The Rush to Regulate:
Legal Frameworks for Microfinance
Robert Peck Christen and Richard Rosenberg

Formal credit and savings for the poor are not recent inventions: for decades, some customers neglected by commercial banks have been served by credit cooperatives and development finance institutions. These organizations have legal charters that govern their financial operations and allow them access to savings or other public funding.

But the past two decades have seen the emergence of powerful new methodologies for delivering microfinance services,especially microcredit. Much of this innovation has been pioneered by non-governmental organizations (NGOs), who typically do not have a legal charter authorizing them to engage in financial intermediation. Governments, donors, and practitioners are now talking about new legal structures for microfinance in dozens of countries. Microfinance regulation and supervision has suddenly become a hot topic, with conferences, publications, committees, and projects appearing everywhere. Much of the attention is focused on NGO microfinance.

For all these reasons, microfinance today seems to find itself in the midst of a rush to regulate. There is no shortage of people willing to offer views on when and how to do it. But all of them, including the authors of this paper, suffer from the same handicap: experimentation with microfinance supervision is so recent that we canít rely much on its historical results to guide us.

Summary of Key Conclusions:

  • Microfinance is unlikely to achieve anything like its potential unless it can be done in licensed environments. Therefore, prudential regulation and supervision of microfinance is a topic that will unquestionably need to be addressed.
  • Nevertheless, in most developing countries today the absence of special licensing regimes for MFIs is not the binding constraint to the development of microfinance.
  • Rather, the bottleneck is usually the scarcity of MFIs who are not dependent on continuing availability of subsidies, and who can operate profitably enough that they are able to pay a commercial cost for a large proportion of their funds without decapitalizing themselves.
  • It seems irresponsible to license MFIs to take deposits if they cannot demonstrate their ability to meet the above test.
  • The challenges facing a given country's supervisory agency, and the realistic obstacles to meeting those challenges, need to be weighed seriously when examining proposals for regulation of microfinance.
  • Regulation and supervision entail significant costs, including non-financial costs like restraint of innovation.
  • Non-prudential regulation needs to be distinguished from prudential regulation, under which the supervisory agency has to vouch for the financial soundness of the supervised institutions.
  • In some settings, reform of non-prudential regulation is probably essential to the development of microfinance, for instance where the licensed financial institutions have no interest in microfinance, but the legal regime makes it difficult or impossible in practice for non-licensed organizations like NGOs to provide credit.
  • Credit-only MFIs, including MFIs whose savings deposits are mainly compulsory compensating balances for loans, should not be subjected to prudential regulation.
  • Small community-based intermediaries-for instance small financial cooperatives-should not be prohibited from taking deposits simply because they are too small or remote to be supervised effectively.
  • The creation of special regulatory windows for MFIs is probably premature in countries where there is not a critical mass of licensable MFIs.
  • The proposition that opening a licensing regime will motivate unsustainable MFIs to become sustainable should be viewed with suspicion.
  • Given today's supply and demand of microfinance funding support, in most countries a solidly sustainable MFI could raise the minimum capital necessary to use an existing form of financial license. The supply of funds available for this purpose in international and bilateral organizations exceeds the demand from financially viable MFIs.
  • More attention needs to be paid to reforming regulations that make it difficult to do microfinance under existing forms of bank or finance company licenses.
  • In developing countries, self-supervision, (defined as oversight of financial intermediaries by a federation or other body that is controlled the same intermediaries being supervised) has a long history of failure, and is highly unlikely to work for MFIs.
  • Rating agencies for MFIs face serious practical obstacles.

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