A Framework for Regulating Microfinance Institutions

Abstract

The continuum of institutions providing microfinance cannot develop fully without a regulatory environment conducive to their growth. Without such an environment, fragmentation and segmentation will continue to inhibit the institutional transformation of microfinance institutions. The authors recommend a tiered approach to external regulations, one that takes into account the different types of microfinance institutions, the products they offer, and the markets they service. A tiered approach can be useful in designing regulatory standards that recognize the basic differences in structure of capital, funding, and risks faced by different kinds of microfinance institutions. The model they develop for a regulatory framework identifies thresholds of financial intermediation activities, thresholds that trigger the requirement that an institution satisfy external or mandatory regulatory guidelines. It focuses on risk-taking activities that must be managed and regulated. They illustrate the usefulness of the model by practically applying prudential considerations to various categories and values of financial risk for each of three broad categories of microfinance institution: 1) Those that depend on other peoples' money (such as donor or public sector funding). 2) Those that depend on members' money. 3) Those that leverage the general public's money to fund microfinance loans. For each category, the model highlights: 1) The observed value ranges for selected indicators of financial risk. 2) Recommended ranges of value suitable for consideration under internal governance. 3) Suggested threshold values that indicate the need for external regulation. A transparent, inclusive framework for regulation will preserve the market specialties of different types of microfinance institutions - and will promote their ultimate integration into the formal financial system. One example of the kind of regulation the authors recommend: Require standard registration documents and procedures - no different from those required of regular corporations - including the designation of a central government agency with which they should register as corporate entities.