The Microcredit Regulations approved by the Monetary Board of the Dominican Republic in August 2014 were an important step forward for the microfinance industry in the region. The document was drawn up following a broad-ranging consultation with the country’s financial authorities and financial institutions, as well as multilateral organisations and other expert bodies and individuals. It reflects local and international expertise and best practices, synthesising them into a set of regulations well suited to the industry´s objectives.

The regulations clearly define the specifications, limits, requirements and responsibilities relating to microcredit. They also give detailed criteria for the assessment and classification of borrowers’ eligibility and the risk categories and provisions associated to such loans. They also detail the mechanisms for implementing the internal models for managing risk on the microcredit portfolios.

The regulations define a microcredit as credit that is: (i) requested by persons with their own small-scale business or activity producing revenues or invoicing up to RD$6m (US$136k) a year; (ii) intended to fund production, marketing or service activities; and (iii) whose principal source of repayment is the proceeds from the sales and revenues generated by such activities. In order for a loan to be considered a microcredit, it must also meet other specifications: (iv) the term should be 1 year or, exceptionally, 3 years; (v) the instalments should be paid every 30 days or less; and (vi) the borrower’s consolidated debt should not be more than 40 minimum wages.

The regulations of most South-American countries run along similar lines. Practically all of them define microfinance as a way of funding production, marketing or service activities. This is the case in Argentina, Chile, Colombia and Peru. It is also usual to limit the total amount of consolidated debt, although the limits vary. They are set at US$50k in Panama; 120 minimum monthly wages in Colombia (~US$35k) and ARS60k (~US$7k) in Argentina; while in Peru the limits are PEN20k (~US$6.7k) for micro enterprises and PEN300k (~US$100k) for small enterprises. Panama or Peru do not specify any definition of borrowers. In Argentina, the borrower’s total assets are limited to a total of 50 basic baskets; in Chile the borrower must be classified as among the 50% most vulnerable in the total population. And in Colombia, micro enterprises, small enterprises and medium enterprises are defined according to the number of workers: 10, 50 and 200, respectively; and by the value of their total assets: 500m 5k and 30k minimum monthly wages, respectively. (The minimum wage is defined in the prevailing legislation).

It is important to bear in mind that any definition of microcredit has the unenviable task of categorising a heterogeneous, constantly changing sector. A legal definition, or even just a working definition, must somehow manage at the same time to be sufficiently broad and sufficiently restrictive. Broad, so that it will not exclude micro enterprises, and restrictive in order not to include sectors that fall outside the scope of such regulation.

It makes sense for regulators to opt for simplicity, breadth and flexibility. They must recognise that the costs of unnecessary exclusion tend to be greater than the costs of misguided inclusion. Moreover, the costs of compliance and supervision increase in parallel to the complexity of the regulation; and a straitjacket can introduce discontinuities that have real effects on the dynamics of wealth creation among the population that can benefit from microfinance. Obliging the microcredit borrowers to comply with requirements regarding their income, total assets and consolidated debt, and demanding that the credit term, rates and instalments meet specifications, could bring in constraints which, if applied across the board, would establish a complexity that made compliance more difficult and, above all, the job of the banking supervisors extremely arduous.

For example, verifying consolidated debt imposes a burden on the supervisor and on the industry as a whole. They must both coordinate their information on borrowers and manage it in a suitable manner. This will become more difficult, there are delays in disseminating the consolidated information. And apart from debt, on the income side, verifying the revenues of micro enterprises also entails significant extra work for the supervisor, which will have to validate the methodology used to report income in somewhat informal business settings. In order to have a regulation that can be enforced efficiently and transparently, the supervisor must tailor supervision procedures to focus on how suitable the methodologies are, and the capacity of intermediaries to successfully use and control the methodologies required of them.

The challenges of dealing with intermediaries in this context are contemplated in the articles on responsible risk management, microcredit risk management and the credit information system. These establish that entities must manage risks with an infrastructure and control function in keeping with their nature, size, complexity and risk profile. The Regulation makes the board responsible for supervising compliance and the senior management responsible for the application of risk policies. It also requires a specific unit to take responsibility for managing microcredit risk, with well-defined duties and sufficient independence. The banking authority (Superintendencia de Bancos) approves the microcredit risk management model for each entity.

The Dominican regulations correctly emphasise the importance of the borrower’s payment behaviour or track-record as a key element in determining the risk associated to each transaction, and require detailed records in the dossier drawn up for each borrower. However, they include the possibility of using digital or partially digitalised files for this. This helps everyone. The intermediaries’ storage costs and the search times can be significantly lowered. And digitalisation will also enable the supervisor to exercise remote oversight and reduce time spent on site-inspections.

The document allows the roll-over of loans to business units that have met up to 75% of their debt obligations, without having to reclassify to a higher risk, provided there is no impairment in their conduct. What the legislator is trying to avoid is the possibility of letting borrowers with outstanding loans simply repay those loans by taking out new ones. However, this has to be offset with the common practice in micro enterprises of taking out loans on longer terms than they need, as an implicit liquidity insurance. They then often end up repaying the loan ahead of schedule and taking out further loans for new amounts almost at the same time. It is hard to establish the common threshold, because the problem is not fixing a parameter. For the intermediary the problem is one that needs to be dealt with through implementation of admission and monitoring policies. And for the banking supervisor, it is a problem of evaluating the criteria and supervising the admission and monitoring capacities of the intermediary.

Another interesting element is the reclassification of the portfolio. The Dominican regulations establish that when the banking supervisor sees fit to increase the risk ratings for more than 5% of the loan portfolio reviewed in its inspections, the intermediary must set aside additional provisions for deficiencies in their classification of risks according to a table. This can mean up to 2% additional provisions for discrepancies of over 30%. It thus becomes important to identify sources of possible discrepancies in advance. Specifically, because the Regulations classify borrowers by days in arrears and demands one sole classification per customer. They take into account the consolidated debt held by each borrower in the entire system. If the classification is based on days in arrears, then this should be done automatically.

The Dominican regulations consider collateral to be a secondary element in managing microcredits, and it is not taken into account either in the classification of the borrower or in the constitution of provisions. Despite its effect on expected loss, it is reasonable to exclude collateral from the provision calculations as in the micro enterprise sector, when there is collateral, it is nearly always from informal guarantees, and is hard to realise and even harder to set a value on.

The document also forbids the payment of fees up-front and compensatory balances. The borrower can redeem the loan early without any penalties, and the financial institutions may not establish any condition that forces the borrower to deposit part of the microcredit in a specific account within the lender’s bank. The Regulations are clearly trying to protect borrowers from predatory practices. But at the same time, they make it impossible to develop financial-inclusion products that use balances in savings accounts associated to the microcredit as a form of education in the use of savings products. These type of products would have to be re-defined in order to comply.

The Dominican regulations are an important step forward in laying down the right kind of banking standards. They reflect best regulatory practices and experience gathered from other jurisdictions, while at the same time taking advantage of the definitions and expertise made available to them by leaders in the Dominican microfinance industry. This ability to strike a balance can also be seen in the management of intermediaries and, especially, the management of banking oversight. However good regulations may be, they are not much use if they cannot be supervised and enforced. There is little point in extrapolating criteria from the oversight of traditional banking and slapping them onto the microfinance industry. The regulations must recognise that this sector has a different mission, a different scale and that its incentives are also different. Its efficiency requirements are resolved differently and its systemic risks are quite different from the traditional banking industry.

Thus, the Dominican regulations also require a significant investment for the supervisor. In order to achieve compliance with the regulations, the supervisor must ensure it has an adequate oversight strategy. This will mean modifying its organisation and its allocation of human and financial resources, as well as its systems. The success of these new regulations largely depends on the Dominican supervisor’s ability to live up to this challenge.