluntarily chooses
the behavior desired because it becomes in its interest to do so.
 11

through coercive regulation induce responses in the form of innovations to avoid the initial
regulation. These innovations may take the form of new products and services (such as off­
balance sheet liabilities) or may lead to product substitution. The efficiency of the process
of prudential regulation is reduced as innovation spreads in the market.

Innovation tends to spread rapidly in financial markets, since both types of innovation ­
product and process - are easily replicated by competitors. Products are opeldy available
and are not protected by patents, and processes are copied through employee mobility or
originate in widely available technology (such as computers or telecommunications).
Regulation may become increasingly less effective in the presence of avoidance unless
regula:ors respond quickly to close the loopholes created by innovation.

Most likely, regulators react to change more slowly than the organizations they regulate and
supervise. Most political systems do not have built-in incentives that promote rapid
responses. Eventually, though, a process of re-regulation takes place and the cycle is
repeated. This is what Kane (197T) identified as a process of regulatory dialectic. Clearly,
realistic regulation and supervision have to develop alongside these market forces. This is
necessary to ensure that regulation remains effective, that potentially risky avoidance
innovations do not become a problem, and that the benefits of competition are harvested.

0 The regulatory framework should be flexible enough to regulate different intermediaries in

different ways. The differences that may be important for regulatory purposes would involve
the environments in which the intermediaries operate, the markets niches they serve, and their
institutional design. By institutionai design, we refer principally to property rights and rules
of control over the organization's assets. For example, a cooperative's assets are controlled
by the system of one person, one vote; the corresponding rule for a commercial bank is one
share, one vote. We assume that the organizational types and charters (such as cooperatives,
NGOs, and commercial banks) found in a given financial market are exogenous or
independent of regulation. In several cases, regulation a.id taxation allow for charger
arbitrage and for the existence of organizations that would not exist in the absence of
asymmetric regulation.

The need for flexibility arises because such differences may imply idiosyncratic risks for
alternative intermediaries. An idiosyncratic risk occurs when an intermediary faces a source
of potential variability in its net income and in the value of its equity capital (in other words,
the possibility of insolvency) that does not affect other types of intermediaries in the same
manner. For instance, there is idiosyncratic risk when the same type of risk is more intense
(that is, has a higher expected value of bad outcomes) for a given t3 pe of intermediary or
when it can be reduced, through diversification or other means, more efficiently by other
intermediaries.

Idiosyncratic risks across economic environments (such as countries or regions) do not allow
for the exact replication of regulatory frameworks. For example, the regulatory framework
in a country with well-developed liquidity markets should be concerned mostly with solvency.
Liquidity reserves should be an overriding regulatory concern when those markets do not
function efficiently.
 12

There may be idiosyncratic risks that originate from the particular market segments or niches
served by an intermediary.' Intermediaries specializad in the provision of housing loans
would probably face consistently higher exposures to interest-rate risk - as a result of term
arbitrage - than would finance companies specialized in short-term lending. The regulatory
framework must be flexible enough to accorrmodate such differences, in order to allow
institutions that operate under different charters to find comparative advantag, s in serving all
possible market niches. Even intermediaries with the same charter should be able to
determine which sectors or segments of the market they can serve at a lower cost and,
therefore, more profitably than can their competitors. The role of regulation is to ensure that
appropriate precautions are taken in each case.

Idiosyncratic risks may also arise as the result of the institutional design of the intermediaries.
For example, some intermediary types (such as cooperatives or NGOs) have a diffused
ownership structure, which may cause owners not to provide an optimal arount of oversight
of operations. The importance of acknowledging these differences is more than academic;
they have vital policy implications. Prudential supervision would be not only better (that is,
there would be a lower probability of failure) but also more efficient (that is, more cost
effective) when these distinctions are recognized.

The fact that some idiosyncratic risks may call for differentiated regulation is not
contradictory with the principle of competitive neutrality stated earlier. Equality of treatment
is not ensured by treating unequals equally. The idea is to allow for a diversity of
organizations compatible with the diverse needs of the market and to assign the regulatory
burden with maximum efficiency.

FREQUENTLY ADOPTED INSTRUMENTS OF PRUDENTIAL REGULATION

The types and scope of government regulation of depository intermediaries vary significantly
across countries. Prudential regulations can be classified as preventive or protective. Preventive
regulations attempt to control the risk exposure of the system, to reduce the probability of failure in the
aggregate. Protective regulation focuses on assuring depositors that they, as individuals, will not face
losses in case a particular intermediary experiences financial difficulties. The main purpose of protective
intervention is to avoid runs on deposits as a result of bank failure. This is achieved by removing the
incentive for a depositor to be the first one to withdraw funds from a troubled intermediary.

In is a brief discussion of the most commonly observed regulations, we examine protective

regulatory measures first:

0 The role of government as a lender of last resort. Governments, most frequently through
central banks, may intervene in financial markets to provide liquidity loans to troubled
intermediaries. This should be differentiated from the open market operations of the central

o Sometimes, consistent risk differentials are the result of bad regulation itself, such as rules that
force certain intermediaries to grant credit only in specific geographical locations or for specific purposes
(consider, for example, the savings and loans industry in the United States). These regulations do not
allow intermediaries to sufficiently diversify their risks.
 13

bank aimed at increasing the liquidity of the entire system for macroeconomic reasons. We
refer here to liquidity assistance to individual organizations.

The idea behind the lender-of-last-resort facility is that there may be intermediaries that are
temporarily illiquid but solvtnt and fit for long-term survival. The implicit assumption is that
liquidity maikets do not work properly or that the authorities possess a better judgment than
the market about the soundnin-s and possibilities for long-term survival of individual
organizations. With properly functioning markets, liquidity shc.uld not be a problem as long
as the intermediary is solvent.21

0 Deposit insurance. The main purpose of deposit insurance is to remove the depositor's
incentive to be the first one to withdraw funds from a troubled intermediary. This is thought
to increase the sta)ility of the system. The removal of the post-dtposit incentive to run is
one possible effect of deposit insurance. However, deposit insurance may also imply
negative changes in the pre-deposit behavior of individuals. In particular, savers may have,
fewer incentives to verify the financial health of the intermediaries where they place their
funds if they feel protected by the insurance.'

Protective regulatory interventions necessarily require an adequate framework of preventive

regulations and an efficient system of supervision. For this reason, protective interventions
should be the last step, if they play any role at all, in the development of a prudential
framework. The establishment of protective measures in the abser.ce of prudential regulation
and supervision removes discipline from the market and encourages risks that may be greater
than those resulting from the absence of regulation.

It is better to have no regulation than to adopt protective regulation alone. In particular,

deposit insurance without a good supervisory system removes the cost for a bank to increase
risk (that is, it eliminates market discipline). It would be impossible, for example, to
calculate risk-based premiums. Such a reduction of the cost of risk for the banks would have
the effect of making them less safe than otherwise - exactly the opposite result of that sought
by prudential interventions.

There are two possible approaches to protective interventions. The discretionary approach
consists of interventions that depend on the judgment of the authorities. This intervention
may or may not occur. The government may or may not bail out depositors or may or may
not act as a lender of last resort. The second approach involves contractual interventions,
such as institutic aalized arrangements for deposit insurance.

Each approach has advantages and disadvantages. The main advantage of the discretionary
approach is that 't does not completely remove market discipline. The fact that the
intervention may or may not occtr implies that some incentive remains for depositors to
monitor risk3. Its main disadvantage is that it may create an asymmetric treatment of

2' Although liquidity and solvency are conceptually different, in practice it may be difficult to
distinguish between them. Unwise liquidity management implies the risk of corresponding adjustment
costs that may endanger solvency.

' As Kane (1985) has shown, in the presence of deposit insurance, the owner-managers of banks
also may assume higher risks than otherwise.
 14

intermediaries, which may result in implicit subsidies for some of them (in essence, lack of
competitive neutrality). The classic example of this is the too-big-to- fail hypothesis, which
argues that regulatory authorities are less likely to allow the failure of comparatively large
banks. Related to this asymmetric treatment of intermediaries is the danger that politically
powerful intermediaries may enjoy better government protection under the discretionary
approach."

The main disadvantage of the contractual approach is that it completely removes market
discipline and creates incentives for taking risks on the part of the depositors and the
intermediaries. Its main advantage is that it removes uncertainty, thereby decreasing the
possibility of a run on deposits.

Among the most frequent preventive regulatory measures are:

" Licensing of financial intermediaries. Almost every government has restricted the entry
of firms into the formal financial industry, by requiring them to obtain a license or legal
charter. Although this requirement is almost universal, the reasons to demand it may differ.
In many cases, promotion of the soundness of intermediaries is nothing but an ostensible
reason for restrictions on entry - when the true purpose of the regulation is to restrain
competition and to influence the structure of the market by creating, through the barriers
adopted, monopolistic rents for the industry's incumbents. This hidden purpose is illustrated
by requirements for additional intermediaries to demonstrate need before a license is granted.

From a purely regulatory perspective, the only purposes of any licensing requirement should
be to ensure an adequate capitalization and the availability of sound management (for
example, competence and moral standing), not to limit entry and reduce competition.

* Capital adequacy. Regulatory requirements dealing with capital adequacy have two different
dimensions. The first one is a pre-established minimum level of capital required for entry.
This is an absolute amount of money. The second dimension is to require the maintenance
of some solvency or leverage ratio. This is a minimum proportion of the assets of the
intermediary.

Capital adequacy regulations probably constitute the most important component of any
regulatory framework, because of capital's key role in the operation of a financial
intermediary. The most elementary definition of equity capital is the amount of money left
for the owners of the intermediary in &e event the organization is dismantled, after all
creditors are paid off.' Equity capital constitutes liabilities that cannot be withdrawn at all
by the owners and on which it should not be necessary to pay a fixed or contracted return.

As such, capital plays two roles. The first role is the traditionally recognized function of buffer
funds, to absoro losses on the income account. For moderate losses, capital would allow dapositors to
redeem claims at full value. Nevertheless, due to high levels of debt relative to capital on the liability

' In several countries, this is the case - government-owned banks are different from private banks.
The cost of mobilizing funds for the public bank is below the financial costs of their private competitors.

•' Under a regime of limited liability, this amount is the maximum loss that may be incurred, since
the owners do not have a personal liability beyond their equity stakes in the firm.
 15

side of depository intermediaries, capital does not represent significant protection. This is because losses
that are small relative to assets may wipe capital out.

The authentic function of capital in terms of consumer protection is to perform the role of a
deductible, in the sense of an insurance policy. Equity capital is the amount that would be lost by the
owners of the bank in the event of bankruptcy. The larger the deductible (that is, expected owner losses),
the more cautious the behavior of the intermediary (that is, less risk assumed). In short, from a
regulatory perspective, the main function of equity capiWfl is to induce compatibility of incentives (that
is, reduce moral hazard) between the depositors and the owners of the intermediary. Given a sufficiently
large deductible, the interests of owners and of depositors would be similar, and the former would behave
accordingly.

Capital adequacy regulations in the form of some minimum solvency or maximum leverage ratio
are incentive compatible. This makes for sound regulation. On the other hand, capital adequacy
requirements as an absolute minimum amount of equity to enter the industry are, conceptually, anti­
competitive regulation. The only justification for this type of regulation is a pragmatic one that has to
do with the difficulty of supervising large numbers of interm,3liaries with small-scale operations.
Actually, the reduced competition in the industry raises the amount of capital, as
the value of the
established firms increases (in other words, hidden reserves).
These reserves represent a transfer from
the clients to the owners of the existing firms, generated by the inefficiencies resulting from restricted
competition.' In most cases, the resulting increased stability may be too expensive in efficiency losses.

There are two general problems with the practical implementation of capital adequacy ratios. The
first problem has to do with the definition of capital and its measurement. Capital as deductible should
include all hidden reserves ­ including the value of the charter or franchise of established firms - under
restricted competition and an appropriate market v.1 uation of assets.

The second problem is the appraisal of the intermediary's off-balance sheet liabilities. These are
usually contingent liabilities, such as guarantees or related contracts, that have not affected the
organization's balance sheet but may generate a claim on the assets of the organization in the future.

Although they do not appear on the balance sheet, these commitments represent actual contractual

obligations that imply risks. Off-balance sheet items

are one of the most common instruments of
regulatory avoidance with respect to capital adequacy requirements.

One of the interesting challenges in the regulation of MFOs is that some of these organizations
have property rights structures that preclude accounting capital to perform the function of a deductible.
This is because these intermediaries do not have owners in the traditional sense. This may suggest the
need for a different type of regulation for some MFOs:

* Prohibitions of loans to insiders. One common and very important regulation of financial
intermediaries is to limit the amount of loans that may be granted to bank insiders (for
example, large shareholders, related companies, or employees). The usual arument for this
regulation is that such credit may not meet the same standards as loans extended to other
borrowers (Polizatto, 1989). That is, loans to insiders may be granted on the basis of criteria
different from the maximization of the risk-adjusted returns for the intermediary. Insider
loans are usually not properly collateralized.

The market value of the franchise when competition is restricted is given by the present discounted
value of any monopolistic quasi-rents resulting from the industry's structure.
 16

More important, credit to insiders may be used by the intermediary's owners to recapture
equity capital, thereby eliminating its function as a deductible. In the event that insiders
receive loans equivalent to a large portion of their capital, they are able to escape their share
of the losses from bankruptcy, by falling in default on the loans they have received. This
possibility of redeeming equity capital through loans eliminates the incentives for not
assuming excessive risk.

Restrictions on credit to insiders are necessary for the successful enforcement of any capital
adequacy regulation. The general rule should be never to allow a bank to !end to its owners,
be it directly or indirectly. However, this is a regulatory challenge, for client-owned
depository intermediaries (such as, credit cooperatives or village banks), since these
organizations lend principally to their owners. This represents one example of the need for
idiosyncratic regulation.

S Diversification rules. This regulatory constraint is aimed at preventing an intermediary's

loan or investment portfolio to concentrate around a few individual costumers or a group of
costumers that constitute a single tconomic risk through the positive correlation of the
outcome of their activities.

Although the precise form and content of this regulation varies significantly, it should
stipulate limits on loans, investments, and exposure (such as, foreign exchange risks). These
limits should not be set in terms of absolute amounts; rather, the amount that any
intermediary may risk in a single gamble should be a function of its equity capital.

Absolute restrictions on the amount to be lent to a single costumer are sometimes used to
segment the market and to limit competition. Restrictions on portion of assets, as opposed
to equity capital, are an incentive for intermediaries to increase the level of leverage, in order
to augmnent the acceptable limits on loan size and concentration. This has obvious negative
implications, since the role of equity capital as a deductible diminishes.

Anti-competitive regulations frequently impede adequate risk diversification. Examples of

these negative regulatory constraints are restrictions on geographic expansion and product
diversification. Unfortunately, this has been the case for many development financial
institutions and may be the case for several MFOs.

0 Regulations about admissible activities. Some countries have tried to separate banking
activities from non-banking areas of business. The practical implementation of this regulation
has been to prohibit or restrict equity investments by depository intermediaries. Two
different traditional arguments have been advanced in favor of this type of regulation. The
first one is not prudential in nature and has to do with preventing the concentration of
economic power. The second argument, based on prudential considerations, is that common
stock or equity investments should be precluded from the portfolios of depository
intermediaries because they are too risky.

This constraint is a good example of the need to adopt different regulations for diverse
market environments. In countries with developed capital markets, the availability of an
additional asset (such as stocks) should be beneficial for bank portfolio performance, from
the perspective of risk-return efficiency. In these countries, the supervisory authority is in
the position to monitor the market price of these assets and, thereby, portfolio performance.
This is acceptable as long as the intermediary does not operate the other business itself.
 17

Developing countries, on the other hand, do not have properly functioning capital markets.
This implies that it may be impossible or prohibitively expensive to monitor bank portfolio
performance when the portfolios include stocks or equity investments of any kind. In these
circumstances, such investments should be avoided. The problems are further compounded
for direct investments. Credit cooperatives in developing countries have invested in and
managed all sorts of businesses (for example, grocery stores) side by side with their financial
intermediation operations. This has been a source of financial distress for these
organizations. Multiple activities seriously endanger the possibilities for effective supervision
and risk assessment of financial intermediaries.

0 General powers for the enforcement of regulation. The regulatory framework should
provide the supervisory agency with1 enough authority to perform its mandate. Among the
most frequently observed general powers granted to regulators are the abilities to require
standard formats for reporting financial performance, to order to cease and desist, to restrict
or suspend dividend payments, or to force intermediaries to create appropriate reserves. The
need for most of these powers originates from the requirements of implementation of the
supervisory activities.

PRINCIPLES FOR THE PRUDENTIAL SUPERVISION OF DEPOSITORY

FINANCIAL INTERMEDIARIES

Prudential supervision refers to the process of enforcing the regulatory framework. Efforts are
aimed at monitoring and directing individual intermediaries to ensure that they obey regulatory
requirements and do not behave imprudently. It is clear that there would be little advantage in having
good regulatory policies in the absence of efficient enforcement mechanisms.

Because the main purpose of regulation is to reduce risk and its negative effects, the supervisory
authority's practical challenge is to design indicators to measure these risks, to monitor and analyze the
impact that external events or exogenous shocks might have on the performance of financial markets and
intermediaries, and to ensure that the data fed into the monitoring system are accurate and reflect the
situation of the intermediary.

The main goal of the supervisory system should be to work as an early-warning mechanism about
changes in the probability of an individual intermediary becoming illiquid, insolvent, or both. This
requires prediction of future events both exogenous to the intermediary and arising from its own actions
and the way these events may affect the financial health of the organization. Since predictions are by
nature difficult, what most supervisors do is to monitor the actual performance of intermediaries and
make inferences about future risks from observed tendencies, in the hope that changes are sufficiently
slow to ailow timely interventions.

As was the case with regulation, there is no easy recipe to follow for sound supervision. The
very nature of banking risks makes their measurement very difficult. Even well-trained and experienced
supervisors issued positive reports on the Continental Illinois Bank only a few months before it had to
be taken over by the Federal Deposit Insurance Corporation. However, there are basic principles that,
to be consistent with the previous section, will be called supervisory commandments.
 18

Principles that should be included among these supervisory commandments are:

" Supervisory activities should not be used to enforce rules different from those related to
prudential regulation. In some countries, bank supervisors are asked to verify compliance
with tax laws, foreign exchange controls, central bank reserve requirements, and the like.
Additional mandates affect the ability of supervisors to concentrate on the main task of risk
assessment and control activities, while creating additional incentives for those regulated to
hide information.

" Supervisory authorities should not manage intermediaries. The line should be drawn between
supervision and total control. Supervisory activities and management tasks should be kept
separate. Supervision should attempt to make intermediaries comply with a comparatively
small number of clear rules. Traditional supervisory activities should have nothing to do with
personnel management, pricing policies, or even technical operational advice to financial
intermediaries. If prudential regulation requires that intermediaries must have a given
percentage of their assets funded with equity capital, then prudential supervision should
ensure that the intermediaries comply with such a restriction. Other issues of internal control
should be of no particular concern, unless there are problems with the specification of
property rights in the organization.

" Supervision requires constant and frequent monitoring. There should be no extended
intervals between supervisory activities. The risks involved in financial contracts change
constantly, given the nature of these contracts, which imply the exchange of money (or
purchasing power, now) for promises of future repayment (usually documented - but
promises, nonetheless). The probability that any intermediary will be able to honor its
deposits may change almost immediately. A single large loan or the adoption of a foreign
exchange position may dramatically change the financial position of an intermediary within
hours of a supervisory visit.

" Supervision of financial intermediaries should have a significant component of prediction.

The assessment of the risk levels faced by an intermediary should not be based only on past
perfomance. Effective supervision requires a better predictive ability than that providet by
the traditional methods of bank monitoring. One suggestion is to undertake simulations on
the performance of intermediaries under different reasonable scenarios. That is, one
important component of prudential supervision is to answer, in a systematic way, questions
such as "What would happen to Intermediary A (or a group of Intermediaries B) if the market
interest rate changes by so many percentage points?" The more efficient the predictions
of the supervisor, the more effective the early-warning system.

" Prudential supervision, as the process of enforcing the law and regulations, should show a
high degree of flexibility and neutrality toward charter arrangements and the market segments
served by particular intermediaries. Questions such as "How does a bank examiner estimate
the necessary provisions for loan losses in an intermediary whose portfolio is backed only by
character references?" suggest the need to differentiate across organizations. Clearly, this

The case could be made that the cost of the savings and loans crisis to the American taxpayers
could have been significantly reduced if U.S. banking supervisors had simulated industry and individual
bank performances assuming a decrease in real estate prices.
 19

evaluation process must be uifferent from that for a commercial bank, whose loan portfolio
is collateralized with assets for which it would be easier to get market values.

By the same argument, an appropriate regulatory environment should be flexible enough to

understand that, however measured, a delinquency rate of, say, 15 percent in an intermediary
that makes very small !oans and charges sufficiently high interest rates may be more
satisfactory than a rate of 5 percent at a commercial bank.

The importance of flexibility goes beyond the need to measure different levels of risk across
different organizations. Among other things, supervision should be responsive to change and
innovations. Riskier intermediaries would simply be required to hold better provisions (that
is, they would not be allowed to cash out bets). In any event, the objective of regulation
should be to avoid excessive or undue levels of risk in financial transactions - not to ensure
certainty, which is anyway impossible. Regulation should allow different degrees of risk, so
that informed agents find an opportunity to choose according to their risk-return preferences.

THE METHODOLOGY OF SUPERVISION

An efficient mechanism for the surveillance of financial intermediaries should have two basic
components. Efficiency refers here to the maximization of the probability of discovering regulatory
violations at a minimum cost. The first component would be an early-warning system based on data
reported to the supervisory authority by the intermediaries themselves. This is the off-site component
of the supervisory structure. Its main purpose is to provide a frequent depiction of the financial health
and risks of each intermediary supervised.

The early-warning system may use standard bankruptcy models to identify those intermediaries
likely to fail in the future. Most of these models are based on multivariate discriminant analysis, using
a series of financial ratios as predictive variables. These statistical models, when properly applied, can
be efficient in predicting bank failure. In effect, Bengston et al. (1986) report that these models are
almost as effective in such predictions as the more expensive bank supervisor visits.

The second component of any supervisory system is a program of visits to the intermediaries;
this is on-site supervision. On-site supervision is necessary to practice those inspections that, because
of their nature, cannot be performed by an off-site analysis (su h as quality of internal control) and to
verify that the data fed to the off-site surveillance system are correct.

If the supervisory authority had perfect information, visits by field personnel would occur only
when special interventions are necessary. The need for such interventions would be indicated by the
monitoring or off-site early-warning system. Any resources invested in a monitoring system would be
wasted, however, if the supervised intermediaries are able to hide possible sources of risk and face a low
probability of being caught when doing so. On-site supervision must, therefore, verify the accuracy of
the data fed into the surveillance system. The possibility of being caught would be a deterrent for most
intermediaries in attempts to disguise the financial situation.
 20

RISKS OF FINANCIAL INTERMEDIATION

The dominant theme of this paper has been the control and supervision of the risks assumed by
depository financial intermediaries. Risk refers to the probability that undesired events may occur, in
particular the failure, or insolvency, of an intermediary. Insolvency results, basically, from negative
variations in net income.

The most common sources of insolvency for financial intermediaries are the following:

" Credit risk. Whenever a financial interi-ediary acquires ail earning asset, it assumes the risk
that the borrower will default - that is, will not repay the principal and interest according
to the contract. Credit risk is the potential variation in the intermediary's net income and in
the value of its equity resulting from this lack of or delayed payment of the obligation.
Different types of assets exhibit different probabilities of default. Typically, loans carry the
greatest credit risk.

* Interest rate risk. This risk results from the potential variability in an intermediary's net
interest income and in the value of its equity capital because of changes in the level of market
interest rates. Interest rate risk has been found, together with lack of appropriate
diversification, to be the most common source of bank failures in deveiopea countries. This
risk originates from the mismatch of the term to maturity of assets and liabilities with fixed
interest rates (that is, from term transformation). When interest rates rise, intermediaries
must pay more for current liabilities, while not necessarily able to adjust their returns on
earning assets. The obvious consequence is a reduction in net interest income that might
result in current operational losses and, eventually, in insolvency.

• Liquidity risk. Liquidity of an asset refers to the owner's ability to convert the asset into
cash, with minimal loss from price depreciation and at low transaction costs - that is, the
ability to rapidly sell an asset without incurring significam losses. Liquidity risk is the
variation in net income and in the vzlue of equity caused by a financial intermediary's
difficulty in obtaining needed cash at a reasonable cost.

* Internal control or fraud risk. Internal control risk refers to the variation in net income
and in the value of equity capital that results from the misappropriation, theft, or processing
errors against the intermediary's assets by a customer or by an employee. Excessive levels
of the risks described above are the most frequently observed cause of failure among
traditional financial intermediaries. A discussion of these risks and of the methods for their
measurement Is widely available in the literature on finance (Maisel, 1981). All these risks
affect traditional intermediaries and MFOs alike. However, the literature on finance does not
recognize risks that are characteristic - because they are exclusive or consistently more
intense - of MFOs.

One risk that is frequent in MFOs but hardly observable in traditional intermediaries is
subsidy-dependence risk.27 We refer to an MFO with a large dependence on subsidies,

27 This risk has been very high in public development banks and explains much of the recent
difficulties experienced by these intermediaries, particularly those that had not actively mobilized deposits
from the public (Gonzalez-Vega, 1990).
 21

which mobilizes savings from the public as well. The problem, from a supervisory
perspective, is that reductions in the annual flow of subsidies may endanger the stability of
the intermediary and, therefore, the savings of its depositors.

We have observed many examples of organizations that had been highly dependent on subsidies,
when the amounts of the subsidy suddenly decreased, making the intermediary unable to cover its
operational costs, leading to insolvency. The supervisor should be concerned with the degree of
dependence that a given intermediary has on volatile and uncertain subsidies (such as government
transfers or donor grants) and with the potential impact of th'r reduction or elimination.

The approach here differs from that of Jacob Yaron, in the sense that his concern with subsidy
dependence is more about viability or pure economic efficiency. The supervisory concern has to do, on
the other hand, with risk. In this sense, the supervisor need not be concerned with equity or capital
transfers from donors, because they do not increase the risks faced by the intermediary, although they
may discourage savings mobilization. Rather, the supervisory authority should be concerned with budget
transfers to cover staff expenses.

Another difference in risk between MFOs and traditional intermediaries is demonstrated by the
external influence exercised by donors or governments. MFOs have been subject to a flooding of fup.ds
from all sorts of donors, who have provided large amounts of cheap resources, relative to the assets of
the MFO, and who demand that these funds be allocated within a fairly short period of time. Frequently,
they also target particular clientele, without due concern about creditworthiness, severely reducing the
organization's degrees of freedom in credit screening. All of this imposes severe credit risks on an
organization, as it has to abruptly increase the pool of its borrowers, frequently from a narrowly defined
subset of the population. Rapid and disproportionate growtb in the number of borrowers is highly
correlated with portfolio losses from default.

Traditional intermediaries, on the other hand, experience portfolio growth in a more gradual
fashion. Time allows them to adjust their loan screening techniques gradually and the development of
bank-client relationships strengthens their costumer base. Some MFOs, because of choice or donor
influence, have not been allowed to diversify their loan portfolios or have not been able to select among
all possible borrowers, but just from a few (with credit directed to particular groups or activities). Rather
than clients, these borrowers usually perceive their status as beneficiaries of paternalistic programs.
These requirements have made MFOs victims of the equivalent of repressive regulation.

Traditional bank regulation and supervision may not be effective for the surveillance of MFOs,
because their techniques have been developed to measure and prevent the risks of a conventional model
of financial organization (that of a private depository intermediary) in very specific settings (those of well­
developed financial markets). This implies that traditional regulation and supervision may overlook
important intrinsic risks or penalize MFOs because of their activities and clienteles. Examples are the
idiosyncratic risks described above and portfolio ratings based on collateral, when MFOs may rely on
collateral substitutes or screening through other terms of the loan contract.

REGULATION OF MICROENTERPRISE FINANCE ORGANIZATIONS

Depository institutions were defined in terms of the structure of their liabilities (for example,
large debt, compared with equity), the fixed-value nature of their debt (such as deposits), and the
predominance of non-marketable loans among their assets. Clearly, organizations that provide loans to
 22

microentrepreneurs, funded with deposits mobilized from the public, would qualify as depository financial
intermediaries and would share many of the characteristics that make regulation necessary.

Nevertheless, MFOs come in a large variety of institutional designs and legal charters and
function in very diverse economic and legal environments. For instance, the range of institutional
designs, according to ownership, goes from finarcial intermediaries without specific owners (for example,
nongovernmental organizations, for particular purposes) to private commerci-l banks that have found an
interesting market niche in the sector (for example, Banco Sol in Bolivia). Inteimediate organizational
arrangements are client-owned financial intermediaries (such as credit cooperatives and village banks),
state-owned banks, and government organizations (such as Bank Rakyat Indonesia unit desas and the
Badan Kredit Kecamatan in Indonesia).

The diversity of MFOs is further compounded by the diversity of the economic and legal
environments where they operate. This is exemplified by the fact that NGOs lend to microentrepreneurs
in countries as dissimilar as the Gambia and Chile, where t'he degrees of development of the
infrastructure, legal systems, human capital, and the financial market itself are at extreme opposites. In
the Gambia, where there are no formal banks, the financial distress of some large NGOs may have
important consequences for the economy at large. In Chile, similar outcomes would be perceived only
by those directly affected, without major macrocconomic implications.

This diversity of MFOs makes it impossible to provide a recipe that is easy to follow for the
regulation of these organizations. Such a uniformity would be an impossible goal even for traditional
depository intermediaries. A generalized cost-benefit analysis for MFO regulation is impossible. The
relative scarcity of the inputs necessary for regulation (as one example, trained bank examiners) changes
the costs and benefits of supervision from country to country.

More important, the nature of the incentives implied by each institutional structure of MFOs
would lead to different behaviors in the presence of the same regulation. NGOs do not usually have a
residual claimant of the profits or losses generated by their financial intermediation activities. This
implies that incentive compatible regulations must be designed that go beyond simple capital adequacy
requirements, which are sufficient to exert the desired behavior from commercial private banks. The
resulting problems may be solved only partially by regulation.

Credit cooperatives, on the other hand, do have owners. The problem is that these owners
behave according to different objective functions and create conflicts for the organization. These owners
may find it privately profitable that the organization does not maximize its profits. This would be the
case for net borrowers, whose payoffs from reduced organizational profits come at the expense of net
savers. These conflicts may make these organizations particularly unstable (Poyo, 1992). The rivalry
among owners increases the risk of disintegration of the organization and creates increased opportunities
for management to pursue its own interests. That is, client-owned financial intermediaries may be
inherently more unstable and may suffer larger principal-agent problems than other intermediaries under
similar conditions.28

28 Agency problems arise when the owner (the principal) of some resources entrusts management to
another one (an agent) who may have an objective function that does not necessarily coincide with that
of the principal. The principal has to incur costs in monitoring and contract enforcement to guarantee
that the agent behaves as desired.
 23

The analysis of the institutional structure of each MFO and of the regulatory implications is
beyond the scope of this paper, not only because of the length of such undertaking, but because the
subject has not been sufficiently researched. Most MFOs are comparatively new organizations. As
experience accumulates and is interpreted from the perspective of the conceptual framework developed
in this paper, useful empirical generalizations will be found. The topic is important, given the
responsibility to protect microentrepreneurs who trust the organizations that mobilize funds and grant
loans and the objective to promote healthy financial markets, where the niche of providing credit to small
borrowers and depository services to small savers becomes sufficiently attractive. In particular, it will
be important to avoid policy backlashes that might result from the failure of MFOs and other
intermediaries not correctly regulated and supervised. Failures and policy backlashes would jeopardize
any progress toward improving access to financial services for microentrepreneurs.
 25

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AGRAP paper.
 GEMINI PUBLICATION SERIES

GEMINI Working Papers:

1. "Growth and Equity through Microenterprise Investments and Institutions Project (GEMINI):
Overview of the Project and Implementation Plan, October 1, 1989-September 30, 1990." GEMINI
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*2."The Dynamics of Small-Scale Industry in Africa and the Role of Policy." Carl Liedholm.
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3. "Prospects for Enhancing the Performance of Micro- and Small-Scale Nonfarm Enterprises in Niger."
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*5. "Gender and the Growth and Dynamics of Microenterprises." Jeanne Downing. GEMINI Working
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7. "Options for Updating AskARIES." Larry Reed. GEMINI Working Paper No. 7. October 1990.
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*8. "Technology - The Key to Increasing the Productivity of Microenterprses." Andy Jeans, Eric
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9. "Lesotho Small and Mic'oenterprise Strategy - Phase U: Subsector Analysis." Bill Grant. GEMINI
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*10. "A Subsector Approach to Small Enterprise Promotion and Research." James J. Boomgard,
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11. "Data Collection Strategies for Small-Scale Industry Surveys." Carl Liedholm. GEMINI Working
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12. "Dynamics of Microenterprises: Research Issues and Approaches." Carl Liedholm and Donald C.
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*Publications of general interest

./1
 2

14. "Review of Year One Activities (October 1, 1989 to September 30, 1990) and Year Two Work Plan
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17. "Kenya: Kibera's Small Enterprise Sector - Baseline Survey Report." Joan Parker and C. Aleke
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*18. "A Financial Systems Approach to Microenterprises." Elisabeth Rhyne and Maria Otero. GEMINI
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*19. "Agriculture, Rural Labor Markets, and the Evolution of the Rural Nonfarm Economy." Steve
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*20. "The Microenterprise Finance Institutions of Indonesia and Their Implications for Donors."
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21. "Microenterprise Growth Dynamics in the Dominican Republic: The ADEMI Case." Frank F.
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*22. "Credit Unions: A Formal Sector Alternative for Financing Microenterprise Development." John
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23. "A Proposed Subsector-Based Monitnring and Evaluation System for CARE/Thailand's Silk
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24. "Steps to the Creation of a Viable Financial Institution for Microenterprise Development in the
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and Nan Borton. GEMINI Working Paper No. 24. November 1991. $2.00
*25. "Village Banking: A Cross- :ountry Study of a Community-Based Lending Methodology." Sharon
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 3

29. "The Subsector Methodology, A Field Orientation for CARE/Egypt, January 20-February 7, 1992."
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30. "'Poverty Lending' and Microenterprise Development: A Clarification of the Issues." Mohini
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35. "BancoSol: A Private Commercial Bank. A Case Study in Profitable Microenterprise Development
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36. "The Structure and Growth of Microenterprise in Southern Africa: Evidence from Recent Surveys."
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 4

5. "Technical Assessment: Rural Small-Scale Enterprise Pilot Credit Activity in Egypt." John W.
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 5

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 6

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November 22-25, 1991. Technical Report No. 38. May 1992. $5.00

39. "Apex Study of the Small Enterprise Development Program of Catholic Relief Services, Thailand."
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44. "Get Ahead Foundation Credit Programs in South Africa: The Effects of Loans on Client
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46. "Micro- and Small-Scale Enterprises in Botswana: Results of a Nationwide Survey." Lisa Daniels
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*47. "The Growth and Dynamics of Women Entrepreneurs in Southern Africa." Jeanne Downing and
Lisa Daniels. GEMINI Technical Report No. 47. August 1992. $3.10.

48. "Small Business Development Programming Trip: Peace Corps/Albania and the Office of Training
 7

and Program Support, Small Business Development Sector." Lauren Spurrier and Wesley Weidemann.
GEMINI Technical Report No. 48. October 1992. $6.00

49a. "Small Enterprise Development in the Russian Far East." Martha Blaxall, Yasuo Konishi, Virginia
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49b. "Supporting Private Enterprises in Uzbekistan: Challenges and Opportunities." Nan Borton, John
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49d. "Small Enterprise Development in Ukraine." Dennis De Santis, Jean Gilson, Max Goldensohn,
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*50. "Skins and Hides in Four Countries in Africa: The Potential Role for Micro- and Small-Scale
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Also available in French.

51a. "Morocco: Assessment of Programming Options for Microenterprise Development." Housni El

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51b. "USAID/Morocco: Assessment of Programming Options for Microenterprise Development.

Report on Workshop and Field Investigations." Matt Gamser, Housni El Ghazi, Sheila Reines, Steve
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[not for general circulation]

52. "Small Enterprise Development in Armenia: Programming Recommendations for Peace Corps
Volunteers." Timothy J. Smith. GEMINI Technical Report No. 52. July 1992. $2.20.

53. "Results of a Nationwide Survey on Micro, Small, and Medium Enterprises in Malawi." Lisa
Daniels and Austin Ngwira. GEMINI Technical Report No. 53. January 1993. $11.80.
*54a. "A Review of Donor-Funded Projects in Support of Micro- and Small-Scale Enterprises in West
Africa." William Grant. GEMINI Technical Report No. 54a. February 1993. $18.80.
*54b. "A Review of Donor-Funded Projects in Support of Micro- and Small-Scale Enterprises in West
Africa: Case Studies." William Grant. GEMINI Technical Report No. 54b. March 1993. $15.60.

55. "Business Linkages and Enterprise Development in Zimbabwe." Donald C. Mead and Peter
Kunjcku. GEMINI Technical Report No. 55. April 1993. $3.40.
 8

Technical Notes:

Financial Assistance to Microenterprise Section:

*1. Series Notebook: Tools tor Microenterprise Programs (a three-ring binder, 1 1/2 inches in diameter,

for organizing technical notes and training material;) and "Methods for Managing Delinquency" by

Katherine Stearns. April 1991. $7.50. Also available in Spanish and in French.

*2. "Interest Rates and Self-Sufficiency." Katherine Stearns. December 1991. $6.50. Also available

in Spanish and in French.

*3. "Financial Services for Women." C. Jean Weidemann. March 1992. $5.00. Also available in

Spanish and in French.

*4. "Designing for Financial Viability of Microenterprise Programs." Charles Waterfield. March 1993.

*5. "Monetary Incentive Schemes for Staff." Katherine Stearns, ACCION International. April 1993.

$3.80.

Nonfinancial Assistance to Microenterprise Section:

*1. "A Field Manual for Subsector Practitioners." Steven J. Haggblade and Matthew Gamser.

November 1991. $4.65. Also available in Spanish and in French.

*2. "Facilitator's Guide for Training in Subsector Analywis." Marshall A. Bear, Cathy Gibbons, Steven

J. Haggblade, and Nick Ritchie. December 1992. $20.00

Field Research Section:

*1. "AManual for Conducting Baseline Surveys of Micro- and Small-scale Enterprises." Michael A.
McPherson and Joan C. Parker. February 1993. $13.60.
 9

Special Publications:
* 1.TrainingResources for Small EnterpriseDevelopment. Small Enterprise Education and Promotion
Network. Special Publication No. 1. 1992. $11.00
*2. FinancialManagement of Micro-CreditPrograms: A Guidebookfor NGOs. Robert Peck Christen.
ACCION International. Special Publication No. 2. 1990 $19.00
*3. The ADEMI Approach to Microenterprise Credit. A. Christopher Lewin. Special Publication No.
3. 1991. $15.00
*4. Microempresasy Pequeftlas Empresas en la ReptiblicaDominicana. Resultados de una Encuesta
Nacional. Miguel Cabal. Michigan State University and FondoMicro. Special Publication No. 4. 1992.
$9.00

Copies of publications available for circulation can be obtained by sending a check or a draft drawn on
a U.S. bank to the DAI/GEMINI Publications Series, Development Alternatives, Inc., 7250 Woodmont
Avenue, Bethesda, MD 20814, U.S.A.

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