Dep’t of Banking and Finance

CHAPTER SIX
THE LEGAL AND REGULATORY FRAMEWORK
The regulatory framework
Regulatory framework is a system of regulations and the means to enforce them, usually
established by a government to regulate a specific activity. A regulatory framework is a model
that can use for reforming and enacting regulations in an effective and logical way. Policymakers
may develop a framework with a specific area of interest, or could use an existing model to work
on a regulatory project. Many governments rely on such frameworks for handling regulatory
matters and developing flexible and useful networks of regulations, laws, and rules.

The regulatory framework can be large and extremely complex. For something like overhauling
financial regulations to address clear shortcomings in an existing system, the work of creating a
framework can take months and includes input from a variety of sources. In addition to people in
the government, it is common to consult people in an industry, as well as agents who will be on
the ground enforcing any regulations the government passes. Public comment may also be an
important component, allowing people to express wishes and concerns so the government can
think about how to meet their needs.

Basic considerations
A. No external regulation should be required for MFIs and those entities in the informal sector
such as rotating savings and credit associations (ROSCAs), club pools and village banks which
are informally organized. Donors, government agencies and commercial banks from which their
funds are sourced may be presumed to have the capability for due diligence and make informed
decisions about them -- a form of regulation through market selection.
B. A standard registration requirement which covers documents of establishment and
governance structure should apply to MFIs in the same manner that other business and social
organizations are required to register. It is not necessary to design and establish a separate
structure of regulatory standards and procedures for MFIs because existing guidelines for
prudential regulation can be adapted to accommodate M FIs.
C. Banking laws govern the mobilization of deposits from the public, but can also address the
mobilization of other types of resources to accommodate the financing and investing needs of

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other sectors, principally by means of non-deposit financial securities and instruments. The
banking laws in a number of countries provide a definition of “public” as persons beyond a
specified number who are not related to each other by law or association. Banking laws should
apply only to voluntary deposits and should not cover forced savings or mandatory deposit
schemes which are specifically tied to loan contracts.
D. Banks and other regulated institutions in the formal sector mobilize non-deposit funds through
capital market activities such as wholesale deposits, commercial paper issues and securitization.
Subject to well-defined requirements and procedures under the banking and securities laws, it
should be feasible to allow MFIs similar (but restricted) mobilization of non-deposit funds. In a
number of countries where institutions can raise funds in the capital markets, an independent
credit rating agency performs an indispensable market-based regulatory role. No special
treatment or exemptions from eligibility or registration requirements should be accorded MFIs
which plan to mobilize wholesale funds, and MFIs should satisfy the same standards required of
other institutions that raise funds in the wholesale and capital markets.
Various reasons for regulating microfinance institutions
 In order to reach significant scale and to provide adequate service to clients, microfinance
institutions need to go beyond government and/or donor support to attract private capital and
to mobilize savings.
 To allow for an orderly development of the sector- Most microfinance institutions started as
donor-funded institutions and have to seek alternative strategies to survive due to donor
fatigue
 Shift from donor-funded NGOs to more commercially oriented entities- regulations lays the
foundation for such transformation
 Ensure financial sector stability- though players in the microfinance sector have little
systemic impact, failure can have negative impact on the credibility of the financial sector
 To render legitimacy and confidence to the sector- attract long-term funding to the sector,
investors, donors, need to have confidence in the systems in which the recipient of the funds
operates in.
 Regulation sets minimum acceptable standards and gives confidence in MFIs as a safe
destination of donor or investor funds

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Dep’t of Banking and Finance

A regulatory framework includes the laws, regulations, guidelines, rules and codes that regulated
entities are required to comply with and an institution or structure for enforcing compliance.The
regulatory structure is therefore an institutional form which carries out supervision of the
regulated entities.
Supervision has broadly been defined as a process of enforcing the regulatory framework. It
includes the interaction between the regulatory authority and the regulated institutions that
enables the regulatory authority to:
- Monitor the financial soundness of the regulated intermediaries
- Proactively identify and respond to emerging trends and problems in the industry and at
specific institutions.
- Enforce compliance with regulations
- Manage the exit of failed institutions from the financial system with the aim of preventing
financial system instability and losses to small, unsophisticated depositors.
The regulation of financial institutions is generally explained as a response to the need for
systems to maximize the mobilization and intermediation of funds, enhance efficiency in the
allocation of capital, ensure appropriate risk management, and protect depositors. Its focus is on
financial sector stability and depositor protection. Standard banking regulation and supervision
tend to impose ineffective and overly burdensome requirements on MFIs if the same is applied
without modification. Need to be clear about the rationale of regulation and supervising the
sector. The general structure must be translated into specific prudential norms, supervision and
reporting systems, and rules governing entry and operations of MFIs and also the implementation
of these norms and systems. Norms and systems should be designed in ways that make them
easy to administer. Supervisory body should have the necessary resources and capacities to
ensure proper implementation of the norms and systems. In determining the regulatory and
supervision structure to be applied to microfinance markets, policymakers need to take into
account a whole range of issues.
Issues that need to be taken into account when designing regulation for the microfinance sector:
 its attempt to deepen financial markets - to serve micro-enterprises and poor households;
 its high unit costs of lending;
 its approach of physically taking banking services to clients who have few other options to
receive financial services;

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 the relatively undiversified and sometimes volatile nature of MFI credit portfolios;
 Any regime of regulation that is adopted must cope with the special problems of regulating
and supervising MFIs. These includes:
- The absence of owners’ capital to draw on to meet capital calls for most MFIs;
- The fact that MFI lending modalities make audits and corrective steps difficult;
- The potentially high costs of MFI supervision.
 Different cost structures and Funds sources;
 The difference in institutional orientation, with some MFIs clearly profit-oriented while
others are committed to providing services to the poorer segments of the population on a
non-profit basis;
 The fact that most MFIs began as unregulated credit NGOs, with a focus on social goals
rather than financial accountability and sustainability;
 The fact that MFIs deal in savings and credit transactions with relatively low value in
relation to the financial system as a whole - and as a result are unlikely to have problems that
cause broad systemic instability;
 The market risk posed within the microfinance sector itself when MFIs (especially large
ones) are not properly managed and monitored.
The regulation and supervision of microfinance institutions by an independent regulatory agency
is relatively new in many countries. The introduction of regulatory framework for MFIs in many
countries was mainly aimed at addressing a number of concerns in the MFI industry. A number
of MFIs are operating in an unregulated market. This is because regulatory agencies focus their
regulatory resources on deposit-taking MFIs. It should be noted that a sound regulatory structure
for MFIs is critical in ensuring that MFIs perform their functions efficiently.
A regulatory framework can either stimulate or retard the growth and development of MFI.
 Excessive regulations can stifle MFIs’ growth
 Appropriate regulations promote market development
Given that most MFIs have or are evolving from NGO forms to commercial forms, there exists a
wide array of regulatory structures for MFIs. There is no ideal regulatory structure that fits all
countries as regulatory structures are dependent on:
 MFI industry development,
 Legislative environment,

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Dep’t of Banking and Finance

 Resources,
 Capacity.
Regulatory Structures
The regulatory structures may be one or a combination of the following forms:
1. Primary registrar 4. Apex institution
2. Network of MFIs 5. Delegated authority
3. Self-regulatory body 6. Central Bank
Primary Registrars - In a number of countries MFIs are registered as legal entities under
various pieces of legislation. Regulation and supervision by the Primary Registrars’ is non-
prudential.
Network of MFIs - Various national and international networks exists that offer support to
MFIs. These networks may comprise formal and informal MFIs. Networks play a regulatory role
in the sense that they develop performance standards and best practices which member
organizations are encouraged to strive to achieve. Failure to abide by the norms of the network
often leads to loss of benefits that such networks offer which include capacity building
opportunities (training and systems implementations) and financial services (e.g. grants and
guarantees)
Self-Regulatory Body - This is a body that is formed, owned and controlled by member MFIs to
be supervised. Self-regulatory bodies play a useful role in regulating market conduct by
formulating codes of conduct and other norms for members. The self-regulatory body has the
primary responsibility for monitoring and enforcing agreed norms. Evidence suggests that this
regulatory structure is not suitable for prudential supervision as participating institutions often do
not have enough incentive to induce them to hold a rigorous line when problems arise. For
instance, they would find it difficult to sanction closure of an ailing member.
Apex Institution - In some countries there is an apex institution or national fund that does
wholesale lending to local MFIs. As an investor, such an apex is by its nature a kind of
regulatory structure. The Apex evaluates and monitors the soundness of the MFIs it lends to. For
MFIs that fail to meet its standards, the sanction is denial of loans. In this regard, MFIs strive to
comply with the terms and conditions of the borrowing which would include:
 Financial soundness (adequate capital);
 Achieving and maintaining acceptable profitability;

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Dep’t of Banking and Finance

 Ability to meet obligations as they fall due (liquidity);

 Having a competent Board of Directors; and
 Having annual audited financial statements
Delegated Supervision - Delegated supervision is an arrangement where a government financial
supervisory agency delegates direct supervision of financial institutions to an outside body, while
monitoring and controlling that body’s work. Delegated supervision can be conducted by an apex
regulatory structure, an association of MFIs or audit firms. Delegated supervision has its own
issues which need to be clearly understood before a decision is taken to implement it. Some of
these issues include:
 Who will pay the costs of delegated supervision?
 If the delegated supervisor is unreliable and its delegated authority must be
withdrawn, is there a realistic fallback option?
 When a supervised institution fails, which body will have the authority and ability to
clean up the situation by intervention, liquidation, or merger?
Financial Supervisory Agency (Central Bank) - The central bank in a number of countries is
the financial supervisory agency that is responsible for regulating banks and other financial
institutions including MFIs. Financial supervisory agencies focus their resources on deposit-
taking MFIs and apply non-prudential supervision on credit only MFIs. There is limited financial
and human resources to effectively supervise all MFIs. Other central banks have raised the
minimum start-up capital for MFIs as a way of rationing prudential supervision.
There are regulatory challenges that arise when supervisory authorities attempt to apply a
regulatory structure to an evolving sector such as the MFI sector. Some of the common
challenges in the MFI sector include the following:
 Corporate Governance: Shareholding limited and Board of Directors
 Regulatory Arbitrage
 Limited delivery channels in rural areas
 Cost
 Pricing of products
 Limited sources of funds
 Supervisory

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Dep’t of Banking and Finance

Prudential or Non-Prudential Supervision

Prudential regulation should not be imposed on “lending-only” microfinance institutions (MFIs)

that merely lend out their own capital, or whose only borrowing is from foreign commercial or
non-commercial sources or from prudentially regulated local commercial banks. Depending on
practical costs and benefits, prudential in some cases may not be necessary for regulation MFIs
that take cash collateral (compulsory savings) as part of a loan contract, but do not take other
savings (especially if the MFI is not lending out these funds). Financial cooperatives—at least
large ones—should be prudentially supervised. Designers of new regulation for microfinance
need to pay much more attention than usual to issues of likely effectiveness and cost of
supervision. In issuing financial intermediation licenses, the government invites public reliance
and implicitly promises effective measures to mitigate depositor risk. Before issuing licenses, a
government needs to be clear about the nature of such promises and its practical ability to honor
them.

Prudential Supervision Versus Non-prudential

Prudential - Aimed at protecting the financial system

- Protect safety of small depositors

- More complex, difficult and expensive

- Minimum capital requirements, lending limits, corporate governance issues, and standard
loan documentation

Non-prudential - Focus on conduct of business

- Applied to non-deposit taking MFIs

- Disclosure of effective interest rates

The rationale for regulating microfinance

As to microfinance, in order to reach effectiveness in relieving poverty by creating a safer
environment for economic development, the main goal of microfinance regulators is to ensure
the soundness of MFIs and the quality of the services that they provide. Beside these

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objectives, a peculiar consideration for microfinance institutions concerns their capability to

attract donor’s and public’s funds for financing microfinance; in some contexts the lack of a
clear regulatory structure of MFIs – based on preventive and protective instruments – as well as
the inadequacy of the general legal environment, determine, ceteris paribus, a difficulty for MFIs
located in some countries to attract funds. In presence of appropriate regulatory schemes and of a
reasonable supervision on MFIs, a greater amount of money could be addressed to those
economic initiatives that, as mentioned before, produce recovery rates higher than the traditional
financial sector and can rapidly improve the life conditions of a huge number of people.
The analysis of the most suitable regulation and supervision to implement for microfinance
should be developed considering four main criteria. These are:
1. The assessment of systemic risk deriving from microfinance. It depends on the development
of the industry in the country, on the industry’s age and on the volumes intermediated by
MFIs in the financial system.
2. The typology of activity carried out by MFIs; particularly, the most sensitive distinction is
between credit-only institutions, entities that collect savings, and intermediaries which
provide other financial services not included in traditional intermediation.
3. The origin of funds utilized in order to provide microfinance services. Under this profile,
there are different interests to be preserved in case the MFIs use public’s sums, donor’s funds
or member’s savings.
4. The nature of MFIs to somehow regulate, analyzing institutions that have different legal
structures, governance, target clients and goals (distinguished, for descriptive reasons, in
NGOs, credit unions, microfinance banks and downscaling commercial banks), which must
be treated according to various approaches.
As far as the first criterion is concerned, until microfinance used to be a marginal phenomenon
that involved a few credit-only NGOs and a small number of beneficiaries, there was no need to
think about the opportunity to regulate, because regulation and supervision are expensive public
goods. Moreover, in some developing countries, it is more likely that these goods are involved in
a host of principal-agent failure such as corruption, which often makes vain any attempt to
supervise microfinance institutions5. Given their nature of expensive public goods, regulation
and supervision should be used in those areas with the highest payoffs in terms of systemic risk
mitigation.

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Dep’t of Banking and Finance

According to the literature and to the experiences of the past years, in the vast majority of
countries microfinance does not create systemic risk, given the small amount of loans and the
very limited access to the payment system of MFIs, where it exists; therefore, in all the countries
where the systemic relevance of microfinance is limited, a vast number of authors agree on a soft
regulation, essentially based on public registration (licensing), or suggest the implementation of
self-regulation schemes and second-tier regulation (delegated regulation).
Also the development of the industry in the country and the volumes intermediated by
MFIs in the financial system affect the decision about how to regulate and the instruments to
adopt. Particularly, the need to design a specific regulatory framework for microfinance
institutions is especially felt in the countries where those institutions are significant actors in the
financial market; otherwise, the most common solution that is adopted is to regulate under
Banking Law those entities which collect deposits and offer loans, whereas credit-only
organizations are often in a shadow area, without any explicit regulation or supervision.
According to second criterion, the choices about regulation and supervision are based on the
nature of the activities that are performed by microfinance entities. All the institutions that
provide credits as a unique financial service are characterized by a very low contribution to the
overall systemic risk. Therefore, they are often not regulated even if some countries require from
them transparency standards and the control of unfair practices (so called “conduct of business”
reporting). Of course, whenever a MFI does not limit its activity to credit supply, but collects
savings, and sometimes offers payment instruments, the institution is almost everywhere forced
to be converted in a regulated entity (commonly a bank), or assumes the status of “microfinance
bank” where a specific regulation exists. Such conversion, as obvious, implies the respect of all
entry requirements, of minimum capital requirements and prudential ratios, as well as of
periodical reporting. Last, for those institutions which offer other financial services, it seems
appropriate to adopt a regulatory approach similar to credit-only institutions, if the only
peculiarity is represented by the lending methodology; on the other hand, for those MFIs which
intend to provide more complex financial service than the traditional financial intermediation, a
specific regulation is strongly recommended.
Third relevant criterion in order to determine regulatory policy is the origin of funds used by
MFIs. Whenever this money is donated by third-party organizations, these usually have
appropriate instruments for assessing the MFI they intend to finance; furthermore, in absence of

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specific regulations, donors can prevent unfair practices by monitoring the selected institutions
and requiring from them specific reporting on the use of funds. The policy considerations can
vary significantly depending on whether funds are provided by the public or by members of
mutual credit entities or savings banks. In this case, the presence of asymmetric information
between depositors and MFIs is often adduced as the main reason why regulation and
supervision are required. In fact, depositors are exposed to moral hazard due to the risk of
savings absorption in the event of MFIs’ crises.
As regards the third criterion, in the light of above the most suitable approach of the ideal
regulation to adopt must be diversified according to the source of funds. All MFIs, whatever is
their source of funding, in order to improve their capability to attract money, should be required
to be publicly registered and should produce periodic reporting (including at least credit
methodologies, concentration, credit provisioning and write-offs) to be addressed to a specific
regulatory body – where microfinance market is a significant portion of the financial system – or
to the authority in charge of supervising the financial system in other cases. Those entities which
collect public’s funds should be compliant with a set of tailor-made rules concerning market
entry, minimum capital ratios, organization and deposit insurance. These regulations on one hand
should impose milder capital requirements than banks, on the other hand they should delimitate
the potential activity, and therefore the risk, that these entities could run.
Last criterion here approached concerns the nature of MFIs, where the distinction usually
performed regards non-governmental organizations, credit unions (and other mutual credit
entities), downscaling commercial banks and microfinance banks. The most significant aspects
to deepen about the nature of MFIs and their regulation are legal structures, the borders of their
activities and their internal organization. As mentioned before, as long as NGOs operate as
credit-only institutions they need a very limited attention from regulators; however when NGOs
begin to offer savings facilities they are required to assume a different legal status, with a well
defined capital in order to calculate prudential ratios and to implement internal control functions.
These institutions, therefore, should then be regulated according to their new nature. Credit
unions and microfinance banks, considering their deposit-taking nature, but also their difficulties
in rising capital and their goal of sustainability, have to be regulated by a specific set of rules
which prescribe less stringent capital requirements and an easier organizational structure than
banks. Last, downgrading commercial banks, which by definition are fully regulated banks

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according to the national “Banking Law”, do not seem to need particular requirements if
compared to other banks, because they go on performing not only microfinance services;
therefore, in most countries they continue to be supervised and regulated as usual banks.
The combination of all the above-mentioned criteria originates a peculiar picture that varies
according to the country, and therefore it is not possible to imagine a single regulatory approach
suitable for microfinance industries worldwide. The role of the regulator in microfinance
development is still an open issue. While some are in favor of a market-directed approach, with
the regulator simply setting the framework for the industry, others advocate a more government-
directed stance with an active promotional role for the regulator. Still, in some countries, such as
India, the role of the regulator is to integrate microfinance into the overall financial
infrastructure, which usually requires a degree of promotional support in the early stages of the
industry’s development; the regulator’s support to ensure the soundness of these institutions
could involve lending assistance and gradually the introduction of prudential norms.
A deep regulation would contribute to make the microfinance safer (and depositors too), but it
would make it too complex for small MFIs to operate in accordance with regulation; the net
effect could be a reduction in microfinance supply, which is the consequence that those who
support regulation want to avoid. Furthermore, a too strict regulation usually limits the capability
to innovate, therefore policy makers deciding which regulation to implement must consider the
overall soundness of the financial system, but also innovation.

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