The regulation of Microfinance
Claudio González-Vega, Chairman of the Board of Trustees of the BBVA Microfinance Foundation
What we today know as microfinance has been the outcome of a series of remarkable innovations in the production and delivery of various types of financial services to populations that had not previously had access to institutional finance. Thus, the true essence of microfinance has not merely been the very small size of the transactions or the fact that the clients are poor and vulnerable (certainly, two major barriers to the emergence of financial transactions).
Rather, the essence of microfinance has been the development and implementation of innovations in financial technologies (that is, new ways of doing things) that have made it possible to prudently manage the risks associated with the target clientele and to lower the costs accompanying very small transactions, much below the levels associated with the use of traditional banking technologies in these market segments.
Thanks to these innovations, the microfinance revolution evolved from a few modest, donor-intensive, non-government (NGO) initiatives into a heterogeneous financial market sector, where a growing number of profitable, self-sufficient, commercially viable actors have been capable of gradually delivering a broad range of financial services, to assist their clients in the pursuit of diverse individual goals. With their transformation, from microcredit entities into microfinance intermediaries, with the intent of mobilizing deposits from the public, the need to prudentially regulate them emerged.
“The prudential regulation and supervision of microfinance institutions became inevitable once they became deposit-taking institutions”
Thus, while other types of microfinance might need (or not) some sort of regulation, the prudential regulation and supervision of microfinance institutions became inevitable once they became deposit-taking institutions. Prudential regulation is the legal framework whose objective is to guarantee stability as well as competition and efficiency in financial markets, setting limits and constraints to the behavior of financial intermediation institutions and, at the same time, offering depositors reasonable protection, shielding the use of their deposits from imprudent behavior.
Prudential regulation and the means to supervise and guarantee its application are critical in discouraging the opportunistic behavior that may emerge among deposit-taking institutions, given the temptation to take excessive risks when seeking higher profits. From this perspective, the purpose of prudential regulation of microfinance would be the same that justifies it in the case of other intermediaries. The important question then is, not if to regulate or not, but how to regulate.
“Digital technologies are transforming finance, increasing the number and variety of new entrants, and challenging its regulation at unprecedented rates”
This matters because, in some cases, regulation may end up being an obstacle to financial market development. In this case, we talk about financial repression, defined as the framework of regulatory measures that distort the flows of funds and the allocation of resources, away from the market optimum. Some of the tools of financial repression are interest-rate ceilings and compulsory portfolio quotas, confiscatory reserve requirements, the inflation tax and overvaluation of the domestic currency, excessive market entry restrictions and unsuitable provisioning and other prudential norms. Despite their return in some countries, the historical evidence has shown the harmful influence of these policies, which in the case of microfinance cause even greater damage and hamper the outreach of marginal clienteles.
Failure in financial markets emerges from pooling equilibria, when different risks are treated as if they were the same. Given imperfect and asymmetric information, all loan applicants look the same. When lenders cannot separate them by risk type, they offer all borrowers the same contract. In fear of adverse selection, lenders engage in non-interest credit rationing. Microfinance as an innovation has increased the scope of differentiation. Rather than evaluating all loan applicants by the assets they pledge as collateral (mortgages), the best microfinance institutions judge applicants by cash flows and intangible attributes: reputation, honesty, attitudes, and habits.
Microfinance has thus broadened the range of criteria for creditworthiness and included the excluded. Furthermore, the most important innovation of microfinance has been the use of the client relationship (that is, the present value of the expected stream of future services) as an incentive to repay. A microfinance contract implies a direct, mutually valuable long-term relationship that creates rights and responsibilities for both parties and generates the structure of incentives that determines their behavior. The borrower repays in the expectation of improved future service, while the lender must credibly promise to be there when the borrower returns (that is, to be sustainable).
This same separating principle must be used by the prudential regulator, when enacting norms for different financial technologies. If a microfinance portfolio represents a different risk profile, it should not be regulated as if it implied the same degree and determinants of riskiness as other portfolios. A pooling regulation would not be optimum. Microfinance deserves prudential norms different from those suitable for commercial banking and consumer finance. The prudential regulators in countries like Bolivia and Peru understood this principle and created a regulatory environment conducive to the success of microfinance. Moreover, as the Basel II framework allowed financial intermediaries to define their own risk management approaches, this opened spaces for innovation that favored microfinance. The potential threat from Basel III is, instead, a restrictive perspective on financial technologies that might not recognize the idiosyncrasies of microfinance.
Moreover, digital technologies are transforming finance, increasing the number and variety of new entrants, and challenging its regulation at unprecedented rates. While, as in the case of microfinance, regulation should not unnecessarily constrain innovation, it is importantthat the prudential regulator understands the unique features of microfinance as a special tool for financial inclusion.