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Microfinance: an analysis of experiences and

alternative regulations

Miguel Delfiner, Cristina Pailh y Silvana Pern*

April, 2006

Summary

In recent years, the interest for the study of microfinance has increased, in relation with the growingdevelopment that the activity has experienced in different parts of the world. This brought about therise to the birth of a whole branch of literature dedicated to the different aspects of this topicincluding the regulatory and supervisory approach that would correspond to apply to the activity.

This work is centered on the analysis of microfinancial institutions (MFIs), at international and locallevel, as well the different regulatory approaches that are suggested for microfinance. The ultimate

purpose is to obtain conclusions of regulatory policy. First, we need to clarify what is meant bymicrofinance in order to understand what is an MFI and what is not an MFI; second, understandhow MFIs operate and their importance at the international and local levels; third, deepen thediscussion of the regulatory aspects of the MFIs, for finally, and according to the analysis carriedout, obtain relevant policy conclusions for the local scope.

* Miguel Delfiner ([email protected]) is Chief Analyst; Cristina Pailh ([email protected]) is Manager andSilvana Pern ([email protected]) is a Senior Analyst; all members of the Gerencia de Investigacion yPlanificacion Normativa; Subgerencia General de Normas, BCRA. The views expressed in this paper are the

opinions of the authors and do not express the official position of the BCRA. The views expressed in this paper arethe opinions of the authors and in no way express an official position of BCRA. The authors are grateful to JoseRutman, particularly for the support provided for this work and the exchange of ideas; and they also appreciate allthe comments received and the valuable discussions in various fields, which contributed significantly to understanding the topic and the quality of work. The remaining errors are the sole responsibility of the authors.


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Index

1. Introduction

2. Conceptual Framework: what is microfinance?

3. International experience of microfinance

3.1. Importance of the MFIs in different countries3.2. Active institutions in microfinance3.3. Indicators of the microfinance industry3.4. The Grameen Bank3.5. The Bolivian experience

4. Credit methodologies of the MFIs

5. Regulatory aspects of microfinance

5.1. World Bank5.2. Interamerican Bank of Development5.3. USAID5.4. Consultant Group to assist the Poor (CGAP)5.5. International Monetary Fund

6. Microfinance in the local environment

6.1. Current situation: active institutions in the area of microfinance and microcredits6.2. Local regulation of financial entities and microfinance

7. Conclusions

Appendix of complementary data

Bibliographical Index


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1. Introduction1

In recent years, the discussion about microfinance has grown remarkably at local andinternational levels. The declaration of 2005 as the "International Year of Microcredit" by theUnited Nations, aimed to promote discussion recognizing ...that microcredit programs have

successfully helped in rescuing people out of poverty in several countries around the world".

2

The phenomenon of microfinance and the experience ofmicrofinance institutions (MFIs) arerelatively new. Thus, compared to other fields of study, microfinance can be considered as anarea of analysis still hardly explored. While there is an increasing number of publications andresearch on the subject, still there is no unanimous consensus on many aspects of itsfunctioning. From a macroeconomic point of view, there is agreement that the MFIssuccessful experiences have helped reduce poverty in the demographic groups covered. Froma microeconomic perspective, there is a rich discussion about how MFIs operate; itsdistinctive characteristics with respect to other financial institutions; regulations that theyshould be subject to, among other aspects.

This work focuses on the analysis of the functioning of the MFIs, without studying themacroeconomic effects. The ultimate goal is to obtain regulatory policy conclusions. This is,first, to clarify what is meant by microfinance in order to understand what is it an MFIandwhat is it not an MFI; second, to understand how MFIs operate and its importance atinternational and local level; third, to deepen the discussion of the regulatory aspects of theMFIs and; finally, according to the analysis, to obtain relevant policy conclusions at the locallevel.

Section 2 contains a conceptual discussion on what is meant by microfinance and thecharacteristics that differentiate it from traditional finance. Section 3 deals with the MFIsinternational experience of undertaking a study by country, by institutions and, at theaggregate level of the microfinance industry, indicators that illustrate the MFIsperformanceare analyzed. In addition, two very well-known experiences are described in detail: theGrameen Bankin Bangladesh and, the case of Bolivia, especially represented by BancoSol.Section 4 contains a description of some of the more used credit methodologies by MFIs.

In Section 5, begins the discussion of the regulatory aspects, exposing a compilation ofapproaches of various international bodies regarding the regulatory policies applicable to theMFIs. Section 6 focuses on the analysis of microfinance at local level. First, experiences ofinstitutions engaged in activities relating to granting microcredit are described. Second, ananalysis of the local laws and regulations and how they envisage the microfinance is carriedout. Section 7 presents the conclusions.

1 This work had an earlier version of the year 2001 developed in the Gerencia de Investigacion yPlanificacion Normativa, in the context of the analysis of a preliminary law design for the creation of theBanca Solidaria , what gave origin to a first investigation and a documental summary of the internationalbackground.2 United nations, Resolution 1998/28


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2. Conceptual Framework: what is microfinance?

The term microfinance refers to the provision of financial services to people of low income,especially to the poor. The entities that carry out those activities are denominatedmicrofinance institutions (MFIs), which can be defined as " any organization - credit union,

small commercial bank, financial non-government organization, or credit cooperative - that provides financial services to the poor". 3 Such services include financing, saving andpayment instruments, among others.

On numerous opportunities, the term microfinance is used in a much more limited sense,referring only to the provision of micro-credit for small informal businesses of micro-enterprises. However, the MFIs clients are not only micro-entrepreneurs seeking funding fortheir business. The range of financial services provided by the MFIs has grown beyond andcovers an extensive menu that includes attracting savings, money transfers and insurance. Inrecent years, attracting deposits has been amplified due to a growing demand of the poorest people and since it is a source of natural funding for MFIs. Micro insurances are stillemerging, being life insurance the segment more developed. Moreover, microcredits are

provided in conjunction with a range of non-financial services, such as technical assistancefor business development and training.4

The microfinance activity started in 1974 with the Bengali economist Muhammad Yunus5,who began a new experience thus far: lend money for micro-enterprises to poor people, withhis own funds, without requiring any of the usual guarantees. What started as an attempt tohelp some families, grew into the current Grameen Bank (Bank of the Poor), a financialinstitution that addresses the provision of microfinance services.6

It is important to look at how MFIs have developed in order to clarify the latter discussion.Most MFIs, that are currently recognized at international level for being pioneers in the fieldand have achieved a significant volume and diversification of operations, began as nonprofitinstitutions, financially supported by Non-Governmental Organizations (NGOs),governments, private contributions and charitable organizations with the aim of grantingmicro-creditto poor people. As they developed, they enlarged the range of services provided,financial and non-financial. As a trend, it is observed that once MFIs reach a certain level ofdevelopment, they begin to broaden their sources of funding, including the collection ofdeposits from the public. When this happens, MFIs are in a new stage, since their role ismuch more similar to a traditional financial institution, in the sense that issues paymentinstruments and savings. It is at this point, when they usually begin to be under the scope of

3 According to the definition of CGAP (2003), Consultative Group to Assist the Poor, consortium of 28public and private development agencies that work together to expand the access to the financial services ofthe poorest. With headquarters in the offices of the World Bank, it assists charity entities, MFIs and marketparticipants, providing technical attendance, training, investigation and development, dissemination ofinformation and funds for innovations.4 FMI (2005)5 Yunus, Muhammad Towards a world without poverty.6 Later on, in this work it is presented a detailed description of the history and current operations of theGrameen Bank.


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prudential regulation, given that the mandate of the regulators is based on protecting theinterests of small savers and maintaining of the systemic financial stability.7

On the other hand, having been the provision ofmicrocreditwhat led to the birth of the MFIs,much of the discussions concerning microfinance tend to concentrate on this concept, leavingaside the consideration of other services provided by the MFIs and its features. Microfinance,as defined in this paper, includes the full range of financial services (and not financialcomplementary services) provided by the MFIs. At the same time, at the international level,there is a broad discussion regarding what is meant by microcredit, without being at present asingle definition of the term. 8 However, it is important to note that while grantingmicrocredits (whatever the exact definition is used) is an inherent activity of the MFIs andcharacterizes them; it is not exclusive of them. In principle, a traditional financial institutioncan provide microcreditand devote part of their business to microfinance, in the terms thatregulations permit. In other words, there are no MFIs without microcredits -since they are atthe core of its loan portfolio and what led to their birth- but the reciprocal is not necessarilyvalid.

In this discussion, it is fundamental to understand and keep in mind the unique characteristicsof microfinance in comparison to traditional finance. For example, the lack of physicalcollaterals or the existence of them, but in an inappropriate manner, is one reason that couldhinder the borrowers to be considered qualified fellows to obtain financing through atraditional bank. How do MFIs compensate for the absence of such guarantees? Table 1, onnext page, summarizes some of the distinctive features of the credit methodologies used bythe MFIs, in comparison with those of traditional financial companies 9 , as well assummarized characteristics of loan portfolios, operating costs involved and governancestructure in both entities, among other relevant aspects.

Usually, the credit methodology applied by the MFIs is labor and information intensive andreferral depends on the person's character, on contracts of solidarity responsibility and the

conditional access to long-term loans, rather than physical guarantee and formaldocumentation. The use of contracts of solidarity responsibility or combined debt (credits to agroup of people where everyone is affected in the event of non-payment) allows to mitigatethe effects of adverse selection (the debtors in a small community know who is a risky debtor)

7 A complete discussion regarding the justifications to regulate the MFIs is in CGAP (2003) and in MFI(2005). Those who privilege the argument of the systemic financial stability, sustain that the MFIs thathave very low deposits-intaking should not necessarily be covered by the prudential regulation since theydon't imply a systemic risk for the financial system and it could suffice if they are established nonprudential regulations. However, the argument of the mandate of representing the interests of the smallsavers remains valid. Later on in this work the discussion of the regulatory aspects is enlarged.8 Muhammad Yunus (2005) says: The word "microcredit" has been imputed to mean everything to

everybody. No one now gets shocked if somebody uses the term "microcredit" to mean agricultural credit,or rural credit, or cooperative credit, or consumer credit, credit from the savings and loan associations, or

from credit unions, or from money lendersI think this is creating a lot of misunderstanding and confusion

in the discussion about microcredit. We really don't know who is talking about what. I am proposing that

we put labels to various types of microcredit so that we can clarify at the beginning of our discussion which

microcredit we are talking about. This is very important for arriving at clear conclusions, formulating right

policies, designing appropriate institutions and methodologies. Instead of just saying "microcredit" we

should specify which category of microcredit .9 In section 4 of this work, a detailed description of the credit methodologies used by the MFIs is carriedout.


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and moral hazard (debtors can easily monitor each other). However, this technique has itslimitations because over time the activities of the members of the group grow at differentrates and, therefore, require different amounts of capital. Members of the group with highergrowth rates will feel constrained by the remaining members and those with slow growth areforced to ensure sums increasingly important. Additionally, as the members of the groupdevelop a credit history over time, the need for a collective guarantee disappears.

As for the loans portfolios, the business nature of the MFIs embeds them with particularcharacteristics. Since the loans are due usually in a relatively short time, the turnover of theportfolio is quite high. In addition, the portfolios tend to be less diversified than conventional portfolios in terms of product, type of customer, industry and geographic area. Therepayment of the loans takes place in a weekly basis because of the economic cycleunderlying the micro-entrepreneur, whose income and expenditures occur in weekly orfortnightly intervals.

The operating costs of the MFIs are influenced by various factors. Since the loans are small,each loan adviser must manage a large number of accounts. The high frequency of collection

of quotas for the repayment of loans, the technical assistance required by clients and theintensive credit methodologies in the use of information also contributes to increase costs. Asa result of these and other features, microfinance unitary costs are high; in general theyquadruple the costs of traditional loans. 10 Consequently, the MFIs usually apply higherinterest rates than other financial institutions to cover these costs, but over time, the acquiredpractice and the developed technology, allows them to reduce them gradually. BancoSol, theBolivian commercial bank that began giving micro-loans in 1992 with initials rates of 65% inu$s, lends at the moment with rates of the order of 20% in u$s.11

The MFIs are also characterized by a capital structure with high participation of NGOs andnon-profit shareholders, at least in its early stages of development, in which equity is the primary source loan funding. In subsequent stages, they tend to expand their sources of

funding to attracting deposits from the public. Lastly, the clientele of the MFIs distinguishesfrom the one assisted by the rest of the financial institutions, because it is composed mostly by groups of people with very low income, with little or no experience in the traditionalfinancial sector and little prospect of submit formal documentation for obtaining financing.

3. International experience of microfinance

At the international level, in its short history, the microfinance industry has undergonedramatic changes. For one thing, although the activities of the MFIs have spread beyond thecountries in which they originated, yet there is a high concentration of activities in a number

of countries and regions. On the other hand, what started as isolated experiments is becominga new industry with its own characteristics and with a growing number of institutionsoffering financial services and a number of customers served. However, there is still a greatheterogeneity within what are considered in general terms "MFIs".

10 FMI (2005) estimates that the operative cost for the MFIs are of the order of 15%-20% of the loan value,in contrast with the traditional entities cost, whose cost is of the order of 5%.11 Presentation of Lic.Pilar Ramrez, president of the FIE of Bolivia in the Seminario Nacional de lasMicrofinanzas, Chancellery - Bs.As. 11/23/2005.


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Regarding the first point, this section begins to carry out a study about the importance ofmicrofinance at the country level, with the aim of having a vision of the "roadmap" at theinternational level. It then performs an analysis to identify the major microfinance providerswhile describing a set of quantitative indicators in order to characterize the activities of themicrofinance industry. Finally, this section describes two well-known cases of experiences inmicrofinance: the Grameen Bank and the Bolivian experience.

3.1. Importance of the MFIs in different countries

Though, at the international level, there are no audited statistics of the total number of MFIs,there are partial data that allow to quantify approximately the importance of their activities.In this regard, one of the most comprehensive sources of data is compiled by TheMicrofinance Information Exchange (MIX). 12 This institution has information from avoluntary survey conducted among a significant number of MFIs in various parts of theworld.13 While the data may have some selection bias, being a voluntary survey, it is the

broadest and most consistent source that is available. The information corresponds to July2003.

Of the data compiled by the MIX for the analysis of this section, a representative subset ofcountries was selected representing the total sample in terms of the total assets of the MFIs,the amount of portfolio loans and the amount of debtors.

According to the data analyzed,14 there is a dissimilar importance of the MFIs betweencountries and regions (see Figure 1). Peru and Bolivia, in that order, are the Latin Americancountries that have larger assets ($ 776 and $ 505 million, respectively) and higher loansamount ($ 612 million in Peru and $ 418 in Bolivia). The MIXs sample did not have detailsabout the activity in Argentina, probably due to the deficiency of available statistics at thelocal level.

Bangladesh, a pioneer in the area of microfinance, has the largest amount of assets, loanportfolios and debtors of the whole sample, well above the rest of the countries. It also standsout that the average loan amount, in that country, is the lowest in the whole group analyzed,about u$s 78. By contrast, the average loan amount is higher in those Latin Americancountries surveyed. In this group, the highest amounts are for Bolivia and Ecuador withapproximately u$s 1,300 and Peru with u$s 1,000.

While it might be expected that the amount of the average loans granted have somerelationship with the GDP per capita of the countries analyzed, a uniform pattern is not

12 MIX (www.themix.org). MIX is a private non profit entity that tries to solve one of the main problemsof the microfinanzas: the lack of information. FMI (2005) offers a description of the alternative sources ofdata and their inconveniences: one of the most complete databases is Daley-Harris (2003) which embraces55 countries, but it has the disadvantage of leaving out an important number of institutions that offermicrofinance products. Christen et al. (2004), gathers a great quantity of institutions related withmicrofinance, but the content of information is limited.13 Data for this survey have been contributed voluntarily by 453 entities, of which 253 provide outstandinginformation.14 The appendix of complementary data, at the end of the document, contains the statistics summary.


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observed in this regard; at least with simple data observation and without controlling forother factors. Figure 2 shows both variables with the countries grouped according to theirHuman Development Index.15

Mexico is the only country, of the sample, that belongs to the group of those of highdevelopment and that has the biggest GDP per capita, of the order of the u$s 9.100. There,the average loan is of u$s 338. In countries belonging to the group of low development, theaverage loan ranges between values exceeding u$s 1,000, in the case of Benin (with a percapita GDP of u$s 1,100), and u$s 104 for Ethiopia (with a GDP per capita of U$s 711). Onthe other hand, the country with lower amounts of loans by debtor, Bangladesh, is amongthose of average development, being its GDP per capita just over u$s 1,700. In the averagedevelopment group, are also located all the other Latin American countries that are includedin the sample.

3.2. Active Institutions in microfinance

At the international level, among the major networks involved in microfinance areOpportunity International, FINCA, ACTION16, ProCredit, the Women's World Bank andGrameen Bank (which has no formal ties with other banks, but a replication program invarious countries). At one end of the spectrum, are those networks and organizations that arecharitable and focus on granting loans, particularly Grameen, FINCA and OpportunityInternational. Typically, these entities belong to religious investors or to entities withphilanthropic purposes that usually seek sustainability and often receive donations (of theorder of u$s 1,000 million in 2004)17 plus the contributions of private funds and technicalassistance free of charge to members of the entity.

As a consequence of the uneven development of the microfinance industry, the distribution ofthe industry size is highly biased as some studies show, with a few large MFIs assisting thetotal customers. As an example, an analysis based on data from 1,500 MFIs operating in 85countries of Asia, Africa and Latin America found that 3% of the largest institutions accountfor more than 80% of the total members of the MFIs. 18 Table 3 presents informationregarding the extent of the activities of the individual MFIs, in terms of the size of its assets,stock of loans and deposits, and numbers of debtors, also for a subset of representativeentities of the total sample of the MIX.

The Grameen Bank is the most important institution in terms of size, while it stands out thatalmost all of its loans (u$s 338 million) are funded with deposits (u$s 328 million). 19 Alsonote that many of the MFIs that had passed the first stage of development receive them.BRACandASA, two other institutions operating in Bangladesh, are leaders in granting loans

after the Grameen Bank, although they differ in the type of funding since it is based, on a

15 United Nations Program for the Development-UNDP - (2005).16 Opportunity International is a non profit organization, with Christian roots that began to give loans inColombia in 1971, while ACTION International is a net of financial institutions that bases its activity inLatin America beginning to give microcredits in 1973.17 According to data of CGAP18 Lapenu and Zeller (2001), mentioned in MFI (2005)19 Later in this work, information about the Grameen Bank is presented, updated to October 2005.


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smaller proportion, in attracting deposits. Next in importance, there are a number of entitiesoperating in Latin America, in countries such as Ecuador (Solidario Bank), Peru (My Bank,CMAC) and Bolivia (BancoSol, Los Andes Bank). As a differential feature, it is observed thatthe portfolios of these institutions, in Latin America, are more concentrated in a smallernumber of customers compared with the MFIs in Bangladesh.

3.3. Microfinance industry indicators

This section performs an analysis of the MFIs aggregated data with the aim of describing thecharacteristics presented at the industry level. In Table 4 are represented some percentiles,maximum values and assets weighted averages of the main variables analyzed, broken downby loans, deposits and operational and profitability indicators.20 It should be noted that thedata were voluntarily provided by the MFIs21 and it lack any type of audit which could leadto distortions.22 A major distortion is caused by the uneven level of subsidies these entitiesreceive which may not be reflected in theperformance indicators; reason why we usually tryto adjust these variables to take into account the external help and to obtain comparable

variables among all MFIs. Another aspect to consider is the divergent form the MFIs dealwith its irregular portfolio (in particular, the accounting rules applied with respect toprovisions, write-off and interests accrual) since this could impact the financial results. Itshould also be noted that the information provided could be contaminated by bias survival.23

In the following histograms you can appreciate that most of the entities are small (62.5% hasless than u$s 10 million in assets), although there are 12 very significant entities (with morethan u$s 100 million of assets, mainly located in Bangladesh, Peru and Bolivia). Regardingthe quantity of debtors, a similar distribution is observed with a median of 10.884 debtors.This is quite reasonable and it is reflected in a high correlation among both variables (77.8%).

However, keep in mind, that the aggregated results are influenced by the particular situationof Bangladesh, where three entities gather nearly 10.5 million of debtors, almost 58% of thetotal debtors at global level. This phenomenon also explains the fact that in Table 4 themaximums of total assets, the amount of gross loans and the number of active debtors is somuch larger than the 90vo percentile. Another interesting variable to analyze, on the loansside, is the high proportion of female debtors: in particular, notice that in 50% of the MFIsthe proportion of female debtors is higher than 64.9%, while if we consider the 70vopercentile, in 30% of the entities this ratio climbs to 85.1%.

Regarding deposits, it is notable that 62% of the entities of the sample do not receive them.There is also a strong relation between the size of the MFIs (measured by assets) and theamount of deposits, with a coefficient of correlation of 85%. In those entities that receive

20 For more information about the meaning of the indicators contained in the Chart, see Jansson andWenner (2002).21 This is based on information from MIX22 It could be suspected that those entities with weak indicators were inclined for not providing theinformation requested, which distort the statistics, in the sense that it would be too optimistic.23 It is the name of the effect of not considering those entities who disappeared from the sample becausethey ended its activities, and with them their statistics, which could contribute to worsen the situation.


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them, the balances of the deposits as a percentage of per capita gross income are very smalland may indicate, besides a poor development of the MFIs, a customer low savings capacity.

Regarding the operational indicators, it is necessary to keep in mind the distortionsmentioned above, due to the different approaches in the treatment of subsidies and to thecriteria applied to the irregular portfolios. Thus, notice the low percentage ofwrite-offloans,with an assets weighted average of 1.8%; value that could also be very sensitive to anysystemic factor.

The results over net worth show that 50% of the entities have a ROE above 11.4% while theassets weighted average of ROE is 21.5%. Still, 20.8% of the entities have a negative ROEand, 22.5% of the additional MFIs have a ROE between 0% and 10%. Regarding operationalself-sufficiency (defined as operating income divided by the sum of financial costs, provisions and operating expenses), the sample has a median of 1.17 while 21.6% of theMFIs have this index lower than a unit, indicating that they are not operatively self-sustainable, even though many of the entities included in the sample receive the subsidies.

With respect to arrears indicators, the correlation coefficient between the portfolios at riskover 30 days (defined as the loans due over 30 days compared to the average portfolio loan)and the write-off (or irrecoverable loans) is 26.4%, initially quite low. This might behappening because the entities manage to recover many of the debtors in arrears (as indeedhappens in some cases)24, or alternatively, because the MFIs are quite reluctant to moveirrecoverable loans to loss. In any case, it can be seen in Figure 4 a fairly uniform distributionof the portfolio at risk over 30 days, except in the range corresponding to "zero write-off",which presents a greater concentration and could be reflecting any of the above factorsregarding the particular policy applied by the MFIs to recognize loan losses. Also, note that90% of the entities have a write-off index below 9%.

3.4. Grameen Bank

One of the most important and well-known experiences in microfinance is that of theGrameen Bank (Bank of the Poor), from Bangladesh, which grants credit through a systemthat is not based on collaterals. The founder of Grameen, the economist Muhammad Yunus,implemented a research project to promote financial services targeted to the poor of the ruralareas of Bangladesh. Among the objectives of the initiative were to generate self-employment opportunities in a population with high rates of unemployment as well as tofinish with the action of usurers.

Yunus had begun paying money out of his own pocket and then enlarged the credits withfunds that he obtained offering himself as a guarantor. Those first loans were returned

completely. The project was developed successfully in Jobra, between 1976 and 1979 and,since that time, with the support of the Central Bank of Bangladesh and other national banks,it extended to several districts. The number of customers grew from less than 15,000, in 1980to nearly 100,000, by mid-1984.25

24 See in this respect the politics applied by the Grameen Bank, Section 3.425 Based on obtained public information of the Grameen Bank


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Unlike other microfinance projects, at global level, the Grameen Bank is a non-profitinstitution whose main objective is to fight poverty rather than auto-sustainability. Thisimplies that, periodically, it should receive external resources to maintain its operations inactivity.

The Grameen Bank applies its own methodology starting to concentrate the activitiesexclusively on the poorest, through clear criteria for client selection. The credits -withouttraditional guarantees, for very small amounts and with an interest rate of approximately 20%- are granted prioritarily to women and are repayable in weekly installments. Themethodology uses as collateral the collective responsibility of the group. Debtors formgroups of five members of whom initially, only two can obtain a loan. Once these repay thefirst six weekly contributions plus interest, two other members get the credit. Canceled thefirst six installments of these last ones, it is the fifth candidate's shift. The behavior of eachmember turns into, somehow, the collateral of the credit (see the Box, at the end of thissection, for more details regarding the methodology and products currently offered by theGrameen Bank). 26

The Grameen Bank accounts, in its home country, with a vast system of branches and centerswith bank managers and agents who have been specially selected. These personnel visit thevillages that are in their area of influence to disseminate the banks objectives and identifypotential candidates; the customer groups are subject to a rigorous supervision. The GrameenBank's experience showed that microcredit is an effective instrument in alleviating poverty.The later evolution of this type of initiatives has led to using the microcredit instrumentwithin broader programs, such as local development, community organizing, training andencouraging poor households to save.

Analyzing the last three years27 of the performance indicators of the Grameen Bank, it isobserved that there are positive operational self-sufficiency levels (operating income inrelation to the costs of financing, operating and provisions) and improvements in the financial

self-sufficiency (identical indicator to the previous one but adjusted by the subsidies receivedby the entity) which shows that in the past two years, the Grameen could have been sustainedwithout the help of the subsidies. The year 2002 shows the weakest indicators, probably as aresult of the internal reorganization which was subject the entity (see the Box at the end ofthe section for details).

In the three years under review, it is also observed a noticeable increase of the productivityper credit officer; in the year 2004 each official assisted almost 500 debtors. At the same time,there is a reduction of the operating expenses, of debtor costs and an increase in the amountof loans administered by each officer. It is probably associated with the introduction ofimproved computational tools for the administration of loans, which allows each credit

official administer a greater number of customers and a higher volume of the portfolio, withthe resulting cost improvement.

26The following section provides a more complete description of the credit methodologies used by the IMF,

based on those applied in Bolivia.27 For more information regarding the meaning of the indicators contained in Table 5, see Janson andWeener (2002).


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Regarding the regulation, the Grameen Bank is regulated since 1983 according to a specialdecree (Grameen Bank Ordinance 1983). It is regulated by the government and supervised bythe central bank of Bangladesh. In addition to the Grameen Bank in Bangladesh, there areover 1,000 semi-formals MFIs constituted as NGOs (being the most important BRAC, ASAand PROSHICA) and whose objective is purely social. Currently, these entities are notregulated nor supervised by the central bank, but only registered as NGOs. In 2000, thegovernment created the Microfinance Research and Reference Unit (MRRU) within theCentral Bank of Bangladesh, with the aim of developing a system of supervision andappropriate regulation for these MFIs-NGO, in light of the importance that these entities arehaving in the country; but the system is not yet operative.28

The Grameen Bank in Argentina

The Grameen Bank, established in 1999, operates in the country through the FoundationGrameen (Village) Argentina (FGA), implementing experiences of microcredit in more than20 locations throughout the country. In the early replications experiences, microfinance

assistance is channeled through non-governmental organizations.

Methodology

Micro credits are planned only for the poor people living in areas here other ReplicationProjects are already developed. The minimum amount of micro credit in Argentina is $ 500and it does not require any collateral. The credit methodology is the same used by theGrameen Bank in the world. While microcredits are to be awarded for individual enterprises,it is necessary to group five people of the same sex and unrelated, who are jointly liable. Thiscreates group responsibility and group cooperation that ensures commitment with the loansrepayment. Generally, microcredits are returned in 50 weekly fixed installments, includingcapital and a 20% annual fixed interest approximately. Initially, the loan amount is low, but ifthe person fully complies with the repayment, it can renew it every year for slightly higheramounts on each occasion.

AchievedResults29

1,250 people have benefited directly, granting them the possibility of sustaining themselvesthrough self-employment, and 6250 indirectly when considering the family group. Nowadays,there are about 1,200 active borrowers with a portfolio of $ 540,000 (u$s 180,000approximately).

More than 1,800 microcredits have been disbursed with the Grameen methodology,

including renewals. The total amount disbursed was $ 810,000 (u$s 270,000).

It has been reached an average repayment of loans superior to 92%, reflecting theborrowers success of its micro-enterprises.

28 Central Bank of Bangladesh29 Based on data of December 2005 from www.grameenarg.org.ar


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Box: The Grameen Bank II*

In 1998, a natural disaster that hit Bangladesh, caused the majority of borrowers of the Grameen Bank losemuch of their possessions and businesses. Soon they began to feel the burden of the accumulated debt tillthen and the rate of repayments of loans started to show quick decline. This situation compounded by itsoverlap with a crisis that began in 1995, in which a significant number of borrowers stayed away from the

weekly center meetings and stopped paying their loans, encouraged by the local politicians from thevillages that demanded the Grameen Bank to pay the so-called " tax group, "a type of savings account thatthe members should open to operate with the bank. These circumstances reinforced some internalweaknesses of the system, which consisted of a set of well-defined standardized rules where no deviation,from these rules, was allowed. Many borrowers began to walk away and that created the multiplier effect: ifone borrower stopped the payments, it encouraged others to follow.

Despite the efforts made, no improvements were achieved. The Grameen Bank decided to redesign itsmethodology, a process that began in April 2000. The transition to the new system, called "GrameenGeneralized System" (GGS), was launched in March 2001 and, in August of 2002 the process wascompleted where the Grameen Bank II kept its operations in all branches, something that Yunus himselfcalled the second generation of micro-credit institutions. Unlike the previous program, ("SystemGrameen Classic" -GCS) it does not require a weekly fixed amount installment nor that the debt is for a one

year fixed term, and it does not require the establishment of a fund group. These were, among otherfeatures, left aside in the new design because it caused tensions between borrowers. The new system allowsdesigning products more tailored to each client needs.

Types of loans

GGS has been built around one product calledBasic Loan (BL). In addition, there are two other parallelloan products: 1) the housing loan, and 2) the higher education loan. All borrowers start with the basic loan.If the borrower complies with their requirements in the most satisfactory manner, they can continue withthis type of loan, cycle after cycle, and increase the amounts of debt. If the borrower fails in repaying theBL; then the bank, the group and the borrower have to go through a renegotiation process and sign a newcontract with a new repayments schedule, which is called theFlexible Loan (FL). On the contrary, if theborrower does not want to go through a renegotiation process then it is considered a "voluntary defaulter".Unlike the BL, the amount of FL can not be increased. This kind of loans are a way out for those borrowerswho face difficulties and cannot comply with the BL repayment schedule, so that they are not excludedfrom the group and do not generate tensions among members, something that happened with the originalmethodology. If the borrowers comply with the FL payments, then they can be again subject to a BL. It isestimated that it takes sometime between 6 months to 2 years. On the contrary, if the borrower is unable tofulfill its obligations, it can only continue applying for flexi-loans. If the borrower still fails to comply, thenit is considered an "unwilling defaulter.

The basic loans provision is 0%. If a borrower fails to pay its dues for 10 consecutive weeks, or if it doesnot pay the stipulated amount to be paid over a period of 6 months and does not move to a Flexible Loan,then it defaulted, and a 100% provision is made for that amount (over the capital and the interest). Exactlyone year later, the debt is write-off on a monthly basis (rather than doing it at the end of the accountingyear).

The flexible loans provision is 50%. Failure to pay a flexi-loan within two years following its issuance, itbecomes overdue, and a 100% provision is made for that amount. After the third year of default, the flexi-loan is written-off entirely. However, all loans in this condition are treated as recoverable loans. Yunusbelieves that under the GGS, 90% of the written-off loans and interest will ultimately be recovered, becausethe borrowers will pay them back, in their own interest, because they might need to borrow money againfrom the bank.

Savings Accounts


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In the GCS, borrowers should contribute to a common account. Under the new program, every borrowerhas three mandatory savings accounts: a) a personal savings account; B) a special savings account and; C) aPension Funds Account (compulsory only for those with loans greater than u$s 138).

Each time a loan is granted, 5% of the amount of the loan is deducted ("mandatory savings"). Half goes to apersonal savings account; the other half goes to a special savings account. The borrower may withdraw the

amount of money she wants from her personal account anytime, which also collects mandatory weeklysavings. During the first three years, withdrawals from special accounts are not allowed. Only once everythree years, withdrawals of these accounts are allowed provided that the deposit exceeds a certain amountand; only under special circumstances, the total amount of the money of the account can be withdrawnwhile a fraction of the money can be used to buy Grameen shares. It also requires all borrowers with loansover u$s 138 to deposit a minimum of u$s 0.86 every month in their pension funds account. After 10 years,the borrower will receive a guaranteed amount that is equal to twice the amount deposited in 120 months.

Insurance

The loan insurance program was organized with the GGS and is a program in which the borrowers depositan amount equivalent to 2.5% of the outstanding debt in a savings account called "loan insurance savingaccount ", on the last day of each year. The income from the interest earned on such accounts goes to aninsurance fund. If the borrower dies any time during the following year, the fund pays the amount of the

outstanding debt, while the borrowers family receives the amount deposited in the savings account. Thereis no requirement for the borrower to make the deposit in the savings account if the loan amount does notincrease from year to year; if that amount grows, then the borrower contributes with a 2.5% increase. If theloan maturity was increased in one year with respect to the previous one and the borrower dies, the fundrepays the full amount owed.

*Source: Yunus, Muhammad (2002)

3.5. The Bolivian experience

In 1985, Bolivia began a process of restructuring the financial sector which later played amajor role in shaping the regulatory structure of the microfinance services: restoring the

autonomy of the Superintendence of Banks and Financial Institutions (SBEF); the closing offour state banks; the elimination of controls on the interest rates and the modification of theregulatory framework of the financial institutions. The closing of the public banks, whichuntil that time were the main suppliers of resources for small producers, resulted in a proliferation of private non profit entities offering loans to small-scale producers who werenot able to access the formal financial system.

The first microcredit program under innovative scheme of guarantees, such as the solidaritygroup, was launched at the beginning of the 80s driven by the Confederation of PrivateBusinessmen of Bolivia, Calmeadow Foundation and ACCION International. Thesepromoted the creation of the Promotion and Development Foundation for the Microenterpise(PRODEM), in 1986.

The success of PRODEM was obvious, to such an extent, that it was difficult to assist thegrowing unsatisfied demand in a sustainable manner. This, among other factors, was decisivein undertaking the creation of Banco Solidario. The board of directors of PRODEM argued,before the SBEF, that they were no longer able to sustain the growth rate with the type andlevel of funding available to non-profits. The interest rate was sufficient to cover theoperating costs but not to finance a portfolio expansion. The demand for loans exceededsubstantially PRODEMs capacity to satisfy it and what any group of donors was willing to


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fund. That is why the creation of a commercial bank was seen as the best way to overcomethese limitations. The project began in 1988 and ended in 1992, with the approval of thecreation of BancoSol, as a corporation. After 13 months of operations, the bank had 16branches (it begun with 7 transferred by PRODEM), 44,000 active clients, a portfolio of u$s11 million and a default rate of less than 1%.30 Nowadays, it has 66 offices, a staff of morethan 600 people and it is positioned as the undisputed leader of the microfinance business inBolivia (see details in theBox).

The "boom" of this emerging financial market also demanded the authorities the developmentofboth a specialized institutional capacity and appropriate norms to establish and supervisethe activity of the MFIs. This allowed the trust in these institutions to increase while theydevelop other financial services demanded by the segments of the market served.

The Supreme Decree 24.000 of May 1995 authorized the creation of the Private FinancialFund (FFPs), as corporations (they are non-banking financial institutions) focusing in the brokerage of resources to small borrowers and micro-entrepreneurs, allowing the majorNGOs targeting that segment meet their objectives through the formation of partnerships with

venture capital, authorized to attract deposits and controlled by the SBEF.

Box: Solidario Bank*

During 2004 and the first half of 2005, the BancoSol maintained a high growth in the activity, whichallowed it to continue increasing the income flow, followed by a reduction of the expenditure provisions,leading to adequate levels of return since 2003. Given the niche that the bank is focused on, the level ofexpenses is usually higher, being this compensated with higher spreads and, consequently, higher active

rates to those of traditional banking implying high efficiency ratios even better than that of banking (62.0%on income in june/05).

During the first half of 2005, the portfolio growth remained as shown in earlier periods, with a substantiallyimproved quality to that of the financial system (arrears of 4.3% versus 12.3% of the financial system) anda conservative provisions policy (158.3% of the arrears). The 83.7% of its portfolio is microcredit that iswhy there is a great dispersion by debtor. Its main source of income remains being the public obligations(72%), with a high concentration in depositors, followed by a medium and long term funding (16.4%) withinternational agencies and institutions. After the deterioration of their liquidity indicators in the course of2004 and given its portfolio growth, its liquid assets increased by more than 2.5 times since the end of thatyear, improving its mismatches in its short and medium term positions.

The prospect of the ratings assigned to BancoSol is stable in the medium term and given its performance inthe current economic environment, it should not be amended. Stability in the current social and politicalenvironment would favor a rating increase. BancoSol is a small bank (3.5% of the deposits of the financialsystem to jun/05), a leader in the market of microcredit in Bolivia. Targeting the micro and smallbusinesses sector operates through 66 offices, 24 ATM's and with a staff of 664 people. During 2004, itsmain shareholder, the group Action International, expanded its participation to 45.8%, followed by theFoundation Prodem (20.2%).

* Source: Fitch Ratings, Financial Institutions, september 2005. wwww.fitchratings.com.bo

30 Gomez, Tabares y Vogel (2000)


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The requirements of initial capital that apply on these non-banks (approximately u$S 920,000while for banks is u$s 8 million)31 and the recognition of the solidarity guarantees, coupledwith a strict prudential structure that establishes limits to credit granting and to the creditconcentration inferior to those established for the banks; as well as the prohibition of grantingcredit to its shareholders and administrators, represents a reasonable combination of assetbacking and credit risks dispersion. The concept of FFP has been the legal figure from whichthe private initiative has been able to direct its efforts towards the attention of an unsatisfieddemand for credit, of sectors traditionally excluded from the financial services.

Similarly, the Supreme Decree 24.439 of 1996 had as its main objective the regulation of thescope of the General Law of Cooperative Societies so that those of financial character can beincorporated to the national financial system. The rules for its operation, development andoversight of its activities were established. There was a tendency to strengthen thecooperative system of savings and existent credit in the country by endowing it with adequatemonitoring, controlling and tracking on behalf of savers and depositors and to guarantee thesolvency of the financial system as a whole.

The regulations developed on the basis of this decree has so far allowed 23 entities, havingstrengthened its financial and operational position, received its operating license and thus,allowed them to access new and varied sources of funding and capture savings.

The Superintendence of Banks and Financial Institutions of Bolivia has specific rules for theactivity of microfinance, covering both the PPF and the Cooperatives of Savings and Credit.Within the prudential regulations, the constitution of a bad debt provision considers thespecific riskof credit default (a table sets the provisions to make, based on the days in arrears,taking into account the short repayment cycle of the credits of the MFIs), and an additionalriskof arrears based on the lending technology adopted by the entities. This last componentrequires generic provisions, provided that the policies and practices carried out by the MFIsdo not meet the minimum guidelines established by the legislation. The opening of branches

and agencies has been simplified with the aim of promoting the geographical coverage of themicrofinance services.32

For the rest of the banks of Bolivia, the provisions for commercial loans, that are notmicrocredit, are not determined on the basis of the days of arrears but to the qualification thateach entity grants the debtor which depends on the estimated capacity of debt repayment. Theentities apply methodologies based on mathematical and statistical foundations to obtain theprobability of default, the loss amount due to the non-payment and exposure at the time ofdefault. Debtors are classified in 8 categories, including each of them a specific percentage ofprovision. The entities also perform generic provisions for their credits.33

It must be noted that microcredit in Bolivia received a great boost from external cooperation.International agencies have played a very important role in the development of themicrofinance activity, focusing its support mainly on institutional strengthening, management

31 Exchange rate at the end of December 2005 (630.000 and 550.0000 of Special Drawing Rightsrespectively). Superintendence of Banks and Financial Institutions in Bolivia.32 Superintendence of Banks and Financial Institutions of Bolivia. Regulation and Supervision of EMFs.33 Superintendence of Banks and Financial Institutions of Bolivia. Digest of Rules for Banks and FinancialInstitutions. Part V Chapter I.


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development and strengthening portfolio, support which was granted to most of the MFIs.But the support is limited and it has been diminishing as MFIs become financially self-sustainable. This led to the development of a new institutional structure in the microfinancemarket: the financial institutions of "second floor" that provide financing primarily tofinancial institutions, banks and non-banks, which assist small and medium enterprises.


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4. Credit methodologies of the MFIs

Given the differences with the traditional finance, mainly regarding guarantees, the MFIshave developed diverse credit methodologies that are suitable to their particularcharacteristics. While its implementation differs between institutions and countries, they all

share a set of general characteristics. This section is a description of the credit methodologiesbased on the Bolivian experience. 34

4.1. Solidarity Group

This methodology is probably the best known and has been adopted by several otherinstitutions, although in many cases it is combined with others of individual or associativenature, or with other non-financial services. The main feature is the use of an intangibleguarantee, called community guarantee which is based on the compromise of all the membersof the group to assume responsibility if one of the members of the group fails to make thepayment. The subject of the credit is the solidarity group as a whole. In some cases, creditsare of free disposal and can be used for any need deemed necessary by the borrower. Finally,

it is a sequential credit in that the group starts with small loan amounts which can grow overtime as the group meets its financial obligations.

When assessing the request for a credit, the assigned advisors visit each member of the groupto verify the existence and operations of each borrowers business. This process usually takesa week. If the request is approved, the loan is disbursed to the group. To expedite the follow-up and repayment of the loan, each group designates a coordinator and a secretary, whoalternates the tasks of distributing the total amount disbursed to the group, collecting theinstallments and ultimately repaying the loan to the institution. The rotation of these types ofloans is very rapid, generally six months on average. If the loan is repaid without problems,the group is able to continue borrowing for larger amounts.

4.2. Individual Credit

The main feature of this methodology is the use of an individualguarantee, which allows theclient create their own business plan in line with the business activity in which they areinvolved. Nowadays, it provides an alternative for those micro-entrepreneurs who either donot want to or cannot participate under the microfinance solidarity group schemes, and whoseonly chance of funding is through informal mechanisms. Besides, it is also used by thoseentrepreneurs who normally need larger amounts of credit than those granted throughsolidarity groups, and are able to provide other collaterals.

In institutions which offer other financial services in addition to individual credit, this

methodology is applicable to those clients, who initially formed part of a solidarity group,demonstrating their credit worthiness throughout time and due to the growth of their Micro-enterprise activity require larger credit amounts over longer terms and are in a position tooffer other types of guarantees.

34 FUNDAPRO (1998)


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The agent in charge of processing the applications visits each potential client to analyze therepayment source and prepares a cash flow and then, forwards the application and the creditproposal to the credit commission of the institution, which ultimately approves or rejects theloan application.

4.3. Associative Credit

The development of this methodology is based on an established organization (association orcooperative), whose function is the intermediation of funds given by the financial institutionfor its members. In many cases, these funds are used for improvements in the activities by theorganization's members, largely producers, mostly in investment capital.

4.4. Communal Banks

The basis of operation of this methodology is the communal guarantee. A communal bank isa grouping of persons who are responsible for the management and return of the fundsgranted by the institution promoting these services, generally known as the Executing

Institution. This institution organizes the communal association, also known as a communal bank and, makes the first credit disbursement. Each communal bank appoints a creditcommittee for the "external account management, funded with funds granted by theExecuting Institution and by the internal account, with resources from the bank members.

The resource of the internal account is composed of two sources. The first, are the savings ofthe members of the communal bank -which is a requirement to have access to credit- andthey are deposited in a bank account in the financial system on behalf of the communal bank.The second source is the interest generated on the external account throughout the loan cycleof approximately four months.

Once they receive the funds of the Executing Institution, these circulate continuously amongthe borrowers of the communal bank, given that they cancel weekly payments of both capitaland interest; funds that are re-lend to customers. In Bolivia, the application of thismethodology is focused primarily on poor womens groups, as in the case of Credit withRural Education (GROW), PRO WOMEN and Save the Children.

Those interested in the services promoted by the Executing Institution, form a communalassociation, which in turn appoints a board of directors to formally request and secure thecredit to the Executing Institution. Once the communal bank is organized, a training course isgiven before the disbursement of funds, where in addition to supplying informationconcerning the credit mechanism and the implications of a group guarantee, each borrowerexplains the activity in which the loan will be invested. A special feature of this program is

that finance small business initiatives and previous experience is not required when applyingfor a credit. In the case of PRO WOMEN, the purpose of this training course is to develop abusiness plan that would ensure a better standard of income to future borrowers. Afterwardssmall solidarity groups are composed of 4 to 6 individuals. In some cases, these groups arealready organized prior to their presentation to the communal bank, but this is not a prerequisite. The credit mechanism is sequential and during the first cycle only smallamounts of funds per individual can be requested.


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5. Regulatory aspects of microfinance

Just as it was mentioned in previous sections, experience demonstrates that the MFIs haveoriginated as non profit organizations of financial services, anchored mainly by ONGs,government entities and international organisms. It is also observed that to be sustainable and

to be able to assist a growing demand of financial services, the MFIs should reach animportant scale. For this, except public funds are allocated (which, in some cases, can attemptagainst the incentives to increase the scale and the efficiency of the services), and givencertain level of activities, there is a need to attract private capital and to mobilize thosesavings coming from the same class of individuals that are being financed. The possibilitythat the MFIs capture the public's deposits; it is the key factor that opens up the opportunityto those entities to be reached by prudential regulations.

This poses challenges to regulators in that MFIs often lack a clear ownership structure andabundant capital; initially they have low earnings perspective and they work with specificmethodologies that supervisors are not familiar. The Superintendences of financialinstitutions face a regional trend of increased formalization of microfinance, which will

probably not diminish. In view of these circumstances, the challenge now lies in the designand implementation of an adequate and profitable regulation for microfinance institutionsthat do not compromise the long-term goals of capital accumulation, allocation of resourcesand stability of the financial system as a whole.

For the purpose of analyzing the specific regulatory aspects associated with microfinance, below are presented different views belonging to various investigations of variousinternational organizations (World Bank, Inter-American Development Bank, USAID, theConsultative Group to Assist the Poor and International Monetary Fund), which have groupsspecifically dedicated to this subject.

5.1. World Bank35

The MFIs regulation should depend on its specific characteristics and, in particular, shouldtake into account its ability to attract deposits. It is suggested, therefore, a "tiered bankingapproach" to classify the type of regulatory requirement, namely the establishment of aclassification of institutions according to the profile of its liabilities. The spectrum rangesfrom the absence of regulation (or self-regulation), to external regulation by the competentauthority.

Table 6 suggests a classification with seven types of institutions, specifying thedistinguishing activities that determine the type of regulation that will be needed. Basically,

the regulatory issue arises as to whether the potential of the institution to attract massivelydeposits from the public to fund its assets could involve a risk to the system as a whole; insuch a case it should be subject to appropriate prudential norms.36 According to this analysis,both the MFIs established as NGOs engaged in financing with its own capital (Type 1) as theones that capture a limited amount of deposits among its members (Type 2) should not be

35 Greuning, Gallardo and Randhawa (1998)36 That is, conceptually this approach favors the argument of systemic financial stability rather than theprotection of small depositors. See Footnote Number. 7.


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subject to any regulation. For both, it is suggested the "self-regulation", understood asinternal fixation of prudential standards by the entity to ensure an appropriate operative.When the MFIs capture a small amount of deposits (Types 3 and 4) it is suggested theimposition of not prudential regulations, as the inscription in a record agency and thecalification by an external agency in the Type 4. Only after that MFIs capture deposits fromthe general public (Type 5 onwards) the implementation of prudential regulations issuggested.

5.2. Inter-American Development Bank (IDB)

A BID study37 declares that it is not obvious that the traditional regulation is adequate toregulate the MFIs, taking into account the differences with traditional financial institutions.An inadequate regulation may tend to raise the cost of financial intermediation, withoutoffering in return a risk reduction for the MFIs. As the total value of its assets is relativelylow compared to the financial system as a whole, a problem that arises in any of these entitiesprobably does not have systemic effects, although it should be considered potential reputation

effects that could damage the consumer confidence in the system.

Although regulatory policies are appropriate for the financial system as a whole, there aresome areas that may conceal a differential policy biased against microfinance. The areaswhere it is more likely to happen are related to prudential controls (loans documentation,provisions and capital adequacy), controls on consumer protection (interest rates ceilings),and structural controls (entry requirements and limits on the activities of financialinstitutions). Although there are other regulations that also impact on microfinance, it is notalways easy to recognize if their effect is different or particularly severe in MFIs, in contrastwith other entities of the system. Below are the problems that could arise in some of theseareas.

Entry RequirementsHigh minimum capital requirements constitute barriers to entry for potential competitors and will tend tocreate a system based on relatively few large institutions. They can make it difficult for MFIs to betransformed into regulated institutions by making it more difficult to gather the funds and, even if theyachieved to raise it, few MFIs might be able to attain a large enough customer base to fully leverage itscapital within a reasonable period of time.

Most countries require that financial institutions are capitalized by cash contributions. For MFIs, this couldbe an obstacle as they are usually formed by NGOs with existing loan portfolios and lack of capital inexcess. Allowing the net present value of the loan portfolios to capitalize new financial institutions can bean option to be considered in those countries that do not wish to diminish the existing capitalizationrequirements or create a new type of financial institution. However, this could result in uncertainty about

the quality of the loans portfolio of the NGO. If this happen, the new institution would not only begin itsoperations in a weak position by possibly having a portfolio of poor quality, but it would also find itdifficult to obtain the support of other investors.

Establishing Provisions

37 Jansson y Wenner (1997)


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The basic logic behind establishing advances in loan-loss provision stipulates they should be equivalent tothe value at risk of a loan portfolio. However, the special characteristics of micro-enterprise loans thattypically repay in weekly installments, in correspondence with the borrower's business cycle, suggest theadvantages of a provision system based on estimates of unpaid assessments, rather than on a generic anumber of days or months of late payments. While for microlending is not possible to require physicalcollateral, and since the regime of establishing provisions in the majority of countries have been designedto ignore this factor, it is often required a provisioning program stricter than those intended for normalloans consumption.

In order to ensure that institutions maintain adequate provisions, the superintendencies of banks need toevaluate a certain number of loans in their portfolio and subsequently infer whether or not the provisionsmade by the institutions are adequate. It seems appropriate to make this assessment through a statisticalstratified sample representative of the portfolio of loans from the bank. This is because loans are small andit is not possible to cover a large percentage of the bank's assets, through the analysis of the more importantloans, as is the case of most commercial banks.

Capital AdequacyThe loans provided to micro entrepreneurs should be classified in the most risky asset category; this ismainly due to lack of collateral and diversification, which in conjunction with the limited flexibility of

capital contribution involves a significant vulnerability to a negative shock. This vulnerability could spreadto the rest of the financial system if the regulations of these institutions were not strict enough to controlthis happening. While it is crucial to consider the institutional solvency, excessively strict capital adequacyfor MFIs could result in less than optimal quantity of financial intermediation as well as from the point ofview of the MFIs, such standards will lower expected returns to equity and thereby reduce private investorinterest.

Guarantee of payment and joint liability groupsThe lack of traditional physical collateral (assets-backed, mortgages) is one of the defining characteristicsof microfinance, thats why MFIs have developed other means to assure repayment of loans. However, theuse of joint liability groups is one of the instruments used by MFIs38. However, sometimes the MFIs avoidusing collateral because they are not considered acceptable due to problems with the property registries and

the high cost to verify the existence, ownership and the status of collateral. Movable collaterals, which maybe more relevant to microfinance, are affected by the deficiencies in the property registries and judicialsystems.

Usury laws and restrictions on interest rateUsury laws are usually implemented to protect the consumer, by establishing interest rate ceilings.Regulators and law makers try to protect unsophisticated clients from being exploited by unscrupulouslenders; however, usury laws often have negative effects on both the financial viability of the MFIs and thesupply of credit to the micro enterprise sector. Not only do these laws prevent MFIs from charging marketclearing interest rates that cover the relatively high per unit costs of microfinance, 39 but they also induceMFIs to screen out clients with the highest credit risk. In fact, many times more risky borrowers aremicroentrepreneurs with no assets to back up their loans. It is also possible that MFIs find other ways to

compensate for their inability to charge market clearing interest rates; closing fees, servicing fees, anddiscounts from face value of the debt instruments are common methods to circumvent a restrictive interestrate ceiling. Although microentrepreneurs may in this case have access to credit, it is more difficult for

38 In Bolivia the law recognizes the concept of the guarantees offered by groups of solidarity (I Decreesupreme 24.000 Art. 8).39 The information coming from Bolivia, that possibly has the microfinance market more developed in theregion, it demonstrates that the interest rates of the microfinance institutions are usually of twice as muchthat the interest rates of the traditional financial institutions (~4% vs. ~2 monthly%).


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them to calculate the real cost of the loan. When restrictions on the interest rate are enforced, this is one ofthe most important obstacles facing microfinance.

Loan documentation requirementsIn traditional regulatory and supervisory practices, loan documentation requested to borrowers is designed

to ensure the reliability of collateral and the financial stability of the borrower. Documentation is, therefore,an important component of prudent banking practice.

In microfinance, however, the viability of the activities to be undertaken with the loan naturally becomesthe principal basis for credit decisions since microentrepreneurs usually lack collateral. To the extent thatMFIs try to establish some sort of guarantee of repayment, they usually rely heavily on personal references,guarantee structures such as joint liability groups, and information about the borrowers character (ratherthan on collateral). Consequently, not only are microentrepreneurs unable to provide many of theaforementioned documents, but these documents are also many times of secondary importance.

Operational restrictionsSince low-income people have limitations to travel long distances or perform their transactionselectronically, MFIs need to have branch offices within close distance of the communities they serve. At

the same, it is possible that the client base in the community may not economically justify the presence of abranch office that is every day of the week full-time, and offer a whole range of sophisticated services. Anextensive branch system implies considerable fixed costs and MFIs need flexibility in adapting operationsand services to a level that is appropriate for the communities they serve. In order to lower administrativecosts and reach their target population, it is important for MFIs to use innovative methods of extendingcredit (platforms") that are less costly than those of conventional branches. These platforms could include,for example, mobile banks or offices that are restricted to providing only limited services.

5.3. USAID

A study of the regulatory aspects of microfinance40 based on the experience of microfinance

in Bolivia, highlights as in the World Bank approach, that the transformation of the MFIs intoregulated financial institutions will be required when the entity needs to mobilize publicfunds (attract deposits). That transformation does not necessarily avoid the need for NGOsengaged in microfinance, as these can continue playing an important role as providers ofcredit to customers not served by the formal boundaries. The MFIs transformation should berestricted to those with a proven technical, managerial and financial capability. The inclusionin the regulation has to be a way through which unregulated entities can expand their servicesand their sources of funding. The solid financial practices should be a requirement to performthe transformation and not an expected result of the regulation. Involving charitable agenciesin the board of directors would not necessarily enhance the ability of management.

It is noteworthy that the NGOs were pioneers in the development of microfinance lending,

which have then been adopted by private entities. Regarding receiving deposits, they hadnever been authorized to do so and thus servicing deposits, in microfinance, isunderdeveloped.

An adequate regulatory framework for microfinance activity is necessary but not sufficient toattract the participation of commercial banks. In Bolivia, it was basically the level of

40 Gomez, Tabares, Vogel (2000)


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profitability of Sun Bank that attracted other banks to the sector. The authorities have tried tocreate a regulatory framework formicro-finance activities and not for the entities involved inthis activity, in particular. From this point of view, microfinance has been treated as anotherniche market with some distinctive features, but sharing a number of different risk factorswith other branches of the more traditional finance. From that standpoint, the supervision andregulation ofthe activity of microfinance should be applied to all types of entities, whateverthat is exclusively devoted to microfinance or not.

5.4. Consulting Group to Assist the Poor (CGAP)

This group has developed a series of principles41 related to the microfinance regulation andsupervision. The discussion starts recalling the generally accepted objectives that the prudential regulation have: 1) to protect the financial systemic stability preventing that thecollapse of an institution might entail other falling and; 2) to protect small depositors who arenot well positioned to monitor the financial position of the entities. If the prudentialregulation is not centralized in these objectives, it is likely to be wasting scarce monitoring

resources; financial institutions could be fill with unnecessary requirements while, at thesame time, could affect the development of its financial system.

With these goals in mind, the Group is developing a series of policy recommendations interms of answering the question of when to implement prudential regulations to MFIs. Someof those recommendations are:

The issues that don't require the supervisor to control the financial solidity of the regulatedinstitutions should not be treated through the prudential regulation. Other regulation forms tend

to be easier and less more expensive.

Proponents of microfinance regulation need to careful about steps that might bring the topic ofmicrocredit interest rates into public and political discussion. Microcredit needs high interest

rates. In many countries, it may be impossible to get explicit political acceptance of a rate that ishigh enough to allow viable microfinance. In other contexts, concerted education of relevant

policymakers may succeed in establishing the necessary political acceptance.

Before the regulator decides the design of the prudential regulation, he/she should obtain afinancial and institutional analysis of the existent MFIs, at least if those MFIs are the candidates

to request licenses. In many countries a paradoxical situation is given: it is supposed that, of

opening up a new window in the regulation, it will be used by the existent MFIs that act asONG and they want to change their status to that of entities attracting deposits. But at the same

time, any or few of the existent MFIs have demonstrated to be able to administer their portfolio of

loans in a profitable way, so that they can pay and protect the deposits they capture. In thatscenario, the government should consider the option of waiting, monitor its performance and to

open the window only after there is more and better experience. To develop a new rgime for the

MFI takes a great time of analysis, consultations and negotiation; the costs of the process canovercome the benefits unless it is expected that a critical mass of institutions that qualify exists. In

that context, the performance of the existent MFIs is an element that many times one doesn't keep

in mind in the discussions referred to a regulatory reformation.

Prudential regulation should not be imposed on credit only MFIs that merely lend out their owncapital, 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 regulation may not be necessary for MFIs taking cash collateral (compulsory savings)

only, especially if the MFI is not lending out these funds.

41 Christen, Lyman, Rosenberg (2003)


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As much as possible, prudential regulation should be focused on the type of transaction beingconducted rather than the type of institution conducting it.

Regulatory reform should include adjusting any regulations that would preclude existing financialinstitutions from offering microfinance services, or that would make it unreasonably difficult for

such institutions to lend to MFIs.

Where cost-effective prudential supervision is impractical, consideration should be given toallowing very small community- based intermediaries to continue taking deposits from memberswithout being prudentially supervised, especially in cases where most members do not have access

to safer deposit vehicles.

Minimum capital needs to be set high enough so that the supervisory authority is not overwhelmedby more new institutions than it can supervise effectively.

Most microlending is for all practical purposes unsecured. Limits on unsecured lending, or high provisioning of unsecured portfolio that has not fallen delinquent, are not practical for MFIs.

Instead, risk control needs to be based the MFIs historical collection performance, and analysisof its lending systems and practices.

Loan documentation and reporting requirements need to be simpler for microfinance institutionsand operations than for normal commercial bank operations.

Limitations on foreign ownership or maximum shareholder percentages may be inappropriate, orneed flexible application, if local microfinance is at a stage where much of the investment will

have to come from transforming NGOs and other socially-motivated investors. Supervision of MFIs especially portfolio testing requires some techniques and skills that are

different from those used to supervise commercial banks. Supervisory staff will need to be trained

and to some extent specialized in order to deal effectively with MFIs.

Financial cooperatives at least large onesshould be prudentially supervised by a specializedfinancial authority, rather than by an agency that is responsible for all cooperatives.

In developing countries, self-supervision is unlikely to be effective in protecting the soundnessof the supervised financial institutions.

External auditors cannot reliably appraise the financial condition of MFIs unless they testportfolio with microfinance specific procedures that go well beyond normal practice.


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5.5. International Monetary Fund

The MFI claims that the reasons that would justify a prudential regulation for MFIs are, first,the possibility that they might pose a threat to financial stability, and second, whether theyaccept deposits to secure their lending operations. In the first case, prudential regulationwould be designed to protect the integrity of the system and, in the second case, to protectsmall depositors who are not sufficiently prepared to assess the reliability of the financialinstitution where they make their deposits.

If the two conditions mentioned in the previous paragraph are absent, it would be moreappropriate to consider a non prudential regulatory approach, since the cost of prudentialregulation is higher and the risk of generating supervision structures, not entirely efficient,would be created or created at the expense of reducing the monitoring of others with highersystemic risks. It should also be kept in mind that to fulfill a prudential regulation isexpensive for the MFIs, which would be added to their high operating costs.

Under current circumstances, the cost of bringing the MFIs under the orbit of prudential

regulation appears to exceed the associated benefits in most cases. This is due to severalreasons:

Despite the large number of clients served by the MFIs, the sector as a whole doesnot constitute a systemic threat in most countries;

Many MFIs get their funding from donors, private sector loans or multilateralagencies;

MFIs taking deposits are pretty small, so that the cost of monitoring them wouldsurpass the benefits, even if they offer explicit or implicit guarantees to its depositors.

An alternative would be to implement a non prudential regulation, which involves fixing a setof requirements for MFIs, as registration procedures and the compliance of a specificregulation carried out by the same MFIs or an associated entity.

The existence of a regulatory environment can sometimes stimulate the formation of MFIs orbroaden the base of existing ones. Favorable conditions for the MFIs could arise from abeneficial legislation for their creation, or NGOs could be allowed to evolve to the status ofan entity acquiring deposits. In these cases, the critical factors to be analyzed are: (i) if theinteraction between the new and the existing regulations do not provide opportunities forregulatory arbitrage; (ii) if the regulations hinder the integration of the MFIs to the rest of thefinancial system; (iii ) if the regulations inhibit financial innovation on the MFIs part.

One way to minimize these potential undesirable effects would be to focus regulation to themicrofinance activities, regardless of which entity develops them, in such a way that they

would receive equal treatment even if they are offered by a large commercial bank thatdecides to enter this segment or a small regional entity.

In addition to the regulatory activity, basic principles that guide the specific activities ofmicrofinance could be disseminated, facilitating good practices and including auditingprotocols and accounting rules.


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6. The situation in Argentina

6.1. Current conditions: active institutions in the area of microfinance and microcredit

In Argentina, there are no cases of formal financial institutions

42

devoted exclusively tomicrofinance. There are, however, financingprograms for poor people implemented mainlyby the government and NGOs channeled, in many cases, through institutions such as mutuals,credit cooperatives and other NGOs. There are also experiences of programs at the regionallevel, of micro-credit granting for micro-enterprises implemented through some of themunicipalities or parishes. Micro-finance, micro-business and micro-enterprises forsubsistence constitute a rising phenomenon in Argentina, driven among other factors, by therecent economic and social crisis.

The microenterprise financing programs in Argentina are highly heterogeneous: there are alot of programs, implemented mainly by the public sector, which provide subsidies or someform of financial assistance that does not require refund while other programs contemplate

the refund of the loan, in the form of goods or services; in the private sector, there exist fromindividual and precarious enterprises up to complex units with legal structure. Since thecredit support generally is not enough by itself, it is often supplemented with training,consulting and performance tracking.

A field study43 conducted between August and September 2005 estimated that 110 entitiesexist in the country dedicated to microfinance 44 which includes the public programs ofnational reach that do not meet the definition of MFI but are included because of its relevance.Regarding their legal form, they are mostly NGOs, especially Civil Associations and a fewfoundations. According to the survey answered by 43 institutions 45 , the average activeportfolio by institution is 340 loans, while the historical quantity of granted loans is 55,462

(14,931 considering only the active portfolio) with a total value of almost $ 38 million. Theabove figures give an idea of the poor development of the activity in our country comparedwith other nations of the world and Latin America.

Among the programs carried out at the state level, the Social Capital Fund (FONCAP), is aninitiative of the Ministry of Social Development, created in 1997 with the objective to boostthe credit assistance to more than one million small enterprises in the country. This is acorporation that administers the Trust Fund Social Capital (FFCP), originally established

42 Formal in the sense that they carry out operations of intermediation of funds and therefore they areregulated by the BCRA.43 Microfinance in Argentina" (PNUD 2005) has been developed by a team from the Economics University

of UBA coordinated by Marta Bekerman together with Santiago Rodriguez, Sabina Ozomek and FlorenciaIglesias.44 According to the cited work , the figure corresponds to their own estimation. It includes three publicprograms of national reach. The state program NETWORKS, which on the date of calculation had 498funds allocated to NGOs and municipalities, was considered as a unique program because all funds belongto the same program. FOMICRO of Banco de la Nacion Argentina was in the same situation. Within theinstitutions of the private sector, the figure individually considers the 22 replicas of Grameen in Argentina,as these institutions are usually managed independently.45 Including the most important institutions within the governmental and non-governmental organization(the latter nation-wide).


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with a contribution from the National State of u$s 40 million. The board of directors isintegrated with representatives of ministries and associations of entrepreneurs andorganizations linked to the microenterprise sector. Its mission is to spend this amount ofmoney in the funding of institutions engaged in microfinance, so that it belongs to theorganizational "second floor". As a novel aspect, even though at first it pro