guidelines of principles for effective
DESCRIPTION
Guia de principiosTRANSCRIPT
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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.
12 ¶ GUIDELINES OF PRINCIPLES FOR EFFECTIVE REGULATION AND SUPERVISION OF MICROFINANCE OPERATIONS
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:
INTERNATIONAL BANK SUPERVISION STANDARDS AND MICROFINANCE INSTITUTIONS ¶ 13
- 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.
14 ¶ GUIDELINES OF PRINCIPLES FOR EFFECTIVE REGULATION AND SUPERVISION OF MICROFINANCE OPERATIONS
- 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.
INTERNATIONAL BANK SUPERVISION STANDARDS AND MICROFINANCE INSTITUTIONS ¶ 15
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-
16 ¶ GUIDELINES OF PRINCIPLES FOR EFFECTIVE REGULATION AND SUPERVISION OF MICROFINANCE OPERATIONS
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.
INTERNATIONAL BANK SUPERVISION STANDARDS AND MICROFINANCE INSTITUTIONS ¶ 17
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.
18 ¶ GUIDELINES OF PRINCIPLES FOR EFFECTIVE REGULATION AND SUPERVISION OF MICROFINANCE OPERATIONS
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
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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
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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.
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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;
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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.
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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.
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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.
PRINCIPLES FOR EFFECTIVE REGULATION AND SUPERVISION OF MICROFINANCE OPERATIONS ¶ 27
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-
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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.
PRINCIPLES FOR EFFECTIVE REGULATION AND SUPERVISION OF MICROFINANCE OPERATIONS ¶ 29
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.
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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.
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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%.
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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;
PRINCIPLES FOR EFFECTIVE REGULATION AND SUPERVISION OF MICROFINANCE OPERATIONS ¶ 33
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.
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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.