Lesson 1.

4:
Effects of the Local Environment

In this Lesson
Successful MFIs operate in a variety of different economic, social, legal and
policy environments. Many factors present in the local environment affect an
MFI’s operating choices, methodology and strategy. The factors include, among
others, the regulatory environment, the level of inflation, the rule of law and
attitudes towards sustainable interest rates. Enabling environments vary, and the
rush to regulate MFIs before sufficient market experience has been accumulated
often can be more harmful than beneficial in stimulating the growth of
microfinance.

In Depth
Financial policy and financial deepening

Financial deepening refers to the growth and outreach of the financial system. It measures the pace at which financial assets
grow compared to growth in national income. In countries where domestic and foreign savings are scarce, sustained income
growth requires financial deepening. Only when policies exist that encourage the channeling of savings to potential investors
can economic opportunities be seized. Shallow financial policies, such as those that restrict access to credit, impose prohibitive
legal restrictions on financial intermediaries or lead to negative real interest rates (where inflation outpaces nominal interest
rates) and undermine financial intermediation. When there is no effective financial intermediation in an economy, economic
growth potential can be severely restricted.

Why regulate deposits

Governments around the world find the need to regulate institutions that mobilize deposits from the public. The concern over
deposits stems from two particular problems of financial intermediation: liquidity risk and information problems. Information
problems were discussed in the previous section of this workbook. Institutions that mobilize savings from the public, including
some MFIs, must be able to return these deposits to clients when called upon. When lending to borrowers, MFIs have several
possible sources of funds, including their own equity base, liabilities from a bank or other institution, or deposits from savers.
Should an MFI experience a significant repayment problem, it essentially loses its source of funds, and risks not having
enough liquidity to cover savers’ deposits. This harms individual savers. Combined with an information problem, when current
clients do not know if the MFI is a safe place to keep their money, this lack of confidence can lead to a “run on the institution”,
where savers withdraw deposits all at once. When confidence is undermined in one institution, it easily spreads to others and
can often lead to a more general breakdown of the payment system in the country.

Rating agencies

Donors, investors, other stakeholders and the MFIs themselves are increasingly turning to specialized microfinance rating
agencies for standard, transparent evaluations of MFI operations and financial performance. Given the lack of experienced
audit firms in the industry, rating agencies often perform audit functions following financial disclosure guidelines. Rating
agencies sample and verify the financial systems and statements that MFIs produce. Ratings provide opinions on the
investment quality of an MFI, rating it according to its general risk profile. More than project evaluations or institutional
assessments, ratings put the central focus on risk, and particularly the risk inherent in portfolio management. The creation of
reliable rating techniques for MFIs will prove an important development, not only for potential investors, but also for
regulatory and supervisory bodies.

Prudential and non-prudential regulation

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 In the push to regulate financial institutions for the safekeeping of the financial system, we must draw a distinction between
prudential and non-prudential regulation. Prudential regulation directly implicates the financial authority in sanctioning and
assuming the responsibility for the soundness of regulated institutions. Prudential regulation, as such, requires detailed
standards for financial structure and accounting policy, with monitoring and enforcement mechanisms by the financial
authority should these standards be breached by the financial institution. This is a substantial burden on the central financial
authority of a country and requires the physical capacity and level of expertise to regulate all licensed institutions throughout
the country. Non-prudential regulation, on the other hand does not imply the sanction of the financial authority. Rather,
non-prudential regulation 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, or reporting of borrowers to a credit
information bureau, among others.

Access to capital and interest rate caps

In an open credit market with perfect information, interest rates will settle at a price that satisfies both the needs of the
suppliers of funds and those who require access to them. Interest rate caps install an artificial price ceiling and limit the amount
of total loanable funds available. In countries with a shallow financial system, people with the least prior access to funds and
those who are in the least advantageous position to demand favors, suffer first from this shrinkage in the credit market. Interest
rate ceilings effectively lower the poor’s access to credit.

Current Discussions
Microfinance institutions operate within a country’s legal and regulatory framework. The timing, the form and the extent of
that framework, however, have generated debate among many analysts.

What type of regulatory environment best fits a country?

Who should regulate?
What regulations will allow MFIs to grow while protecting customers

Some advocate centralizing regulation of the financial system in government agencies and authorities. The government, they
contend, has responsibility for ensuring the soundness of and confidence in the financial system. As operations of
deposit-taking institutions can directly affect financial stability in the country, the government has an interest in monitoring
deposit-taking MFIs and ensuring that they meet a series of prudential norms. Through special microfinance windows in the
central bank or financial regulatory authority, the government brings microfinance institutions that mobilize public deposits
under the same system as other financial intermediaries mobilizing funds from the public.

Others advise that centrally controlled oversight is too cumbersome for effective microfinance operations. Indeed, several
analysts suggest that a single government oversight approach to all MFIs mobilizing deposits would force many MFIs out of
savings operations, leaving a currently underserved market without access to an important financial service. Rather, some
advocate a tiered approach to regulation, whereby more central banking regulatory compliance is required only as an
institution directly intermediates public savings into loans. Instead, independent bodies, such as credit union rating agencies or
market-driven deposit insurance schemes would put the information on deposit risk in the hands of the poor savers, allowing
them to choose how and where to save. There is, however, general agreement that the market should shape the regulations,
rather than the regulations shaping the market.

Recommended Reading
CGAP. “The Rush to Regulate: Legal Frameworks for Microfinance,” Occasional Paper No. 4, April 2000.

Additional Reading
Regulation of the financial sector

Cuevas, Carlos E. “Enabling Environment and Microfinance Institutions: Lessons from

Latin America,” Journal of International Development, 8:2 (1996), pp. 195-210.

Fry, Maxwell J. Money, Interest, and Banking in Economic Development. Baltimore and London, 1991, pp. 353-372, 428-430.

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 Hubbard, R. Glenn. Money, the Fiancial System and the Economy. Reading, MA: Addison- Wesley, 2000, pp. 51-54, and
351-377.

Regulation of MFIs

Hannig, Alfred and E. Katimbo-Mugwanya, Eds. “How to Regulate and Supervise Microfinance? Key Issues in an
International Perspective,” Bank of Uganda – German Technical Co-operation Financial System Development Project.

Wright, Graham. “Principles and Practices: Myths of Regulation and Supervision,” MicroSave – Africa, 12 January 2000. (*)

Financial sector policy

Mishkin, Frederic S. The Economics of Money, Banking and Financial Markets. Reading, MA, 1998, Chapters 1 and 2.

Gillis, Malcolm et al. Economics of Development. New York: W.W. Norton and Co., 1996, Chapter 14.

Macroeconimic stability

Fry, Maxwell J. Money, Interest, and Banking in Economic Development. Baltimore and London, 1991, pp. 375-392.

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