Austin Harris, KF11 Rwanda
Blue Financial Services is a Microfinance Institute (MFI) that began in 2001 and gained extensive coverage in Africa operating in 13 countries. The MFI champions itself as providing ethical microfinance to underbanked people of Africa. In 2007, Blue Financial Services Rwanda, a subsidiary of South Africa’s Blue Financial Services, was licensed as an MFI and started providing financial services, including salary advances, personal loans, home improvement loans, education loans, and debt consolidation. In June 2010, only three years after its launch, Blue Financial Services Rwanda lost its operating license due to unethical practices. After reporting a loss for each year of operations, this MFI was discovered to be misreporting income and repatriating a sizeable amount of money abroad.
This is not the first case of fraud in Rwanda. In June 2006, Rwandan Prosecutor General, Martin Ngoga, announced that fifteen former microfinance institution managers had been arrested for defrauding depositor money. The government shut down eight microfinance institutions and distributed USD $5.5 million to compensate clients up to half of their deposits.
As in other developing countries, Rwanda has developed regulations for the microfinance industry to prevent fraud and ensure ethical practices. Regulation of the microfinance industry is commonly believed to be both crucial and necessary to protect consumers and stabilize financial markets. The detection of recent fraud in Rwanda may not have been possible without it. Microfinance regulation, however, is not simple process. The microfinance industry encompasses a wide array of institutes that provide a variety of services to many different customers. Though regulation is beneficial to customers and markets, it does come with its own costs. There is a balancing act between protecting customers and securing markets, and increasing the cost of borrowing and impeding microfinance services to the poor.
Types of Regulation
Financial institutions are generally subject to prudential and non-prudential regulation. Prudential regulation ensures the financial soundness of the industry. This regulation provides the appropriate legal framework for financial operations to help prevent and reduce financial sector instability.
A financial authority directly sanctions microfinance institutes and assumes the responsibility for the soundness of regulated institutions. Non-prudential regulation, on the other hand, encompasses regulations about the institution’s business operations. A financial authority does not sanction the business, but offers guidelines and invokes standards that do not involve the implicit guarantee of the financial authority. Examples of non-prudential regulation could include truth in lending laws, fraud and financial crimes prevention, interest rate policies, among others. These rules serve to protect the consumer. The type and level of regulation depends on how the microfinance institute is formed and what services it provides.
Benefits of Regulation
The advantages of regulation in the microfinance industry for the customer and financial markets are numerous. Regulation serves to ensure the financial soundness of an MFI, reducing the chance of failure and reinforcing the public’s trust in these financial institutions. Regulations in the form of capital adequacy requirements, reserve requirements, loan loss provisions, and loan documentation are all examples of measures to ensure an MFI will be able to maintain its operations. Regulations also serve to protect borrowers by preventing profit maximization at the client’s expense. MFI’s can often have considerable local market power which can result in monopolistic lending practices. These practices can result in usurious interest rates and expensive fees. For MFI’s that take deposits, regulation helps to prevent a loss of client savings from failure of the MFI. For the poor, these savings can be vital to deal with economic uncertainties and their loss can have grave effects. In addition, regulation and supervision may promote the development of the microfinance industry, attracting greater borrowing and more deposits from the public.
Microfinance, in All Shapes and Sizes
Regulation of the microfinance industry has its many benefits, though it can be an involved process due to the variety of MFI’s. Very generally, microfinance institutes can be divided into non-bank and bank MFI’s. Within these two divisions, however, are numerous types, including cooperative societies, commercial banks (both state-owned and private) and development banks, Non-governmental Organizations (NGOs) and International NGOs (INGOs). The many types of MFI’s also differ in the nature of their business and the services they provide. Given the breadth of this industry, there is often no single body to regulate and supervise the operations of all MFI’s. The regulatory requirements and standards for each of these regulatory bodies are different, complicating the regulatory framework.
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Costs of Regulation
Regulation has many obvious advantages, however it can come at a price. The breadth and diversity of the microfinance industry can lead to difficulties and great expenses in order to administer and monitor all of the MFI’s. Also, establishing regulatory rules intended to service microfinance customers and markets, can potentially harm MFI’s and their customers as well.
Cost of supervision
Regulatory authorities will need to supervise a growing number of MFI’s in a country. Given the variety of MFI types and the different regulatory requirements and standards for each, supervision can often be costly. These costs are partly passed on to MFI’s in the form of licensing fees, making it more expensive for the MFI to operate. The microfinance industry already endures high operating expenses in relationship to its loan portfolio size, and these additional costs add greater difficulty to maintaining operations.
MFI’s are often small, numerous, located in remote regions, and have poor record keeping. The administration and reporting requirements for the MFI can involve high levels of supervision and can be burdensome and expensive. This added work and expense will partly be borne by the clients in the form of higher interest rates and fees. In addition, higher costs may slow the growth of financial services offered to disadvantaged groups. Ultimately borrowing will become more expensive and more limited for the already poor clients.
Control of interest rates
Regulatory institutions can impose interest rate caps. MFI’s naturally bear high costs as they provide small loans in remote areas. Often higher interest rates are charged to compensate the MFI for the added expenses in servicing its clientele. Limiting interest rates can prevent usurious lending, however it can also limit the customer base and the geographical scope for the MFI. Higher interest rates may be the only way MFI can operate in a sustainable manner. Limiting interest rates may adversely affect the very poor and those who live in remote places by discouraging microfinance services in these areas and for those people.
Capital requirements
A minimum capital requirement can limit entrance into the industry. Capital requirements might also restrict future operations in terms of cost and outreach. These requirements can limit the start-up of a new MFI to service clients and can limit existing MFI’s in terms of how widely they can operate. These limitations can reduce the reach of MFI’s and may reduce the competition in the industry, preventing potential borrowers from receiving financial services or making financial services more expensive.
A Balancing Act
If an MFI is authorized to operate, its operations should be subject to some pragmatic limits. Many MFI’s are entering the industry and rules and supervision are necessary to ensure their clients are protected and financial markets are stabilized. The recent cases of fraud in Rwanda highlight the need for regulation. However, regulation has its drawbacks for the industry and clientele. Regulation increases costs, limits operations, and reduces the feasible scope for MFI’s. The added costs and limitations can result in increased interest rates, higher fees, reduced competition, and limited services. These results serve to make financial services more expensive or unavailable to the poor. Though regulation is often advantageous for customers and markets, it is necessary to question its negative side effects.
Austin Harris is a Kiva Fellow working with Urwego Opportunity Bank in Rwanda and a member of Friends of Urwego Opportunity Bank lending team.
