Developing economies need to encourage greater domestic production and entrepreneurship within the country in order to reduce poverty indexes. Since the beginning of the last century, microfinance has proven itself to be the most efficient way of channeling financial resources to the parts of the population excluded from formal banking services: enterprising people who can set up and manage micro enterprises.

In Latin America and the Caribbean, microfinance has been the most efficient, most sustainable way of helping people escape the poverty trap¹. Nonetheless, if we wish to continue to combat poverty through economic development driven by microfinance, we need a competitive regulatory and supervisory environment that helps entities servicing the productive activities of the unbanked population to grow responsibly.

Regulating an economic sector only makes sense if the regulations take its particular characteristics into account. Each industry and each market segment will have peculiarities that require made-to-measure responses from the regulator.  If regulation is slapped on without sensitivity towards the differences between the composite parts of the market, it can end up exerting far too much pressure on some and insufficient pressure on others.

Finance is a complex industry. It requires different standards for the different types of financial services that it provides. An obvious example is retail banking and investment banking. These are not comparable, since retail banking takes the public’s deposits and investment banking does not. So although there may be grounds for regulating investment banking², the requirements regarding capital, provisions and reserves cannot be the same as those applied to retail banking.

The microfinance industry provides small sums of money to people with low incomes and entrepreneurs wishing to develop small enterprises. Its scope of operation is highly specific. Consequently, the microfinance has to work in a highly specific way too.

Microcredits are at the very heart of the microfinance industry. They are targeted at low-income brackets of the population (often operating in the informal sector or underemployed) and to people wanting to establish small businesses. In general, the customers of microfinance entities are concentrated in specific geographical areas, which tend to be eminently rural or still underdeveloped) or specific social strata (the least well-off. Due to their geographical location, their social characteristics or the size of their businesses, the potential demand for microcredit tends to come from those encountering difficulties in obtaining finance from retail banks. Microfinance involves small amounts of money, with relatively short repayment terms and no liquid collateral.

Analyzing micro-credit risk is a complex, decentralized activity, because many microfinance customers live in rural or semi-rural areas, do not have a credit history or can not even show proof of their income, which is likely to come from undocumented sources. Their credit risk analysis has to largely rely on the work done by commercial agents who can go out and visit the customers at their homes or workplaces and help them fill in the forms needed to give them access to funding.

The regulation and supervision of microfinance entities requires in-depth knowledge of the business model that such entities employ. The Microfinance Workstream of the Basel Committee on Banking Supervision³ has specifically recognised this. If regulators do not have the necessary insight into how the microfinance system works, their regulatory policies can only be based on their experience of traditional banking. This could lead them to impose excessive costs on the microfinance industry, discouraging investment in this vital financial sector.

Certain aspects of the financial industry are considered to require an approach that can focus on the particular issues of the entities involved in providing microfinance. The requirements regarding aspects such as capital and liquidity requirements, the assessment of credit risk, operational risk, provisions and reserves are highly specific to this industry.

Of all these aspects, perhaps the most relevant are those relating to credit risk and operational risk.

In the microfinance business, the customer profile, product design, credit placement methodologies and, in general, its core business model, have to be based on the existence of very specific risks. The regulator must understand the specificities and know how to manage the tools used for their identification and quantification, and not be content to simply apply the regulatory tools conceived for traditional retail banking.  For example, although the regulator must require the microfinance entities to submit written credit policies, these must contain some flexibility to deal with the real situation of the market segments they are meant to be targeting.  Decentralised credit analysis, decentralised pay-out, the use of alternative collateral instruments, and group loans are all likely to form part of these policies as standard practices that although unusual in traditional banking, have to be commonplace in the microfinance business model by dint of its very nature.

Likewise, regulatory requirements on contract documentation must take into account that the bounded-rationality problems besetting retail banks are enormously accentuated in the microfinance segment. Thus it makes no sense to oblige microfinance entities to disclose sophisticated information or include clauses in their contracts that have nothing to do with the products being offered to their customers.

With regard to operational risk, regulation must acknowledge that the tendencies and practices in the microfinance sector differ significantly from those of retail banking. Different regulation is required to adapt to operational and internal-control policies tailored to a highly decentralised process for granting microcredit. It should also take into account that the operational risk associated to commercial advisors is the microfinance entities’ biggest single risk, as these advisors’ business is quite different from those of the staff selling traditional banking products. Similarly, given the high degree of decentralisation and deconcentration of the segment serviced, the regulations must facilitate the use of new information technologies to enforce regulatory standards, such as remote supervision systems (pre- and post-disbursement), control systems and reporting systems.

Right from the outset, microfinance has enabled certain vulnerable sectors of the population world-wide to escape from the indignity of poverty. Without the microfinance industry, millions of people all over the Earth would simply not have the possibility to access funding. Of course regulation is necessary, as the microfinance entities take funds from the public.  However, to apply the same qualitative and quantitative rules to these entities as are applied to the retail banks may have a seriously adverse impact on the growth of this financial sector. It can generate the imposition of inefficient compliance costs if it fails to take into account the business model or the size of the enterprise. It could also lead to high concentration in the sector, as the smaller entities, unable to bear the burden of such compliance costs, simply give up the struggle.

There is thus a clear-cut argument in favour of the need for adaptation, so that each jurisdiction has a regulatory and supervisory framework in keeping with the characteristics of the sector, promoting its development by ensuring a correctly targeted risk-management, with robust corporate governance and transparency in microfinance institutions.

Just as regulators have decided to regulate investment banking in the light of its specific characteristics, they must also adopt a specific set of regulations for microfinance. The regulatory framework should be informed by the real business model employed by the microfinance sector, so that it can be tailored to the size and type of credit transactions actually required.

In the BBVA Microfinance Foundation Group, we are working towards a better future for the people who are at present most economically disadvantaged. We aim to sow wealth by encouraging the growth of enterprises conceived by people currently excluded from the formal economy. We are convinced that microfinance is a force that can drive forward a society’s development. Thus, within the framework of our mission, we want this publication to benefit all the stakeholders in this industry. We aim to facilitate the information required to reach informed decisions that can encourage the healthy growth of this sector and provide key assistance in the fight against poverty. Accordingly, this issue of Progreso discusses the recent Microcredit Regulation approved by the Monetary Board of the Dominican Republic as well as other legislation enacted in the different jurisdictions of Latin America and relevant for the microfinance industry.