March 2002 Insights Issue #40

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Blurring the boundaries?
Microfinance vs formal banking

Microfinance practitioners want to see special regulations allowing microfinance institutions to provide a range of financial services without attracting formal banking sector regulations - especially minimum capital requirements. If adopted, this approach will stretch the limited financial resources and technical capacity of many central banks in developing countries. It will blur the traditional boundaries of financial sector regulation. What options would best help regulators faced with a burgeoning microfinance sector?

Research in Zambia by the University of Manchester's Institute for Development Policy and Management, argues against the need for the central bank to impose an excessive level of prudential regulations. The microfinance industry in Zambia is still relatively new and should be nurtured within the parameter of an accommodating legislative and regulatory structure. So too, regulatory theory is in its infancy and lacks sufficient guidelines for regulators faced with a growing microfinance sector. At this stage, a detailed regulatory structure may stifle rather than promote the growth of the sector.

Ideally for Zambia, a flexible graduated regulatory structure would encourage microfinance institutions to increase their capital base voluntarily, allowing them to engage in the permitted activities in the next regulatory level.

Recommendations for designing and developing effective regulatory classifications for microfinance institutions include:

• Simple registration procedures are needed for all microfinance institutions that take public deposits. A self-regulating association should be responsible for non-prudential monitoring of these institutions.
• Classifications should be based on an institution's potential systemic risk to the financial sector and not size of membership or area of operation. Regulators cannot verify membership and geographical size in an economically efficient manner, especially in an industry where there is high group turnover and mobility.
• Regulators must carefully delineate between seemingly homogenous groups such as co-operatives. Some cooperatives do not accept deposits while others provide demand accounts facilities and a wide range of other banking type services. Only the latter need regulating.
• No capital requirements should be stipulated for microfinance institutions at the lower end of the regulation ladder for an interim period of five years. There is currently no justifiable basis upon which such capital requirements can be made.
• Prudential limits on the scale of microfinance operations, if required, should be based on the institutions deposits-to-loans ratio. The ratio measures the extent to which a microfinance institution is able to mobilise deposits from its members and, where applicable, from the general public. A higher ratio is associated with a greater element of risk.

The regulatory responsibility of the central bank should be restricted to those institutions with potential systemic financial sector risk. Greater emphasis should be placed on strengthening the self-regulatory capacity of the Association of Microfinance Institutions. Self-regulation combined with targeted central bank involvement is more favourable at this early stage of the industry's development.

Samuel Munzele Maimbo
World Bank
1818 High Street NW
Washington
DC 20433
USA

T +1 (202) 472 3115
F +1 (202) 522 2433

smaimbo@worldbank.org

See also

'The regulation and supervision of microfinance institutions in Zambia' by Samuel Munzele Maimbo in 'Financial System Regulation and Supervision in Zambia' edited K. Mwenda, forthcoming, 2002