Thanks to Vikram Akula and SKS, microfinance — the provision of financial services to low-income persons and small, informal businesses — is in the news.
First it was on account of the phenomenal success of the SKS Microfinance initial public offering and, more recently, on account of the unsavoury happenings at the company.
In the process, the more important aspect, regulation of microfinance institutions, has not received the attention it deserves.
Fortunately, the lacuna has been made good by the Bank for International Settlements, Basel.
Better oversight, apart from protecting depositors, is bound to enhance access to financial services by increasing confidence in microfinance providers.
However, compliance with prudential rules and other requirements can be costly for both supervised institutions and supervisors relative to the risks posed by this line of business.
Thus, microfinance oversight, whether over banks or other deposit-taking institutions (ODTIs), should weigh the risks posed by this line of business against supervisory efforts necessary to monitor and control those risks and the role of microfinance in fostering financial inclusion.
While the Core Principles for Effective Banking Supervision developed by the Basel Committee on Banking Supervision have become the de facto standard for sound prudential regulation and supervision of banks, there is no guidance for microfinance institutions yet.
A recent BIS paper attempts to fill this gap.
It lists four priorities: (i) allocate supervisory resources efficiently, especially where depository microfinance does not represent a large portion of the financial system but comprises a large number of small institutions,
(ii) develop specialised knowledge within the supervisory team to effectively evaluate the risks of microfinance activities, particularly microlending,
(iii) recognise proven control and managerial practices that may differ from conventional retail banking, and
(iv) achieve clarity in the regulations with regard to microfinance activities.
While many of the principles apply equally to banks and ODTIs engaged in microfinance, others require some tailoring.
Lower initial capital requirements for ODTIs may be appropriate given the limited complexity, scope and size of their operations, especially in rural areas.
However, the threshold should be high enough to discourage unviable candidates and yield a manageable number of institutions to supervise.
In exchange for lower initial capital, supervisors should limit the kinds of activities permitted to ODTIs.
Ongoing monitoring and surveillance may be used to identify when certain players or sectors become systemically significant or begin using new technologies — such as mobile phones and non-bank agents — that require different supervisory approaches.
A similar tailoring is appropriate for applying norms regarding capital adequacy requirements.
These should relate to (i) the nature of microfinance risks for all institutional types, and (ii) the size and constituents of capital of specialised ODTIs.
With respect to microfinance institutions, supervisors should focus on credit risk, as the loan portfolio is their main asset.
They also need to take into consideration the relative significance of microfinance within a diversified institution; that is, where microfinance is one of many lines of business in a diversified financial institution, risks may be more easily mitigated.
Specialised knowledge of characteristically labour-intensive microlending methodologies and an appropriate degree of flexibility from supervisors are imperative for assessing asset quality and risks.
For example, supervisors should set loan documentation standards that are efficient and feasible to maintain relative to the nature of the customers and their businesses, which may differ from those of conventional retail lending.
Again, supervisors should adjust provisioning and classification norms to the unique risks of microcredit.
Microfinance is another ball game. Rules and guidelines that apply to normal banks must be tweaked to adapt to microfinance realities without in any way diluting their rigour.
Posted by George Varuggheese , President at Godimages Good Governance Society | 14 Oct, 2010
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