Guidelines of Principles for Effective

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Table of contents

Presentation 6

1. International bank supervision standards andmicrofinanceinstitutions 9

1.1 BaselCorePrinciples(BCP)andmicrofinanceinstitutions 9

1.2 BaselIIandmicrofinanceinstitutions 14

1.3 Rationaleforcomplementaryprinciplesforregulation andsupervisionofmicrofinance 16

2. Principles for effective regulation and supervision ofmicrofinanceoperations 19

2.1 Scope 19

2.2 Preconditionsforeffectiveregulationandsupervisionofmicrofinance 19

2.3 Regulationandsupervisionofmicrofinanceinstitutions 23

2.4. Regulationofmicrocreditoperations 28

2.5 Supervisionofmicrocreditoperations 31

Bibliography 34

Project Team 35

PRESENTATION

Theprimarypurposeofthisdocumentistopresentguidelinesofprinciplesforinternationalusethatcomprisebestpracticesonthetopicofregulationandsupervisionofmicrofinanceoperationsexecutedbydeposit-takingfinancialinstitutions.

ThisdocumentwasdevelopedbetweenMarch2008andMarch2010andwaspreparedbyaMi-crofinanceWorkingGroupofBankingSupervisors,supportedbytwoconsultingfirmsthatcom-binedtheexperienceoffinancialentities´regulatorsandsupervisors,expertsonregulationandsupervisionofmicrofinanceinstitutions(MFIs),consultantsonpublicconsultationprocesses,aswellasmanagersofmicrofinanceinstitutions.1Thedocumentwasdevelopedintwostages:

Thefirststage,whichwasimplementedbyoneoftheconsultinggroups,includedthefol-lowingactivities:

i. Identificationandreviewofspecializedbibliography,focusingonstudiesthatcon-tributetoestablishprinciplesfortheregulationandsupervisionofmicrofinanceop-erations;

ii. Developmentandapplicationofa surveyaimedat supervisors,about thestateofregulationandsupervisionofmicrofinance institutions inorder to identifysoundpracticesinLatinAmericaandtheCaribbean;

iii. Detailedanalysisofinternationalstandardsofbankingregulationandsupervisionandtheirapplicationtomicrofinanceinstitutionsandoperations;

iv. Reviewofthelegalandregulatoryframeworkformicrofinanceinstitutionsincoun-triesthatareleadersintheregiononthistopic;

v. Analysis of quantitative information on the status of microfinance in the regionpreparedannuallybytheMultilateralInvestmentFund(MIF),memberoftheInter-AmericanDevelopmentBank(IDB)Group;

vi. FourconsultativeeventswiththeMicrofinanceWorkingGroupoftheAssociationofSupervisorsofBanksoftheAmericas(ASBA),comprisedofrepresentativesofbank

1 ThisworkwassupportedbyfundingfromtheSwissTechnicalCooperationTrustFundforConsultingServicesandTrainingActivities(STC)oftheIDB.

supervisorsfromBolivia,Brazil,Colombia,ElSalvador,Peru,andtheUnitedStatesofAmericathroughtheFederalDepositInsuranceCorporation(FDIC);and

vii. DraftingofGuidelinesofPrinciplestouseasabasedocumenttobedisseminatedthroughabroadconsultativeprocesswithregulatorsandindustrystakeholders.

Thesecondstage,whichwasimplementedbyasecondconsultinggroup,includedthefollow-ingactivities:

i. Designandimplementationofaconsultativeprocesswithmicrofinanceindustryop-eratorsthroughtheapplicationofacomprehensiveon-linesurvey.Thesurveywasansweredby156microfinanceindustrystakeholdersinLatinAmericaandtheCa-ribbean.Additionally,theprocessincludedin-depthconsultationsthroughindividu-alinterviewswithagroupofexperts,networkdirectors,andmicrofinancemanagersinLatinAmericanandtheCaribbean;

ii. EditingofthedraftGuidelinesofPrinciplestoincorporatetheresultsoftheconsulta-tiveprocess;and

iii. DiscussionoftheGuidelinesofPrinciplesintwoworkshops.ThefirstworkshoptookplaceduringaneventonRegulationandSupervisionofMicrofinanceattheXIIInter-AmericanForumonMicroenterprise(Foromic)organizedbyMIFthattookplaceinPeruinSeptember2009.ThesecondworkshoptookplaceonMarch25and26,2010inMexicoCity,withtheparticipationofmembersoftheWorkingGroupand,thosesupervisorsthatwerenotpartoftheGroup,experts,andindustryrepresentatives.

At theconclusionof theprocessesdescribedabove, the Inter-AmericanDevelopmentBank,throughitsrepresentativesfromMIFandASBA´sMicrofinanceWorkingGroup,proceededtothefinaleditingofthedocumentforitspresentation,whichcontainsanintroductionandtwochapters.

ThefirstchapteranalyzestherelevanceoftheapplicationoftheCorePrinciplesforEffectiveBankingSupervision,aswellastheBaselIIprinciplesissuedbytheBaselCommitteeonBank-ingSupervision. tomicrofinance institutions.Theproposed recommendationsare intendedtobeconsistentandcoherentwiththeseprinciples,sothattheireventualapplicationcanbeanalyzedduringassessmentsofBaselCorePrinciplescompliancebytheWorldBankandIn-ternationalMonetaryFund.

In thesecondchapter,asetof recommendations ispresented, synthesizing theconclusionsfromtheprocessdevelopedinthisdocument.Thisincludespreconditionsandprinciplesforeffectiveregulationandsupervisionofmicrocreditportfolios,aswellasforthemicrofinanceinstitutions. The recommendations aim to facilitate a harmonious development ofmicrofi-nance.TheserecommendationsarepresentedintheformofPrinciples for Regulation and Su-pervision of Microfinance Operations.

INTERNATIONAL BANK SUPERVISION STANDARDS AND MICROFINANCE INSTITUTIONS

Theprinciplesofregulationandsupervisionof microfinanceoperationsseektocomplementthestandardsandlawsbywhichacountry’sfinancialentitiesoperate.Internationalbankingstandardsareappliedinthemajorityofcountrieswheretherearemicrofinanceoperations,althoughnotalwayswiththerigorofestablishedbestpractices.Therefore,microfinancein-stitutionsaresubjecttonationalstandardsand, inthemajorityofcases, internationalstan-dardsthatleadtobettermanagementofthefinancialsystem.Suchstandardsdonottakeintoconsideration theparticularnatureof these institutions and theirmicrofinanceoperations.ThereisaneedtobroadentheBaselCorePrinciples(BCP)applicabilityconditions,byofferingacomplementaryregulatoryandlegalframeworkthatallowsfortheeffectiveregulationandsupervisionofmicrofinanceinstitutions,withoutimposingconditionsthatdonotrespondtotherealityoftheiroperations.Despitethefactthattherearedifferencesbetweenmicrofinanceinstitutionsandtraditionalfinancialentities,thesearefewerthanthesimilarities.Therefore,themajorityoftheBaselprinciplesareapplicabletothissector.

1.1 Basel Core Principles (BCP) and microfinance institutions

Theregulationof financialentitieshasthreemainpurposes:1)toprotectconsumers;2)toensureefficientfunctioningofmarkets;and3)topreservethestabilityofthefinancialsystem.Regulationtargetedatprotectingconsumersgenerallyseekstopreventabusesofclientrightsandincludesstandardsoftransparency,corporategovernance,andotherrulesofmarketcon-duct.Regulation targeted at improving efficiency in the functioningof the financialmarketincludesrulestopreventandcorrectmarketimperfections(suchasinformationasymmetry,externalitiesormonopolisticbehavior).Thesetwopurposesforregulationareusuallyappli-cable,withsomenuances,totheentirerangeofentitiesthatmakeupafinancialsystem.Ontheotherhand,regulationtopreservethestabilityofthefinancialsystemisusuallylimitedto

1

10 ¶ GUIDELINES OF PRINCIPLES FOR EFFECTIVE REGULATION AND SUPERVISION OF MICROFINANCE OPERATIONS

Box No. 1

Core Principles for Effective Banking Supervision

The Basel Committee issued the 25 Core Prin-

ciples for Effective Banking Supervision (BCP)

in 1997, with the objective that its application

would be a first step in the process of strengthen-

ing domestic and international financial stability.

Over time, BCP have become the standard for

banking supervision in the majority of countries.

With the goal of guaranteeing the relevance of

the BCPs in light of advances in regulation and

supervision, a revised version of these principles

was approved in 2006.

The 25 revised principles can be grouped into

seven categories:

- Institutional aspects (BCP 1): objectives,

independence, power of the supervisor, trans-

parency, and cooperation;

- Licensing and structure (BCPs 2–5): permis-

sible activities and criteria for granting

banking licenses, transfer of ownership, and

significant investments;

- Regulation and prudential requirements

(BCPs 6–18): capital adequacy, requirements

for risk management, internal controls, and

the prevention of abuse of financial services;

- Supervision methods (BCPs 19–21);

- Accounting and disclosure (BCP 22);

- Corrective power of the supervisor (BCP 23);

and

- Consolidated cross-border monitoring (BCPs

24–25).

According to these principles, taking deposits from

the public is an activity that is generally reserved

for institutions registered and supervised, such as

banks (BCP 2). The Basel Committee has declared

that the term “generally,” introduced in the BCP for

the first time in 2006, acknowledges the presence

of non-bank institutions that take deposits from

the public and are not supervised like banks, under

the condition that these non-bank institutions

will not collectively have a significant share of the

financial system’s deposits. The text of the BCPs

explicitly establishes that this exception can be ap-

plicable, for example, to microfinance institutions

that are not supervised.

The Basel Committee also defined the precondi-

tions for effective supervision. Even though these

are not under the direct control of banking supervi-

sors, they are necessary to achieve effective su-

pervision. The preconditions are classified into the

following groups:

- Adequate and sustainable macroeconomic

policies;

- Well-developed public infrastructure, in-

cluding an adequate legal framework for

the development of businesses; account-

ing and auditing practices consistent with

international standards; an efficient and

independent judiciary system; and a safe and

efficient payment system;

- Market discipline based on flow of infor-

mation between market participants and

congruent public policies that foster a good

business climate and do not generate moral

risks; and

- Mechanisms to ensure financial security in

the case of systemic problems.

INTERNATIONAL BANK SUPERVISION STANDARDS AND MICROFINANCE INSTITUTIONS ¶ 11

thoseentitieswhosefailurescouldgeneratehighsocialcosts.2Althoughsomerulesservesev-eralofthesepurposes,thepreservationoffinancialstabilityisthemainpurposeofprudentialregulation,whichisabasicstandardintheCorePrinciplesforEffectiveBankingSupervision(BCPs),issuedbytheBaselCommitteeonBankingSupervision.BoxNo.1outlinesabriefin-troductiontotheseprinciples.

Microfinanceinstitutionsshouldbesubjecttoaregulatoryframeworkandprudentialsupervi-sion,iftheyaregeneratingrisksbytakingdepositsfromthepublicandinvestingtheminriskyactivities.3Consequently,asafirstpremise,microfinanceinstitutionsthattakedepositsshouldbe subject to a regulatory and supervisory framework that is consistentwith internationalbankingsupervisionstandards.However,itisnecessarytoclarifythattheBCPsarealsoconsis-tentwiththeexistenceofnon-bankinginstitutionsthattakedepositsfromthepublicwithoutbeingsupervisedasbanks(suchassavingsandloancooperatives,non-governmentalorgani-zations,andhomesavingsandloanassociations),aslongastheseinstitutionscollectivelydonothaveasignificantshareofthefinancialsystem’sdeposits.TheBCPsmentionexplicitlythatthisexceptioncouldbeappliedtomicrofinanceinstitutions.

BecauseasignificantpercentageoftheinstitutionsthatperformmicrofinanceoperationsinLatinAmericaareregulatedinstitutionsthattakedepositsfromthepublic,theeffectivesupervisionofthemajorityoftheseinstitutionsrequiresaregulatoryandsupervisoryframeworkthatisrootedincompliancewithinternationalstandardsonbankingsupervision.Inthissense,LatinAmericancountriesshouldcontinuewiththeireffortstoincreasecompliancewiththeBCPs.

TheevaluationofcompliancewiththeBCPs isbasedonmaterialitycriteria.Theevaluationmethodologyacknowledgesthattheweaknessesintheregulatoryandsupervisoryframeworkofsomeinstitutionsarenotreflectedinacountry’scomplianceratingwithacoreprinciple,iftheseinstitutionsarenotmaterialtothestabilityofacountry’sfinancialsystem.Inthema-jorityofcountriesintheworld,theparticipationofmicrofinanceinstitutionsinthefinancialsystemislowandtherisksstemmingfromsupervisoryweaknessesareoftennotmaterialtothefinancialsystem’sstability.Therefore,inthecontextofanevaluationofcompliancewiththeBCPs,thesearenotconsideredwhenestablishingthedegreeofcompliancewiththeBCPsinacountryandgenerallyarenottakenintoaccountintheseassessments.Atthesametime,themethodologyforevaluatingcompliancewiththeBCPsacknowledgesthatsomecoreprin-ciplesbenotapplicabletoaparticularfinancialsystemortosegmentsofafinancialsystem’sinstitutions,whentheprincipleisassociatedwithrisksthatarenotmaterialtothissystemorsegment.ThusthefailuretocomplywithsomeBCPsbysomemicrofinanceinstitutionsinacountrymaynotaffectthecompliancewiththeBCPsofthefinancialsystemasawhole,iftheBCPsarenotrelevanttothesoundnessofmicrofinanceinstitutions.

2 Foradetaileddiscussionofthereasonsforregulation,refertoCarmichael,JeffreyyPomerleano,Michael.The Development and Regulation of Non-Bank Financial Institutions.TheWorldBank,2002.

3 Theprospectofrunsonbanks,interruptionsinthepaymentchainandviolationsofdepositors’rightsareassociatedwiththetakingofdepositsfromthepublic.However,therecentfinancialcrisisindevelopedcountrieshighlightsthatinstitutionsthatdonottakedeposits,suchasinvestmentbanks,alsocanputthestabilityofthefinancialsystematrisk.


IfaBCPcomplianceassessmentwouldsolelyfocusonacountry’smicrofinanceinstitutions,theassessmentwouldrequiretakingintoaccounttherelativeimportanceofspecificBCPsinrela-tiontothismarketsegment.Forexample,theabsenceofasupervisoryframeworkforcountryriskwouldnotlikelyhaverepercussionsontheeffectivenessofsupervisionofmicrofinanceinstitutions.However,deficiencies inmechanismsformonitoringcorporategovernanceandinternalcontrolsystemsareafundamentalweaknessinthesupervisionofsmallmicrofinanceinstitutions,whichtendtohaveratherconcentratedgovernanceandmanagementsystems.

Atanyrate,inamicrofinanceinstitutions’complianceassessmentwithregulationsandpol-icies of theBCPs, the supervisorwouldneed to take into account theparticular aspects ofthemicrofinancebusinesseswhenassessingeachcoreprinciple.Forexample,thesupervisorshouldconfirmthateachinstitutionhasadequatepoliciesandprocedurestorateitsassetsandtodeterminetherelatedloanlossreserves.Inthissegment, itisessentialthattheratingandprovisioningsystemsidentifythemicrocreditcomponentofaloanportfolioanddefineappro-priatespecificcriteriaforitsratingandprovisioning.

Unfortunately,itisimpossibletogeneralizebystatingthatsomeBCPsareinapplicabletomi-crofinanceinstitutionsintheregion.TheapplicabilityofcertainBCPsformicrofinanceinstitu-tionsdependsonhowthebusinessofmicrofinanceisdevelopedineachcountryandonthecomplexityofoperationsundertakenbyentitiesoperatinginthissegment.However,fourprin-ciples(BCP5,12,24,and25)haveverylittlerelevanceformicrofinanceinstitutions,whethertheytakedepositsfromthepublicornot,forthefollowingreasons:

- BCP5(Investmentcriteria):Usuallymicrofinanceinstitutionsintheregiondonotmakelargeinvestmentsorhavecross-borderoperations,sotheexistenceofinvestmentman-agementcriteriawouldhavelimiteduse.

- BCP12(Countryriskandtransferrisk):Microfinanceinstitutionsdonotusuallymakein-ternationalloansorinvestments,sotheywouldnotneedsystemstomanagethecountryandtransferrisk.

- BCP24(ConsolidatedSupervision)andBCP25(RelationshipbetweentheSupervisoroforiginanddestination):Microfinanceinstitutionsarenotnormallypartoflocalorcross-borderfinancialconglomerates,sotheneedforconsolidatedandcross-bordersupervi-sionislimited.Theexceptionsintheregionarethosemicrofinanceinstitutionsthatarepartofinternationalgroupsspecializedinthemicrofinancebusiness.Theclearestexam-pleistheProcreditGroup(forprofit).ThisGrouphasspecializedbanksin19countriesworldwide,includingsixcountriesintheregion(Bolivia,Colombia,Ecuador,ElSalvador,Honduras,andNicaragua).

Asidefromthesefour,compliancewiththeothercoreprinciplesisessentialforadequatesu-pervisionofthemicrofinanceinstitutionsegment.However,theevaluationmustconsiderspe-cificcharacteristicsofmicrofinance.Thesecharacteristicsshouldbeconsideredinthefollow-ingprinciples:


- BCP1(Objectivesandresponsibilitiesofthesupervisor):Theresponsibilitiesofthefi-nancialsupervisorregardingmicrofinanceinstitutionsmustbeclearlydefinedinthele-galframeworkandproperlydisseminated.Ifthecountryhasoptednottosupervisemi-crofinanceinstitutions,thisshouldbecleartothepublic.Additionally,totheextentthatnon-supervisedinstitutionsaffecttheactivitiesperformedbysupervisedentities,thereshouldbe adequatemechanisms inplace so that the supervisor canmonitor financialrisks andadapt the regulatory framework, if it isdetermined that the impactof theseinstitutionsontherestofthefinancialsystemcouldbematerial.Inthecaseofdelegatedorsharedoversight,theresponsibilitiesoftheauthoritiesmustbeclearandthecoordina-tionmechanismsmustbeappropriate.

- BCP2(Permissibleactivities):Iftherearedeposit-takinginstitutions4andthesearenotprudentiallyregulated,theyshouldrepresentaninsignificantproportionofdepositsinthesystem.However,thegrowthofdeposit-takingmicrofinanceinstitutionsthatcompetewithsupervisedentitieswithoutprudentialsupervisionmaygenerateriskstothesystemasawhole.Topreventthisproblem,thelegalframeworkshouldlimitdepositsininstitu-tionsthatarenotsupervisedasbanks(withlowerleverage)or,inlieuofthis,itshouldestablish that these institutionswillbe superviseddirectly, if they reacha certainsizeenablingthesupervisorstotakeactionifnecessary.Theattentiontothisissuebysuper-visorscanpreventtheemergenceofnon-supervisedrisks.Also,thefinancialsupervisorshouldhavemechanismstolearnoftheactivitiesofunregulatedinstitutionstoensurethesedonotperformregulatedactivities.

- BCP3 (LicensingCriteria):Among the criteria for grantingbanking licenses is the su-pervisoryauthority’sassessmentofthestrategicplans(especiallyofsignificantmarketresearch)andtheverificationthattheproposedsystemsofcorporategovernance,riskmanagement,andinternalcontrolsareadequate.Theproposedstructureshouldreflectthescopeandcomplexityoftheproposedactivities.Asamatterofscale,relativelysmallmicrofinance institutions often have concentrated structures and limited segregationofduties.Whilethismaybeinevitable,itisessentialthatsupervisorsensurethatthesestructures facilitate adequate internal control, riskmanagement, and corporate gover-nance.Inparticular,institutionsmustunderstandtherisksofrelyingonone(orafew)keyperson(s)andcontroltheserisksappropriately.

- BCP6(Capitaladequacy):Ingeneral,capitalrequirementsshouldreflecttheriskprofileofbanks.CompliancewiththisprincipledoesnotrequirethatcountriesapplyBasel IICapitalStandards5.However,theimplementationofBaselIIwouldprovidecountriesoftheregion,theopportunitytoanalyzetherisksofmicrofinanceoperationsandestablishcapitalrequirementsthatbettercapturetheserisks.TheimplicationsofBaselIIformi-crofinanceinstitutionsaresummarizedinthefollowingsection.

4 Includingcontributionsfrompartnersinthecaseofcooperativesandothersimilarformsoforganizations.

5 Thesestandardswerepreparedforbankswithwideinternationalpresence.


- BCP8(Creditrisk):Sincethisisacriticalriskofthemicrocreditbusiness,anappropri-ateframeworkforitssupervisionshouldtakeintoaccountthenatureofmicrocreditanditsbusinessmodels.Thisincludesexplicitidentificationofmicrocreditintheregulatoryframework,andtheestablishmentofappropriateclassificationandprovisioningcriteriaforthistypeofcredit.Also,tocontroltherisksofoverindebtedness,thesupervisormustensurethatinstitutionshavepoliciesandprocedurestomonitorthetotaldebtexposureoftheirborrowers.IntheBaselCommitteeonBankingSupervisiondocument,thisiscon-sideredanadditionalcriterion,notanessentialcriterionforcompliancewiththeBCP.

- BCP13(Marketrisk):Microfinanceinstitutionshaveexposuretomarketrisk,includinginterestrateriskrelatedtothemismatchbetweentheirshort-termassetsandlong-termliabilities.Thereisalsoforeignexchangeriskforthoseinstitutionsthathaveacurrencymismatchontheirbalancesheet.Thishappens,forexample,whenfinancialinstitutionsfinancetheirloansinlocalcurrencywithfundsreceivedinforeigncurrency.

- BCP15(Operationalrisk):Thisisalsoafundamentalriskofthemicrocreditbusinessandas such, theoperational riskoversight framework formicrofinance institutions shouldrecognizeitsspecialcharacteristics(theyaremassmarketswithansignificantnumberofloanofficers),including,forexample,fraudrisk,humanerror,andprocedures’failurescommontodifferentlendingprocessesprevailinginthisbusiness.

- BCP19(Supervisoryapproach):ThisBCPrequiresthatthesupervisoryauthoritieshaveathoroughknowledgeoftheoperationsoffinancialinstitutionsindividually,andofthesystemasawhole.This includesmonitoringandevaluatingtrends,developments,andrisksinthemicrofinancesector.Propermonitoringofrisksinthissegmentrequireshav-ingtheabilitytoobtainacertainlevelofinformationabouttheactivitiesofmicrofinanceoperatorsthat,withoutbeingsubjecttocontrolbythesupervisor,canhaveanimpactontherisksofthesupervisedsegment.

AgoodlevelofcompliancewiththeBCPisnecessary,butmaynotbesufficientforadequatesupervisionofmicrofinanceinstitutionsintheregion.Nocountrywithaninadequatesystemofbankingsupervisionwillhaveanadequatesystemofsupervisionformicrofinanceinstitu-tions.However,therearecountriesthatrelyonadvancedregulatoryandsupervisorysystemsthathavenotdevelopedadequatemonitoringsystemsfortheirmicrofinanceinstitutions.

1.2 Basel II and microfinance institutions6

In2004,theBaselCommitteeonBankingSupervisionissuedthedocument“International Con-vergence of Capital Measurement and Standards – A Revised Framework,”betterknownasBaselII,theproductoftherevisionprocessoftheBaselAccordissuedin1988.Theobjectiveofthepaperwastoestablishanewinternationalcapitalstandardforinternationallyactivebanks,soastopromoteanappropriatecompetitionframeworkinalljurisdictionsofthemembercoun-

6 See:“International Convergence of Capital Measurement and Standards – A Revised Framework”,BaselCommittee;and“BaselIIImplementation:PracticalConsiderations”,BaselCommittee.


triesoftheCommittee.However,theCommitteerecognizedthatthefirstagreement-knownasBaselI-hadbecomeareferenceforsupervisoryauthoritiesworldwide,whouseditsconceptstosetregulationsforallfinancialinstitutions,includingthosethatonlyoperateatalocallevel.Likewise,theCommitteeincorporatedinitsnewstandards,aneededcombinationbetweenrulesandtheappropriateframeworkunderwhichthesemustoperate,makingBaselIImorethanacapitalstandard.Thus,thedocumenthas3pillars:

- PillarI-Establishestwoalternativeapproachestodeterminecapitalrequirementstocov-erafinancialinstitution’screditandmarketrisks:thestandardapproachandtheinternalrating-based approach. It also introduces capital requirements for operational risk forwhichthreealternativeapproachesaredefined.

- PillarII-Seekstoprovidebankswithenoughcapitaltowithstandrisksandpromotegoodriskmanagementpractices.

- PillarIII -Seekstopromotemarketdisciplinethroughthedevelopmentof informationdisclosurerequirementsthatwouldenablemarketagentstoevaluatetheinstitutions.

BaselII leavestothediscretionofthesupervisors,thedecisionoftheapproachinstitutionsundertheirjurisdictionwillusetodeterminetherequiredcapital.Italsosuggestssomecri-teriatodeterminetowhomBaselIIwillapply:sizeoftheentity;natureandcomplexityofitsoperations;internationalpresence;interactionwithinternationalbanks;riskprofileandriskmanagementcapabilities;resourcesavailableforvalidationandmonitoring;andacost-benefitanalysisduetothecomplexityof implementingBasel II.Underthesecriteria,mostmicrofi-nanceinstitutionsintheregionwouldnotberequiredtoapplymoresophisticatedmethods.Thus, it isexpectedthat, ifcountriesmovetowardsBaselII,microfinanceinstitutionsapplyBaselIorthestandardizedapproachofBaselII.

ThemaineffectsofimplementingBaselIIformicrofinanceinstitutionswouldbe:

- Onassetsrisk-weightingsince,underthestandardizedapproach,supervisorshavesomediscretiontodefinethem:

- Themicrocreditportfoliodoesnotusuallyreceiveaclassificationfromratingagen-cies,thus, itsriskweightwouldbe100%unlesstheregulatorchoosestodefineitasa“regulatory retail portfolio”thatwouldbeassignedaweightingof75%.Themi-crocreditportfoliomeetstherequirementsofaregulatoryretailportfolio(loanstoindividuals,tosmallbusinessesandgranularity)setbytheBaselCommittee.

- High-risk portfolioswithout loan loss reserves could have aweighting exceeding100%.

- The introductionofcapital requirements foroperational riskwouldprobablyhave thegreatestimpactonmicrofinanceinstitutions,asthecapitalrequirementissetbasedongrossincome.Itwouldalsohaveasignificanteffectonthemicrocreditbusiness,whichhashigheradministrativecoststhanthecommercialloanbusiness,andrequireshigherrelativegrossincometobeprofitable.Forexample,accordingtotheBasicIndicatorAp-


proach,thecapitalrequirementforoperationalriskwouldamountto15percentofgrossrevenuesaveragedoverthelast3years.

- It is possible that entitieswithwhichmicrofinance institutions compete could accesscapitalsavings, throughtheapplicationof internalmodels,whichcouldgeneratesomecompetitivedisadvantage.

- ThereisgreateremphasisunderBaselIIontheresponsibilityofdirectorsandmanagersofinstitutionstounderstandtheriskstowhichtheirinstitutionareexposedtoandhowtheserelatetotheircapitaladequacy(PillarII).

- Basel IIrequires institutionstohaveapolicyof informationdisclosureandofmaterialevents,andasystemtoevaluatethatpolicy(PillarIII).

TheimplementationofBaselIIwouldprovidecountriesintheregiontheopportunitytoana-lyzetherisksofmicrocreditandtoestablishcapitalrequirementsthatbestcapturetheserisks.Oneparticularissuetoevaluateisthesuitabilityofestablishingaregulatoryretail portfoliothatincludesthemicrocreditportfolio,whichisweightedat75%forpurposesofcalculatingrisk-weightedassetsunderBaselII.Applyingthislowerweightingmayberecommendedincoun-trieswheremicrocreditisproperlyidentified,classifiedandprovisionedfor,providedthatthesupervisorshaveestablishedthattheinstitutionsoperatinginthissegmenthaveappropriateriskmanagementsystems.Supervisorsshouldreviewinadvancewhetherthislowerweight-ingisconsistentwiththebehaviorofmicrocreditportfoliosintheirrespectivecountries.Thismodificationcouldbemadewhenimplementingcapitalrequirementsforoperationalriskes-tablishedinBaselII,sothatthelowerweightingsforthemicrocreditportfoliowouldpartiallyoffsethigherrequiredcapitalforoperationalrisk.

1.3 Rationale for complementary principles for regulation and supervision of microfinance

Althoughtheneedtoregulateandsupervisebanksrigorouslyisrarelychallenged,theimple-mentationofarigorousregulatoryandsupervisorysystemformicrofinanceinstitutionsisasubjectofdebate.Themajorityofmicrofinanceinstitutionsarenotmaterialtothefinancialstabilityoftheircountries,buttheirpresenceandactivityrequiressomecomplementarystan-dardstotheBCPstoensureeffectiveregulationandsupervision.Aside fromtheprudentialpurposeofpreservingfinancialstability,supportforacomplementaryregulationandsupervi-sionframeworkcanbefoundontheobjectivesofprotectingconsumers(depositorsandbor-rowers),andcorrectingmarketimperfections(informationtoimprovetransparencyandef-ficiency).Likeallregulation, ithascosts. Inorderto justify implementingacomplementaryframework,thebenefitsmustoutweighthecosts.

The strict regulation andprudential supervisionofmicrofinance institutions is socially de-sirable,even if these institutionsdonotundermine thestabilityof the financial system.Aninadequate regulatory framework for these institutions can encourage some institutions totakeexcessiverisks,leadingto,forexample,overindebtednessofborrowersinthatsegment.


Excessiveindebtednessofborrowershasadevastatingimpactonsociety,breakingdownthepaymentcultureandreducingthepopulation’sabilitytogeneratewealth.Overindebtednessnotonlyaffectsthesemicrofinanceinstitutions,butallotherfinancialinstitutionsaswell,gen-erating losses that could lead toa tightening in themicrocredit supplyandeliminatea sig-nificantcreditsourceforanimportantsegmentofthepopulation,withsignificanteconomicandsocialconsequences.Eventhoughthefinancialsystem’sstabilitymaynotbeatrisk,thissegment’sprudentialregulationisjustifiablebecauseitisdesirabletohaveasustainablemi-crocreditsupply,whichatthesametimecallsforinstitutionsthatprovideitinaprudentandsoundmanner.

Ifaninstitution(oraproductivesector)canproducesignificantdamage(socialcosts)withitsmarketconduct,aregulatoryframeworktopreventsuchdamageis justifiedtoprotectcon-sumers.Additionally,theregulationofmicrocreditbusinessshouldhaveanimportantcompo-nentofconsumerprotection,butwithoutreducingtheirdecisionmakingresponsibility;thatistosay,notaffectingthepaymentcultureorgeneratingmoralhazardrisks.Forexample,thedisclosureofcreditcostsandothertermsofcreditagreementstoconsumers,providesthemwithinputstomaketheirdecisions,anditisessentialfortheadequateoperationofthemicro-creditmarketandtopreventthesocialconflictscausedbyoverindebtedness.Thesupervisoryauthorities’evaluationoftheclausesofacreditcontract,topreventandpunishabusiveprac-tices,alsofavorstheproperfunctioningofmicrocredit.

Thecorrectionofmarketimperfectionsistheultimategoalofregulatingthemicrocreditbusi-ness.Mechanismstocorrectvarioustypes ofinformationasymmetrycansupporttheefficientfunctioningoffinancialmarkets.Forexample,creditbureausmitigatetheinformationasym-metries that exist between financial institutions and their borrowers about theborrowers’ability(andwillingness)topay,enablingfinancialinstitutions tomakeinformedcreditdeci-sions;thus,strengtheningthemicrocreditsupply.Thesharingofinformationaboutthecostsandconditionsofcredit,allowsborrowerstomakeinformeddecisionsabouttheirindebted-ness’capacityandwhooffersthemthemostappropriateproduct.


PRINCIPLES FOR EFFECTIVEREGULATION AND SUPERVISION OF MICROFINANCE OPERATIONS

2.1 Scope

Thischapterpresentsasetofprinciples for theregulationandsupervisionofmicrofinanceoperationsthatapplytomicrofinanceinstitutionsandall financialentitieswithmicrocreditportfolios,includingbanks.

ExceptforwhatismentionedinChapterI,thereiscoherencebetweenthefollowingprinciplesandtheBaselCorePrinciples(BCPs).NoaspectoftheseprinciplescontradictstheBCPs,butrathertheycomplementthem.

ItisdesirablethattheprinciplesintheseGuidelinesbeappliedtonon-supervisedcreditinsti-tutionsthatoperateinmicrofinance,asthey constitutesoundpracticesthatseektominimizetheriskstheyareexposedto.Itisalsorecognizedthatinthecaseofnon-regulatedentities,theState’sroleisnottoregulateandsupervise,butrathertoestablishanenvironmentofsoundandethicalpracticesthatwouldallowaccesstoqualityfinancialservicestosegmentsofthepopulationthathavebeenexcludedfromtheseservices.Consequently,theseGuidelinescanconstituteamodelofsoundpracticesfornon-regulatedentitiesandfortheinstitutionsthatregulatethem,aswellasforwhoeverassociateswithorinvestsinthem.

2.2 Preconditions for effective regulation and supervision of microfinance

Role of the State, Market Entry, and Interest Rates

2.2.1 Role of the State

TheStateshouldcreateconditionstofacilitatethedevelopment,strengthening,andpro-tectionof the institutionalsoundnessofmicrofinance institutions.Microfinanceopera-tionsenjoyastablelegalandregulatoryframeworkthatallowstheassumptionofprudentrisk.Standardsappliedtomicrocreditarenomorelenientorpermissivethanthosefor

2


othertypesofcredit.TheStateensurestransparencyofinformationthatenablesusersofmicrocreditoperationstomakeprudentdecisions.TheStatesupportstransparencyintheindustry,beginningwithraisingpublicawarenessabouttheprotectionthattheStateoffersdepositorsinregulatedfinancialinstitutions.Thedefinitionof“microcredit”7is de-tachedfromconceptsassociatedwithlabor,tax,orpoverty-alleviationpurposes,aswellasfromtransfersofStateresourcesorsubsidies.

TheStaterefrainsitselffromestablishingportfolioquotasforfinancialinstitutions.TheStateavoidsdistortingcontractualconditions,suchasamount,price,terms,guarantees,andcurrency.

TheStateestablishesalegalenvironmentthatsupportsthecollectionofdebtsandcer-taintyinthesettlementofguarantees.Inaddition,ithasacleartaxtreatmentoverfinan-cialproducts.

TheStatesupportsthedevelopmentofaninfrastructurethatprovidesfinancialconsum-erswithasingleidentificationsystem.

TheStateaimstoensurethatthesupervisorhassufficientcapacityandresourcesfortheeffectiveimplementationoftheseprinciplesinmicrofinanceinstitutions.

TheStateknowsoftheoperationandscopeofworkofnon-supervisedmicrofinancein-stitutionsandhastheauthoritytointegratethemintothesupervisedcategorywhentheircharacteristics,impact,ormaterialnaturedeemitappropriate.Thecriteriaforincorpo-ratingnon-supervisedmicrofinanceinstitutionsintothesupervisedcategoryareclearlyestablishedintheexistingregulation.

TheStaterequiresaclearidentificationbetweensupervisedandnon-supervisedinstitu-tionsforpublicusethatincludesthedifferentiationofbrandsornames.Nosupervisedinstitutionusesabrandorcommonidentitywithnon-supervised institutions.Non-su-pervisedinstitutionsstateintheiradvertisingthattheyarenotmonitoredbythefinancialsupervisor,norauthorizedtotakedepositsfromthepublic.

TheStaterequirestheadoptionofaunifiedaccountingsystemforthefinancialsectorap-plicabletoallinstitutions,whethertheyaresupervisedornon-supervised.

Within the judiciarybranchofgovernment, therearemechanisms forrapidresolutionofminordisputesregardingfinancialservicescontracts.Thejudiciaryalsopossessesaspecializedexpertiseintheareasofcommercialandfinanciallaws.

2.2.2 Freedom to set prices

Microcreditloansarenotsubjecttointerestratecapsorpricesforservices.Therearecon-ditions thatpermithealthyandvigorouscompetitionbetweenfinancialentities.These

7 Theprovisionofcredittolow-incomeindividuals,informal,intheprocessofbeingincludedinthebankingmarket,poorandverypoor,whichareusuallypresentinsomedefinitionsofmicrocredit.

PRINCIPLES FOR EFFECTIVE REGULATION AND SUPERVISION OF MICROFINANCE OPERATIONS ¶ 21

conditionsincludetheavailabilityandtransparencyofinformationthatallowsthepublictocomparedifferentalternatives,suchasformulasforcalculatinginterestratesformi-crocreditoperations.

2.2.3 Market access

Allfinancialinstitutionsthatprovidemicrocreditdosotoindividualswhomaylack com-mercialortaxregistration, formalaccounting,orguaranteesthatcanberegistered.In-stitutionsestablishtheirownpoliciesanddeterminetheuniverseofeligibleclients.Allmicrocreditoperationsofsupervisedinstitutionsareguidedbytheseprinciples.

Non-supervisedcredit institutionsarepermitted tograntmicrocredit loans,butnot totakedepositsunderanycircumstances.Thisincludesdepositsandnon-compulsorycon-tributionstosavingsand loancooperatives. Italso includesclients’cashcollateral thatis not deposited in theborrower’s name into regulated financial entities by the creditinstitutions.

Minimum infrastructure

2.2.4 Credit bureaus

Therearecreditbureausthatarepublic,private,orahybridofboththatrelyoncentral-izednational databases, andprovide current andhistorical information to anypersonwithalegitimatebusinessinterest.Thisincludesinformationonanindividual’samountofdebt;paymentstatus;andbehaviorinthefinancialsystemincludingoperationswithnon-supervised credit institutions, public utilities, taxmatters, and commercial credit.Thecreationofcreditbureausthatarespecializedinmicrofinanceorthatcontainonlynegativeinformationdoesnotcontributetothedevelopmentofthispublicgood.Microfi-nanceinstitutionsandthoseoperatinginmicrocreditareobligedtoreporttheirdebtorstoacreditbureau,andconsultthebureaubeforegrantinganycreditfacility.

Creditbureausmustkeepadequate information security controls toguarantee theac-curacyofreportedinformation,andtominimizetheriskthatsuchinformationmaybealteredormisused.

2.2.5 Financial client protection

Therearelawsorregulationsonmarketconductaswellasonprotectionanddefenseoftheuserofmicrofinanceservices.Theselawsorregulationsshouldclearlyestablishtherightsandobligationsofpersonswhorequestloans,makedeposits,orhavesometypeof contractual relationshipwitha financial institution.There isanobligationofall su-pervisedfinancialentitieswithmicrofinanceoperationstoprovidetimely,completeandrelevantinformationontheconditionsofamicrofinanceproducttousersbeforesigningacontractorthroughout itsduration.This information includestherightsofclientsofmicrofinanceproductsandservices,aswellasthewaystofileacomplaintbothbeforethe


financialinstitutionandtherelevantagencies.Italsoincludesthelegalrightsoftheclientwhofindshimorherselfinacollectionprocess.

Thereistransparencyofdocumentationthatpreventscontractual abuse.TheStatehastherighttoreview,objecttoorapprovethetextofmodelcontractsormicrocreditstan-dardspriortotheirapplication,aswellastosanctionviolationsoftheobligationofpro-vidinginformation.Thecontractsaredraftedinsimplelanguage.

Public campaigns are conducted on users’ rights and obligations. Financial legislationorregulationrequiresfinancialinstitutionstoinstruct,explainorwarntheircustomersabouttheirrightsandobligationsassociatedwithmicrofinanceservicescontracts.ThecreationofaFinancialSystemAdvocate(FinancialOmbudsman),asanindependentper-sonof irreproachablereputationwithextensiveknowledgeofthefinancialsystemandwithsufficientpowerstoexercisehisorherfunctions,ispromoted.Thecustomeradvo-cacyservicecanbeprovidedattheaggregatelevelwhenintheopinionofthefinancialsupervisorthenumberoffinancialtransactionsinanentityjustifiesthisservice.

Public andprivateentities relatedwith thebroad financial sector, implement financialeducationprogramsthatallowclientstobecomeknowledgeableofresponsiblefinancialadministrationpractices.

2.2.6 Financial information

Financial institutions regularly draft and publish through mass distribution media(writtenandelectronic)theirfinancialstatementsinaccordancewithInternationalFi-nancialReportingStandards(IFRS).AsIFRSbecomeseffectiveinagivencountry,thesupervisedinstitutionswillapplytheaccountingrulesofthefinancialsupervisor.Intheevent thatmicrofinance institutionsprepare financial statements in accordancewithaccounting standardsprescribedorpermittedby the financial supervisorybody, theaccountingandfinancialeffectofthedifferencesbetweenthetwoaccountingmethodsmustbemadepublic.SuchentitiesandinstitutionssubjectthemselvestoexternalauditandpublishtheirfinancialstatementsannuallyinaccordancewithInternationalAudit-ingStandards.

2.2.7 Product and price transparency

Allfinancialinstitutionsinthesupervisedfinancialsystemdiscloseinformationregard-ingthetypesofproductsandmicrofinanceoperationsthattheyoffer,theirrequirements,conditions,andrateplansand;inthecaseofloans,thecalculationofthenetamountre-ceivedbytheborrowerandtheamountoftheloanrepayments.Thisinformationdisclo-sureshouldbeconductedbyafinancialinstitutionusingthemethodologybestsuitedforitscreditculture,institutionalcultureandinfrastructure;whichshouldbemadeknowntothesupervisoryauthoritybeforeitisimplemented.Giventhephysicalproximitytotheclient,thatisacharacteristicofthemicrocreditmethodology,thisinformationdisclosureandfinancialeducationshouldbeprovidedthroughdirectcontactwiththecustomer.


Theeffectiveinterestrateschargedandpaidbyfinancialinstitutionsareregularlypub-lishedanddisclosedtothepublic.Themethodologyusedfollowstheguidelinesestab-lishedbythesupervisor.

Theclientknowstheeffectiverateorcostofhiscreditandisabletocompareitwiththeratesofothercreditproviders.

2.2.8 Deposit Protection

Thesaversinmicrofinanceinstitutionshavethesamelegalandeconomicrightsasothersaversinthesupervisedfinancialsystem.Depositinsurancecoverageisbasedoncriteriaofreasonablenessandequitywiththeobjectiveofminimizingmoralhazard.Thedepositinsurance system, explicitly or implicitly, only gives coverage to regulated financial in-stitutions.Thepublicisadequatelyinformedofthecoverageorlackofcoverageoftheirdeposits.

2.3 Regulation and supervision of microfinance institutions

2.3.1 Supervisory scope

Thefinancialsupervisor’sresponsibilitiesregardingmicrofinanceinstitutionsareclear-lydefined in the legal frameworkandareadequatelydisseminated. If the countryhasnon-supervisedcreditinstitutions,theseshouldbemadecleartothepublic.Additionally,there are appropriatemechanisms for the financial supervisor tomonitor the risks ofnon-supervisedmicrofinanceinstitutionsinatimelymannerandtoadjusttheregulatoryframeworkifitisperceivedthattheimpactoftheseinstitutionsontherestofthefinan-cialsystemcouldberelevant.Ifthereisdelegatedsupervisionorsharedoversight,theresponsibilitiesofthedelegatedentitiesarewelldefinedandappropriatecoordinationmechanisms are in place.

2.3.2 Public supervision

Deposit-takingmicrofinance institutionsaredirectlymonitoredby the financial super-visorybodyindependentlyoftheircharter(jointstockcompanies,cooperatives,thrifts,non-profitcivilassociationsorfoundations,publicormunicipalfirms).

2.3.3 Microfinance institutions

Thelicensingofmicrofinanceinstitutionsrequiresalegalframeworkthatconsiders:

i. Aminimumcapitalfordeposit-takinginstitutionssufficienttocovertherisksofun-expectedandexpectedlossesuptoabreakevenpoint,thecostsofareasonableinfor-mationmanagementinfrastructure,andworkingcapitalneeds.Theinitialcapitalofaninstitutionshouldnotnecessarilybeequaltotheminimumrequirement;

ii. Absenceofgeographicrestrictionstooperate;


iii. Anoperationalframeworkthatallowstheinstitutiontodevelopawiderangeofas-setandliabilityoperationsandmicrofinanceservicesforthepublic;

iv. Capitalrequirementsequaltothosesetforotherfinancialentities,butstricterforthoseinstitutionswhoselegalorownershipstructure,inthesupervisor’sopinion,wouldpresentdifficultiesforadequateandtimelycapitalreplenishments;

v. Theprohibitiontograntlargeloanstoshareholders,management,ordirectors,ortodivertlargeamountsonnon-creditassets;and

vi. Requirementsforadequatecorporategovernance,earlywarningsystems, internalcontrols,andriskmanagement.

2.3.4 Licensing of microfinance institutions

Thesupervisormusthaveanassessmentprocessforallshareholdersorpartners(includ-ingassociationsandnon-for-rofitcivilorganizations)ofmicrofinanceinstitutionswithastakegreaterthan5%.Thesemajorityshareholdersorpartnerswillcomplywiththeregulator’scriteriaof“fitandproper”accordingtothepracticesoftheregulatedfinancialsystem.Theseshareholdersorpartnerswillalsohavethefinancialsolvencytoincreaseorreplenishthecapitalofthemicrofinanceinstitutions,ifnecessary.

Thelicensingprocessofnewmicrofinanceinstitutionsisnolessstrictthanforotherfinan-cialentities.andrequiresthedeterminationoftheirfeasibilitybasedonmarketresearch.Asa resultof this research, specificproducts for thatmarketaredesigned,developed,andimplementedalongwithamicrocreditmethodology,technologicalinfrastructure,hu-manresources,andthecorrespondinginternalcontrolsandfinancialresources.Amicro-financeinstitution’sinitialpaid-in-capitalcanonlybeincash.

Inthecaseofmicrofinanceinstitutionscreatedfromtheoperationsofannon-super-visedcreditinstitution,thesupervisorshouldalsoconsiderthehistory,evolution,andsuccessfulperformanceofthisinstitution;itshouldnotallowtheshareholdersorpart-nerstoengage inactivities thatcreateconflictsof interest;and, in theeventthat thenewinstitutionacquirestheportfoliogeneratedinthenon-supervisedentity,theport-foliomustbeassessedbeforehandbyaqualifiedindependentthird-partyaswellasbythesupervisor.

2.3.5 Exposure limits

Legislationorregulationestablishesacreditlimitonmicrofinanceinstitutions’individualloansthatislowerthanthatofacommercialbank,measuredasapercentageofitseq-uity.Additionally,theseregulationsprohibitloanstotheinstitution’sowners,directors,ormanagement.


2.3.6 Market information and risk

Thefinancialsupervisorybody,tradegroupsthatbringtogetherfinancialinstitutionsop-eratinginmicrocredit,orotherorganizationsprepareandperiodicallypublishcompara-tiveinformationonthefollowingaspectsofmicrocreditportfolios:

i. Microcreditportfolioaspercentageoftotalloanportfolio;

ii. Loanspastduemorethan30days(absolutevaluesandpercentages);

iii. Writtenoffloans(absolutevalueandpercentages);

iv. Annualrotationofloanofficers;

v. Loanlossreservesovertotalportfolio;

vi. Effectiveinterestratecharged(portfolioincomeaspercentageofaverageportfolio);

vii. Loan portfolio and deposits by city/region, by product, and by length of arrears(measuredinamountsandnumberofclients);and

viii. Locationofagenciesorpointsofservice(tellers,ATMs,correspondents).

Theperiodicpublicratingoffinancialinstitutions’riskispromoted,byexperiencedfirmsofrecognizedprestige,whichusemethodologieswithhighqualitystandards,registeredandsupervisedbythefinancialsupervisor.

2.3.7 Integrated risk management8

Legislationorregulationestablishesspecificnormsforriskmanagementpracticesinmi-crofinance institutions.Regulationplaces emphasisonproportionality and specific as-pectsregardingcredit,operational,governance,strategic,reputational,liquidity,andmar-ketrisksinadditiontotherisksthatareproducedbythedynamicsbetweentheserisks.

2.3.8 Credit risk management

Legislation or regulation requires that microfinance institutions have an appropriatemethodologytoassesstheirpotentialclients’paymentcapacity,andthattheyhavesuf-ficientinfrastructuretomonitortheirmicrocreditportfolios.Thisinfrastructureshouldataminimuminclude:

i. Computerizedinformationsystemsformicrocreditadministration;

ii. Riskmanagementpoliciesonmicro-borrowers’overindebtedness;

iii. Systemstoestimatesensitivityofarrearsofmicrocreditportfoliosindifferentad-versescenarios(stresstests);and

iv. Appropriateincentivessystemsforcreditofficials.

8 Whoseportfoliocanbecomprisedalsobyothertypesofloans(consumer,commercial,housing),andofferdepositsandotherfinancialservices.


Legislation should establish capital requirements for specializedmicrofinance institu-tionstoaccountforthisrisk.

2.3.9 Operational risk management

Legislationor regulation requires thatmicrofinance institutionsappropriatelymanageoperationalrisks,which,giventhenatureofmicrofinanceoperations,representthemainrisksofthisindustry.Assuch,theyshouldrequiremethodologiesthatallowforthe:

i. Identificationofthoseriskeventsthathavetheirorigininhumanerror,processes,systems,andexternalevents;

ii. Measurementoftheprobabilityofoccurrenceandimpactofsuchevents;

iii. Settingofmitigationmeasuresandactionplansfortheirimplementation;

iv. Implementationofmonitoringandmanagerialinformationsystems;and

v. Developmentofriskevents’databases.

Inaddition,thefollowingshouldberequired:

i. Policies,procedures,andsystemstocontrolinformationsystems’securityrisks;

ii. Internalcontrolsystemsforthepreventionoferrorsandfrauds,includinganinternalauditingfunctionthatreportsdirectlytotheBoardofthemicrofinanceinstitution;

iii. Informationverificationproceduresandcontrolsthatensureinformationquality;

iv. Institutionalcontingencyplans;

v. Supportandlegalcounselthatpreventpotentiallegalactions;and

vi. Implementationofplansforpersonneltraining.

Legislation should establish capital requirements for specializedmicrofinance institu-tionstoaccountforthisrisk.

2.3.10 Corporate governance risk management

Legislation or regulationpromotes the existence and application of sound corporategovernanceprinciplesinmicrofinanceinstitutions.Theseprinciplesappropriatelyhar-monizetheinterestsoftheinstitutionanditsowners,withtheinterestsofitsusersandclients.Therearecodesofethicsandconductthatguidethebehaviorofthefinancialinstitutions’owners,directors,managers,andemployees,aswellasestablishingtheirpowersandcompetenciesinordertopreventtheconcentrationofpowerandconflictsofinterest.9

9 Whenthelawdoesnotprohibitorevenconsiderstheconcessionofloanstoowners,directors,andmanagementoftheinstitutionasalegalactivity,theinterestsoftheinstitutionanditsdepositorsmayconflictwiththeinterestsoftherelatedparties.


2.3.11 Strategic risk management

Legislationorregulationpromotessoundcorporategovernancepoliciesandpracticesinmicrofinanceinstitutionsthatwouldensurethattheyaremanagedinacompetitiveandsustainablemanner,thattheyparticipateinmarketsegmentswithdemonstratedexperi-ence,thattheyhavesoundanalysisofmarketsegmentsandtheirenvironment,andthattheypromoteinnovationinaprudentmanner.

2.3.12 Reputational risk management

Legislationor regulation establishes the obligation ofmicrofinance institutions andoftheirdirectors,managers,andemployeestopreservetheinstitutionalimageandpublicconfidencethroughcompliancewithapplicableregulationsandlaws;fair,equitable,andnon-discriminatorytreatmentoftheirclients;applicationofethicalprinciples,moralval-ues;andthepromotionoffinancialinclusionandeducation.

2.3.13 Liquidity risk

Legislationorregulationestablishestheobligationofmicrofinanceinstitutionstoimple-mentmechanisms thatminimize liquidity risk,which comes frommismatches in cashflowsaswellasfromnotbeingabletocloseopenpositionsinatimelymanner,inasuf-ficientamount,andatareasonableprice.Themanagementmechanismsshouldincludemeasurement,monitoring,andmitigationof riskswhose impactcouldcause failure tocomplywithfinancingrequirementsandapplicationoffundsintheinstitution.Giventheneedtoapplyapreventiveapproach,theinstitutionsshouldrelyoninformationthatper-mitsthemtoseetheirfuturemismatchesandtodevelopcontingencyplansthatallowsthemtoactinresponsetoadversemarketsituations.

2.3.14 Market risk

Legislationorregulationestablishestheobligationofmicrofinanceinstitutionstoimple-mentmechanismsthatminimizethepossibilityoflossesduetoadversemovementsinthepriceoftheirassets,theimpactontheirbalancesheettochangesininterestratesortheimpactofchangesintheexchangeratewhentakingpositionsindifferentcurrencies.Also,regulationsrequirethatmicrofinanceinstitutionswillonlybeabletooperatewithser-vicesandinstrumentstheyhaveauthorizationfor,andthattheywillhavetorequestandobtainpriorapprovaltooperatewithotherinstrumentsthatarenotauthorizedwithintheirlicense.

Thelawshouldestablishcapitalrequirementsforspecializedmicrofinanceinstitutionsduetothisrisk.

2.3.15 Over indebtedness limits

Legislationorregulationestablishesalimitfortherepaymentcapacitythatcanbeafunc-tionofthenetincomeofabusinessunit.Theyalsoestablishtheobligationthatallfinan-


cialinstitutionshaveinternallyestablishedintheirmicrocreditoperationsarelationshipormaximumlimitbetweentheamountofamortizationpaymentsofallobligationsofaborrowerandhis/herregularnetincome.Thereistheobligationoflimitingrisk,basedonthedebtor’spaymentcapacityandtheconsiderationofthedebtor’spotentialoverin-debtedness.

2.3.16 Anti-Money Laundering and Counter-Terrorism Financing

Legislationorregulationestablishestheobligationofmicrofinanceinstitutionstoimple-mentmechanismsthathelpthemto“knowtheirclient”andtoavoidthemisuseoftheirproducts and services. Microfinance institutions should comply with the Anti-MoneyLaunderingandCounter-TerrorismFinancingrules.

2.4 Regulation of microcredit operations

2.4.1 Appropriate credit classification

Financiallegislationandregulationsdefineandcharacterizedifferenttypesofcreditthatfinancialinstitutionscangrant,takingintoaccountthesourcesofthecashflowsthatpayfortheobligationincluding:saleofgoodsandservices(microcreditandcommercialcred-it);orsalaries,pensions,retirementincome,andthelike.

Amicrocredit isatypeofcredit,whichhasspecific informationrequirementsfortheircreditfiles,loanlossreservesregime,interestincomegeneration,writeoffsandexpectedlosses.

2.4.2 Microcredit definition

Thereisadefinitionofmicrocreditcontainingimportantanddifferentiatingelementsofthisparticular typeofcreditoperation:asmallamount loangrantedtosmallbusinessowners,thatwillbepaidbackmainlywiththecashflowfromthebusiness’ssaleofgoodsandservices.These loansaregrantedusingspecializedcreditmethodologiesbasedonthoroughpersonalcontactto,amongothers,assessanddeterminethepotentialclient’swillingnessandrepaymentcapacity.

2.4.3 Maximum exposure limits

Legislationorregulationestablishesamaximumlimit(forexample,amultiplierof thegrossdomesticproductpercapita)forthedefinitionofamicrocredit.Thislimitshouldconsiderthetotalloanexposureofaborrowerinthefinancialsystemincludingthatwithnon-supervisedcreditinstitutions.Thislimitshouldbeobservedatthemomentofloandisbursementandshouldnotdeterfinancialinstitutionsfromassessingtheborrower’scapacityandwillingnesstopay,norofthepotentialneedtorequireregisteredcollateralortoseekaccountinginformationofthebusinesswhenavailableduringtherelationshipwiththeclient.


2.4.4 Fundamental characteristics of microcredit

Microcreditisprocessed,documented,assessed,approved,disbursed,andmanagedun-derspecialcreditmethodologiesthatdifferfromtraditionalcorporateorconsumercreditmethodologies.Itisinherenttomicrocredit:

i. Thatcreditapplicantshavesmallbusinesses;

ii. Thatnoexclusionof theapplicant ismade solely for lackof accounting, auditing,formaldocumentationorofficialrecords;

iii. Thattheremaybenocollateral,astheapplicantmaynothaveone;

iv. Thatthereisarequiredconsultationwithacreditbureau,bothfortheapplicantandtheguarantorsifany;and

v. Thatacashflowandabalancesheetarepreparedbyaloanofficeralthoughnotnec-essarilyforeachloanoperation.

2.4.5 Minimum information requirements

Legislationor regulationestablishesmicrocreditborrowers’ information requirementsthatmustbeonrecordintheirloanfiles(physicallyand/orelectronically).Thisinforma-tioncomprisesatleastthefollowing:

i. Copyofofficialidentificationdocument;

ii. Certificationorverificationofplaceofresidenceorlocationofthebusinessunit;

iii. Declarationofincomepresentedbytheapplicant;

iv. Bankreferences,ifany;

v. Creditbureauinformationfortheapplicantandforhis/herguarantor,ifany;

vi. Commercial references from members of the community, suppliers, clients, andnearbybusinessesevenifinformal;

vii. Certificationofcollateraliftheloanrequirescollateral;

viii. Balancesheetandcashflowpreparedorreviewedbytheloanofficer;

ix. Presentation/submissionandapprovaloftheoperation;and

x. Copyoftheloancontract.


2.4.6 Loan loss reserves requirement

Therearerulesestablishing:

i. Thatmicrocreditisconsideredanindependentcreditcategory,differentfromothertypesofcredit(likecommercial,consumer,orhousingloans);

ii. Thatdifferentgeneralledgeraccountsareusedtorecordup-to-datemicrocreditop-erationsandpastdueloans(restructured,pastdue,andinlegalcollection);and

iii. Thatthelackofrepaymentofoneoftheinstallmentsofthemicrocreditcausesanaccountingtransferofthewholeloantopastdueloans.

Therearealsospecific rules for theratingofmicrocreditportfolios todetermine theirspecificorgenericloanlossprovisions.Theessentialriskcriteriaestablishedforthecre-ationofspecificloanlossprovisionsare:

i. Numberofdayspastdue;

ii. Numberofreschedulingevents;

iii. Termsandpaymentplansofirregularpayments;

iv. Nodeductionofthevalueofanyreceivedcollateral;

v. Intheeventthatsharedclientsarefoundtohaveworseratingsinothernon-super-visedfinancialinstitutionsorcreditinstitutions,theworseratingwillbeapplied.

Thedeterminationofspecificorgeneralloanlossreservescanbemadebasedonrefer-encemodelsforthecalculationofexpectedlossesappliedtonewandreturningcustom-ers,withup-to-dateorpastdueloans.Thefinancialsupervisorybodyhasthepowertodefineloanlossreservesforexpectedlosseswhenitfindsthatthemicrocreditportfoliodoesnothaveadequatecreditpoliciesandprocedures;informationsystemsorinternalcontrols;or if theclassificationprocessof themicrocreditportfolio isnotreliable.Thesupervisorybodyalsohastheauthoritytoaskforadditionalcapitalrequirementsforun-expectedlossesandlossesresultingfromadversefluctuations,asaresultoftheeconomiccycle.

2.4.7 Interests and fees treatment

Regulationestablishesthat:

i. Amicrocreditstopsgeneratingincomethroughinterestandfeesfromthefirstdaythattheloanoroneofitsinstallmentsbecomespastdue;

ii. Accruedinterestsonrestructuredorrefinancedmicrocreditoperationsareonlyre-cordedatthetimeofcashcollection;and

iii. Thefeesareproratedandaccruedduringthetermoftheloan.


2.4.8 Microcredit write-off

Regulationestablishesanumberofdaysafterwhich financial institutionsproceedtothewrite-off of past duemicroloans.10Microcredits to bewritten-off are fully provi-sioned for, although itwill notbenecessary that theybeundergoing legal collectionproceedings.Theseloansarereportedtocreditbureauswithwhichthemicrofinanceinstitutionoperates.

2.4.9 Microcredit portfolio

Thelegislationandregulationestablishesthatfinancialinstitutionsmusthavethefollow-ingtooffermicrocredit:

i. Anichetargetmarketresearchsubstantiatingtheirparticipation;

ii. Acreditmethodology,definedasthesetofactivitiesthatshouldbeperformedbyacredit institution toreasonablyresolve typicalproblemsof information, selection,incentives,andcontractcompliancethatariseinmicrocredittransactions;

iii. Amanagementandoperations’teamwithexperienceandcapacityinthissector;

iv. Atechnologicalinfrastructureallowingfordailycontrolandmonitoringofloansandloanofficers;

v. Astatementofhowthemicrocreditactivityisincorporatedintotheinstitution’sin-tegralrisk,governance,reputational,operational,credit,andliquidityrisks’manage-mentpolicies.

2.5 Supervision of microcredit operations

2.5.1 Specialized unit

Microfinance institutionsandmicrocreditportfoliosofdeposit-taking financial institu-tionsaresupervisedbyaspecializedunitofthefinancialsupervisorybody.Thesupervi-sorybodyhasatleastoneteamabletoevaluatetheadequacyofthespecificcreditmeth-odologyusedbyfinancialinstitutionsthatoperateinmicrocredit.Thesupervisorybodyhastheauthoritytoestablishadjustmentsandcorrectionsdeemednecessaryforfinan-cialinstitutionstoproperlyoperateinthemicrocreditmarket.Thesupervisorybodyhassufficientknowledgeandexperienceinthemicrocreditbusinesstobeabletoeffectivelyevaluatean institution’s integral risk, governance, reputational,operational, creditandliquidityrisks’managementpolicies.

10 Tocalculatetheeffectivearrearsuniformlyinallinstitutionsandthecomparisonbetweenthem,considerthattwoinstitutionshaveamicrocreditportfolioof105,ofwhich5areinarrears.Loanlossreservesamountingto4,ofwhich2correspondtotheportfolioinarrearsover360days,hence100%provisioned.EntityAwrites-offloansthatare360daysinarrears,recordinginitsbooksaportfolioof103witha3%inarrearsandprovisioncoverageof67%.EntityBthathasnosuchwrite-offpolicyshowsaportfolioof105witharrearsof5%andprovisioncoverageof80%.


2.5.2 Preventing over indebtedness

The financial supervisory body has procedures to permanently analyze, evaluate, andmonitorthetotaldebtandpaymentstatusoftheborrowersofmicrofinanceinstitutionstopreventoverindebtedness.

2.5.3 Off-site procedures for microcredit portfolio supervision

Inexercisingitsoff-sitesupervisoryduties,thefinancialsupervisorybodyperformsatleastthefollowingactionswithrelationtothefinancialinstitutions’microcreditportfolios:

i. Establishesandappliesspecificwarningsignals;

ii. Analyzeskeyindicatorsofportfoliomanagement;

iii. Conductsongoingmonitoringofthepastdueaccountsineachinstitutionandinthefinancialsystemasawhole;

iv. Analyzestheindividuals’exposurepermicrocreditandothertypesofcredittopre-ventexcessiveindebtedness;

v. Performsanalysistodetectanyunderestimationofthemicrocreditportfolio´srisklevel(forexample,derivedfrominadequatereportingofrestructuredorrefinancedloansand/ornumberofdaysinarrears);

vi. Publishesanddisseminatesinformationthatpromotescompetitioninthemicrofi-nancemarket;and

vii. Plansvisitsasafunctionofperceivedrisks.

2.5.4 On-site procedures for microcredit portfolio supervision

Exercisingitsdutiesofon-sitesupervision,thefinancialsupervisorybodyundertakes,at minimum, the following actions in relation to financial institutions’ microcreditportfolios:

i. Evaluatestheappropriatenessoftheclassificationofthemicrocreditportfolio;

ii. Evaluatesthesoundnessandcompliancewiththepoliciesandregulationsoncorpo-rategovernance,operations,andriskmanagement;

iii. Verifiesthecorrectcalculationandgenerationofreportsonthedailystatusofloansinarrears,throughtheapplicationofcomputer-assistedauditingtechniquesonthedatabase;

iv. Verifies the reporting of rescheduled/refinanced loans through the application ofcomputer-assistedauditingtechniquesonthedatabase;


v. Reviews, through sampling, the appropriate monitoring of non-performing loanscarriedoutbythesupervisedinstitution’sstaff,inaccordancewithpoliciesandpro-ceduresestablishedbytheinstitution;

vi. Verifies,throughsampling,thatthesupportingdocumentationcomplieswithmicro-creditpoliciesandproceduresestablishedbytheinstitution;

vii. Verifies the correct calculationof loan lossprovisionsand thenon registrationofinterestincomeandfeesofpastdueloans;and

viii. Throughsamplingselectsagroupofmicroborrowerstobevisited.11

11 Oneofthemainrisksofmicrocreditislinkedtothe“creation”ofdebtorsbytheloanofficer.

Bibliography

Carmichael,JeffreyandPomerleano,Michael.The Development and Regulation of Non-Bank Financial Institutions.TheWorldBank,2002.

CGAP. AML/CFT: Strengthening Financial Inclusion and Integrity. September 10, 2009.http://www.cgap.org/p/site/c/template.rc/1.26.11505.

CGAP.Financial Access 2009: Measuring Access to Financial Services Around the World.WashingtonD.C.,2009.

CGAP.Regulation and Supervision of Microfinance.DonorBriefNo.12.May2003.

Claessens,Stijn;Honohan,PatrickandRojas-Suarez,Liliana.Policy Principles for Expanding Financial Access. ReportoftheCGDTaskForceonAccesstoFinancialServices,CenterforGlobalDevelopment.WashingtonD.C.,2009.

Comité de SupervisiónBancaria deBasilea.Convergencia Internacional de Medidas y Normas de Capital – Marco Revisado.June2004.

ComitédeSupervisiónBancariadeBasilea.Implementación de Basilea II: Consideraciones Prácticas. Julio2004.

Cull, Robert; Demirgüç-Kunt, Asli and Morduch, Jonathan. Does Regulatory Supervision Curtail Microfinance Profitability and Outreach?PolicyResearchWorkingPaperNo.4748,TheWorldBankDevelopmentResearchGroup,FinanceandPrivateSectorTeam.June2009.

Ledgerwood, Joanna;White,Victoria andBrand,Monica.Transforming Microfinance Institutions: Providing Full Financial Services to the Poor.WorldBankPublications.WashingtonD.C.,2006.

Peck,Robert;Lyman,TimothyR.andRosenberg,Richard. Microfinance Consensus Guidelines: Guiding Principles on Regulation and Supervision of Microfinance.CGAP.WashingtonD.C.,2003.

Peck,Robert andRosenberg,Richard. The Rush to Regulate: Legal Frameworks for Microfinance. CGAP.WashingtonD.C.,2000.

Rhyne,Elizabeth;Lieberman,Ira;Busch,Brian;andDolan,Stephanie,Aligning Interests: Addressing Management and Stakeholder Incentives During Microfinance Institution Transformations.MultilateralInvestmentFund,Inter-AmericanDevelopmentBank.WashingtonD.C.,2009.

Project Team

Working Group

PresidentLuisArmandoMontenegroSuperintendent of Financial System of El Salvador

Members: IvetteEspinozaSuperintendence of Banks and Financial Institutions of Bolivia

FabianoCostaCoelhoCentral Bank of Brazil

AmandaBolivarFinancial Superintendence of Colombia

GaloCevallosFederal Deposit Insurance Corporation, USA

FranciscoMierSainzTrapagaNational Commission of Banks and Securities of Mexico

JuanArmandoOlivaresLopezSuperintendence of Banking, Insurance and AFP of Peru

IDB Respresentative: SergioNavajasSenior Specialist of the Multilateral Investment Fund, member of the IDB Group

Technical SecretaryRudyAraujoSecretary General of ASBA

Consultants:International Consulting Consortium: RamónRosales,Principal Consultant MiguelBarba, Legal AdvisorLuisEcharte,ConsultantSocorroHeysen, Consultant

EA Consultants: BarbaraMagnoni,Consultant and Team LeaderOscarBasso,Specialist Consultant

ABOUT THE MULTILATERAL INVESTMENT FUND

The Multilateral Investment Fund (MIF) is the largest provider of technicalassistance to the private sector in Latin America and the Caribbean. As amember of the IDB Group, the MIF’s overall focus is providing low-income

households, and micro and small enterprises with access to financialservices, basic services, and markets and capabilities. For more

information, visit www.iadb.org/mif.

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