Policy Analysis Paper on Draft Proposals for Regulating MFI in Sri Lanka S.P.

Premaratne The objective of this article is to evaluate the proposed Micro Finance Institution legislation drafted by the Central Bank of Sri Lanka (CBSL) recently. The article identifies key issues and potential outcomes of the draft proposal for legislation for micro finance institutions (MFIs) focusing on how the proposed regulatory framework affects MFIs and their clients. This paper focuses on the possible guidelines that could animate a debate about the opportunity to regulate MF as well as how to perform such regulation, in order to foster the expansion and the sustainability of the MF approach to poverty. Information for this study was gathered from published documents and papers, and discussions with practitioners and expertise in the field of MF and micro and small enterprise (MSE) sectors. Broadly, all MFIs can be classified into three categories based on their main sources of funding. They are (A) all MFIs which depend on other peoples money to finance their lending activities, (B) formal MFIs which use members money to grant loans exclusively to members, and (C) MFIs that use the general publics money to finance their lending business. As the MF industry grows, MFIs begin mobilizing substantial savings, and the sustainability of MF programs receives a great deal of attention. As a consequence, the complexity in managing MFIs has increased too. Since at present MFIs begin to offer a range of and a more complex set of services and the sustainability becomes an important variable also for donors, a need for some kind of regulations for MFIs is arising. In Sri Lanka, currently, there is wide range of institutions that are involved in providing MF services. These institutions vary largely in terms of their sources of funding, clientele, coverage, legal, and organizational structure, key stakeholders, main activities and financial services provided to individuals/households. Apart from these institutions, as in many other countries, there are also moneylenders. Institutions that engaged in MF activities have been registered under different Acts. Therefore, the legal and regulatory environment remains challenging for MFIs in Sri Lanka. The CBSL has drafted proposals for regulating Micro Finance in Sri Lanka with the purpose to provide for the licensing, regulation, and supervision of institutions that carry on MF business and connected matters. According to the draft proposals, only institutions licensed by the CBSL will be permitted to carry on MF businesses. These proposals will directly affect positively and negatively on MFIs, on MSEs, and on the grass roots community particularly the poor. Special Aspect of Regulating MFIs: The creation of a new type of financial institution to do MF requires consideration of a whole new set of regulatory issues which includes legal form and purpose, ownership structure, management, minimum capital, internal control, capital adequacy, the credit methodology, risk profiles, product characteristics, permitted operation, distribution of dividends, geographic scope and hours of operation, non-commercial credit, and investment in fixed assets and other companies. Role of Regulation in MF Development: The role of the regulator in MF development is an open issue. In some countries, the role of the regulator is to integrate MF into the overall financial structure. A strict regulatory framework would contribute to make the MF safer, but at the same time, it would make it too complex for small MFIs to operate in accordance with regulation. Obviously, the next and final effect could be a reduction in MF supply. It could have a negative impact on poverty alleviation since MF is usually used as poverty alleviation strategy. Further, a strict regulatory framework usually limits the capability to innovate. Reasons for Introducing the Proposed Bill: It is generally accepted that financial institutions should be subject to prudential regulation and supervision for two main reasons: namely (1) to protect depositors, and (2) to ensure that the financial system as a whole does not become unstable through a loss of confidence as a result of major financial institutions becoming insolvent. In Sri Lanka, like in many other countries, approaches to the regulation of MFIs are complicated by the fact that many institutions are involved in providing MF services under different legal structures. Therefore, unlike the formal financial system (commercial banks), which as a

whole is far more organized, and well regu lated, the MF sub-sector remains rather disorganized and scattered around with insufficient harmonization and uniformity. Formal MF providers in the country are governed by different Acts/legislation. Meanwhile, the informal sector is not governed by any regulation at all. Meanwhile, the existing legal and regulatory framework fails to enforce laws against MF-NGOs mobilizing savings deposits and offers no clear legal path for those institutions to transform into formal financial institutions subject to prudent supervision. The cooperatives are not adequately regulated and supervised. The lack of a sound legal and regulatory framework for MF-NGOs and cooperatives places clients savings at risk and thus threatens the reputation of the entire MF industry. Many in favor of establishing new regulations argue that without an appropriate regulatory and supervisory framework, it is hard to see how these institutions can expect to continue their rapid growth while providing the safety and stability expected by depos itors and the general public. But it is still a question mark, whether the sector in Sri Lanka needs such regulations and supervisions provided by the CBSL. Reasonable questions are: whether MFIs in Sri Lanka maintain non-member deposits; whether this sector plays a crucial role in the entire financial sector in the economy; and whether such regulation framework creates a negative impact on poverty alleviation. ANALYSIS OF THE PROPOSAL FOR LEGISLATION MFIS IN SRI LANKA Achievements of Objectives: A number of reasons were given for regulating and supervising the sector. The ultimate purpose is to maintain the appropriate and soundness of the financial system in the economy. The second objective is to protect depositors. Some also identify a third objective of the regulation, that is competitiveness in the financial sector. Fourthly, Sri Lankan authorities believe that regulation is needed to ensure that donor funds are used efficiently and effectively for the purpose for which they are intended. Fifthly, regulation will improve the integrity and credibility of MFIs operating in the sector. Sixthly, regulation is necessary to promote the industry. Lastly, regulation would reduce the amount of ambiguity that exists in the current MF environment. In addition to the above, other stakeholders and expertise consulted felt that the MF sector should be regulated to facilitate the mainstreaming of MF, the collection of information and the monitoring of development in the sector. With regard to the first objective of maintaining financial stability, the MF sector in Sri Lanka is miniscule as a proportion of the financial sector which is dominated by the banking sector. The failure of even the largest MFI would not have any impact on the financial sector. Therefore, having this as an objective for regulating the MF sector is questionable. The second objective is that of safeguarding depositors savings. The MF regulators proposed to establish and maintain a Deposit Protection Fund for the purpose of securing deposits. However, the existing MFIs in Sri Lanka hardly accept non-members savings. It is also not sure whether a significant amount of non-members will save in the MFIs since the country has a good formal banking sector. The third objective is to maintain competit ion among MFIs. Economists argue that free-market creates competition. Moreover, there are a number of strategies that can be used for this purposes rather than only regulating the industry. The fourth objective is that of investor protection. With respect to ensuring that public resources and donor funds are used effectively and for the purpose for which they were intended, this issue is not directly addressed by the MF regulations and, therefore, this objective will not be met. The fifth objective is that regulation will improve the integrity and credibility of MFIs. As MFIs will have to obtain a license, entrants will be vetted. This will make it more difficult for unscrupulous individuals to own and manage MFIs, reducing the probability of criminal and fraudulent activity. Thus it is likely that the integrity and credibility of MFIs will be improved. The sixth objective relates to regulation setting minimum performance standards and reporting requirements. The proposed MFI Bill does not specifically address this. Regarding the promotion of the industry and encouraging growth, this objective is not likely to be met. If anything, in light of the comments made by the stakeholders and expertise that the MF regulations are too restrictive, it may be concluded that regulation would serve to impede donor flows and more likely to restrain the MF sector than to encourage its growth. This is in complete contrast to the views expressed by the officials who believe that regulation is needed to promote the industry and encourage growth, thus increasing access to financial services by the majority of the population which is not banked. Some felt that it is premature to have MF specific regulations at this stage of the industrys development and that a simple registration procedure to facilitate data collection and monitoring of developments would

suffice. Overall, the analysis suggests that the MF regulations would have very limited impact in meeting the stated objectives. Costs and Benefits: A good MF regulation framework needs to balance both costs and benefits of regulation and supervision. The cost of supervision depends on several factors. It is more expensive in the case of a delegated supervision than if performed directly by the supervisory authority. The cost also depends upon the nature of the supervision procedure. For example, on-site inspections will cost more than off-site inspections. The best way is to compare the cost of supervising MFIs to the cost of supervising the commercial banks. The experiences in some countries indicate that the cost of supervising MFIs is about 30 times as expensive as the cost of supervising of commercial banks. Costs of regulation to MFIs, considering the size of MFIs operating in the sector, will be significant. Firstly, according to the draft proposal for legislation, MFIs would have to pay an annual supervision fee. The annual inspections by the CBSL will increase the costs to MFIs, in terms of both time and resources, associated with preparing for the inspection, assisting inspectors during the inspection and the disruption caused to the business as a result. Secondly, there are the costs associated with obtaining the license and the annual license fee. In addition to these costs, MFIs will incur the costs of converting into a limited company and having an annual audit; institutions with MF units will incur the costs of registering these units as separate legal entities, and MFIs will have to pay a fee for every new branch opened. Thirdly, there are the costs, in terms of time , effort and resources, associated with meeting the reporting requirements of publication and prudential reports. These will be substantial, especially for smaller MFIs and those located in rural areas which may have to upgrade and improve their management information systems. Lastly, there is the opportunity cost of having to hold liquid non-interest earning assets in order to comply with the liquid assets ratio. Since the draft legislation proposes to recover the supervising expenses from licensed MFIs, ultimately, it will increase the costs of credit. Then it would obviously be charged to the borrower. This would hardly be appreciated in a country like Sri Lanka where the MF industry is used as a poverty alleviation strategy. Though it is costly, a good supervision benefits the MFIs by providing the external controls that help them to become more stable and financially sustainable institutions. Flexibility and Simplicity: Any regulatory framework for MF should be based on simple rules and principles. These basic principles- flexibility and simplicity- are necessary to foster a continued and balanced growth of MF. It requires flexibility in terms of interest rates, collateral and internal lending processes. It requires simplicity in terms of client documentation, loan procedures, portfolio classification, loan loss provisioning and loan write-offs. A regime of prudential supervision for MF in Sri Lanka would only bear fruit if an enabling environment is in place in accordance with market principles. Some of the regulations in the proposed legislation are against these basic principles. These include maximum rates of interest payable on depositors, maximum rates of interest that may be charged for loans, the nature and amount of the security required for granting loans. The terms and conditions under which investments may be made by the MFIs are also not market friendly. The maximum rate of interest rate or interest rate ceilings placed on the loans made by MFIs may also alter the sustainability of these institutions. If the MFI can not cover these costs within the interest rate ceiling, an alternative for them is to drop their MF clients. The authority, the CBSL, responsible for MFI supervision has limited capacity in supervising the MF sector. The CBSL is already overburdened just by the task of overseeing and regulating the formal banks that currently exist. Impact on Poor Clients and thereby Poverty Reduction: Regulation of MFIs is important as it ensures financial soundness of the institutions and helps to build the confidence of donors, funders, members, and the depositors. At present, there are no significant barriers to entry into the MF industry in Sri Lanka. The minimum capital

requirement to establish a licensed MFI is still too high. Thereby the poor clients will face problems in finding finance. MFIs are usually grant-driven, project oriented, and unsustainable beyond the life of the projects that support them. Likewise, heavy reliance on donor grants encourages providing subsidized loans, discourages savings mobilization, or obstructs the formation of desired values of thrift, self-reliance, and responsible borrowing among the target clientele. This will enable the MFIs to serve the poor more effectively to reduce their poverty. But the strict regulations imposed on MFIs will lead to more problems in becoming sustainable. Promoting the Growth of the MF sector through Regulations: The growth of the MF industry is hindered by the absence of an enabling regulatory framework and legislation for MFIs. Since a coordinated and institutionalized MF is in its developing stage, the policy guidelines provided are useful considerations for the development and sustainability of the financial services given the fact that regulations should be set up with the consultation of the practitioners and experts in the industry. MFIs can be discouraged by the competition coming from private commercial banks, government directed MF schemes, and other regulated financial intermediaries and thereby the contribution from the MFIs into the MF sector can be adversely affected. Savings is a major component of MF and is an important source of funds to many MFIs. Savings can also be used as collateral for loans taken by members. But as mentioned earlier, as per the existing regulatory framework NGOs are not permitted to mobilize savings. These kinds of regulations would not promote the growth of the MF sector because it will discourage the NGOs. CONCLUSION AND RECOMMENDATIONS The purpose of this article is to analyze the draft proposal for regulating MF in Sri Lanka. Regulatory and supervisory authorities try to achieve several objectives by imposing various restrictions on risk exposure and accounting and reporting practices. It is not clear whether the authority in Sri Lanka can achieve these objectives by implementing the draft proposals for MFI legislation. MF sector in Sri Lanka is insufficient to threaten the security of the national financial system. Moreover, there is no saving from the general public or non-members. Typical non-depository MFIs do not pose a significant risk to the financial system, and, therefore, do not require prudential regulation. The regulation would create unnecessary burdens to those MFIs. Nevertheless, MF as an industry can never reach its full potential until the industry is regulated. Among others, four peculiar aspects- contribution to systemic risk, typology of activity, origin of funds, and nature of MFIs arise as more significant in order to select the regulatory framework. The creation of prudential regulation would reduce market distortions, promote entry into the industry, promote savings mobilization, and finally improve the performance of MFIs. Furthermore, on-site and off-site supervision, and the external audit requirement would improve transparency and accountability. In spite of the above positive notes, the prudential regulation would limit the scope of services of MFIs and fail to address the financial needs of the poor and low -income people including MSEs. Institutions that engaged in MF activities in Sri Lanka have been registered under different Acts. Many of the legal systems permit a variety of institutional types to engage in micro-lending and to provide other MF services. The common types of regulations would create certain problems due to different MFI types, namely credit-only MFIs, member-owned and member-governed organizations, NGO -MFIs, government-funded MFIs. The lowering of the capital requirement should have a positive impact on the MF sector in that more organizations will be able to satisfy the lower capital requirement and possibly a higher number of MFIs will enter the market than would be the case otherwise. The proposed legislation has proposed reasonably low minimum capital requirements, which is a g ood sign. It also varies with the business coverage of the MFIs. Some of the unique features of MFIs are their decentralized structure and the close relationship between clients and loan officers. Therefore, proposed restrictions on opening new branches would definitely have a negative

impact on the clients and the industry. A number of micro and small MFIs would have to cease operating, as they will not be able to meet the licensing requirements if they are strictly enforced. The costs with regard to meeting reporting requirements, facilitating inspections, and governance are quite significant, especially for smaller or rural MFIs which may have to incur additional costs of upgrading their management information system. This will negatively affect the MF sector. The draft proposal for regulating MFIs proposes to recover the supervising costs from MFIs. Increased administrative or supervising costs will have to be passed on to clients in one form or another. Though it is costly, a good supervision benefits the MFIs by providing the external controls that help them to become more stable and financially sustainable institutions. Rather than promoting the growth of the MF sector and increasing access to financial services for MSEs and finally for low income households as intended, the results of the analysis indicate that the passing of the MF regulations is more likely to have the opposite effect. The impact of a legislative framework in terms of regulatory burden on the sustainability of development MFIs and the poverty alleviation, in particular outreach to the poor, requires careful thought. Key Recommendations In order to reach its full potential and to integrate with the financial system of the country, the MF industry must eventually be able to enter the arena of licensed, prudentially supervised financial intermediation, and a regulatory framework must eventually be designed. MFIs must be regulated if they mobilize savings from the public or from non-members. Even membersonly savings mobilization MFIs should be also regulated, if they exceed a certain size. However, the design of a regulatory framework for MFIs should understand the special features of the MF industry and on the nature of the activities that are performed by MFIs. For example, as far as NGOs operate as credit-only institutions, they need a very limited attention from regulations. Smaller MFIs, particularly MFIs in the informal sector must not be forced to submit to regulation. It will be danger for the poverty alleviation efforts. Examining the risk profile of MFIs can help to identify necessary adjustments to regulatory guidelines and supervisory methods. Designers of regulation for MF also need to pay much more attention on costs and benefits of supervision. In the case of small MFIs, the costs of supervising far exceed the benefits. Since small MFIs represent only a small percentage of the total deposits of the financial system, and their depositors are often only their members, it may seem unrealistic for the bank supervisor to supervise smaller MFIs. The regulatory framework should allow the existing formal financial institutions to offer MF services. Loan documentation and reporting requirements need to be flexible and simple for MFIs. When introducing interest rate regulation, t e authority should keep in mind both the development of h sustainable MFIs as well as outreach to the poor. Proposed restrictions on operating outside the operative area, and opening and closing down branch offices should be carefully evaluated before implementing the draft Bill. The appointing the Agent of the Director for the supervision of MFIs should be carefully analyzed since it would be politicized the sector. Regulatory framework should allow foreign ownership or maximum shareholder percentages since most of the MF investment come from transforming NGOs. Supervisory staff will need to be trained in order to deal effectively with MFIs since supervision of MF is different from the supervision of commercial banks. Standard accountancy and audit techniques may not be suitable for bookkeeping and auditing MFIs. Since the CBSL responsible for MFI supervision has limited capacity in supervising the MF sector, in the short-term, it may be more practical for reform to focus on removing the barriers currently impeding the growth and development of the MFIs that already exist, rather than on creating a new department in the CBSL. Capacity-building of supervisory authorities is essential.