MICROFINANCE PAPER WRAP UP: Microfinance Activities and the Core Principles for Effective Banking Supervision, by the Basel Committee on Banking Supervision

Written by the Basel Committee on Banking Supervision, released in August 2010, 57 pages, available at h ttp://www.bis.org/publ/bcbs175.htm

This paper written by the Basel Committee on Banking Supervision, a subcommittee of the Bank for International Settlements, which is an intergovernmental organization of central banks, reviews the applicability of its 2006 Core Principles for Effective Banking Supervision [1], the de facto standard on prudential regulation and supervision of banks, to the emerging class of microfinance institutions (MFIs), including both depositing-taking MFIs and cooperatives.

The report focuses on comparing conventional retail banking with microfinance. Part One of the report lists each of the 23 Principles and discusses why certain Principles should be adjusted to account for the characteristics of microfinance operations. Part Two of the report summarizes a survey carried out by the Microfinance Workstream, a working group within the Basel Committee on Banking Supervision, to identify the regulatory frameworks facing MFIs around the world.

Permissible activities and licensing [Core Principles 2, 3]

The range of permitted activities is generally more restrictive for MFIs than banks. However, most regulators have similar licensing requirements for MFIs. The Basel Committee recommends having lower initial capital requirements for MFIs, taking into account the relatively small size of their operations. As a trade-off, however, MFIs should be limited to providing certain kinds of services such as microcredit, microsavings, microinsurance, payments, remittances and other money transfer services. The report noted that services such as offering checking accounts or engaging in foreign trade financing might be beyond the capabilities of smaller MFIs.

Capital adequacy [Core Principles 6]
Results from the survey in Part Two indicate that most regulators do not view member shares in an MFI as part of its high-quality capital, as members could withdraw their capital without much restriction. The report also recommends that MFIs be held to higher capital adequacy ratios (CARs) as their funding options are more limited than are those of conventional retail banks.

Risk management processes, credit risk [Core Principles 7, 8, 9, 10]:
The survey indicates that most countries do not have separate regulatory requirements for microfinance loans despite the difference between ordinary loans and microfinance loans. The committee calls for “a clear regulatory definition of microcredit distinguishing it from other loan types, [which] is necessary for adequate supervisory oversight of credit risk.”

Abuse of financial services and related party exposures [Core Principles 11, 18]:
MFIs are often subject to lower ceilings with respect to transactions with related parties such as the staff of the MFI, although they are also less likely to be the subjects of anti-money laundering or counter-terrorism financing legislation. The report recommends that supervisory bodies adopt a specific risk-based approach towards MFIs, focusing on particular institutions that have weaker governance and are more susceptible to insider abuse.

Market, liquidity, interest rate risk [Core Principles 13, 14, 16]:
Most regulators do not have requirements for MFIs that are separate from those of traditional banks. Nevertheless, the committee emphasized the risks posed by foreign currency borrowings, as a sudden change in exchange rates could radically affect the value of an MFI?s assets, which are mostly loans denominated in local currency.

Supervisory approaches and tools [Core Principles 19, 20, 21, 22, 23]:
As is stressed multiple times in the report, the committee identifies the lack of supervisory expertise and understanding of the microfinance market as key areas for further development. The report stressed that supervisors must be trained in the nuances of microfinance and tailor cost-effective supervisory approaches for MFIs.

The report argues that microfinance is an important financial innovation and observes that more formal financial institutions are beginning to offer similar services. In particular, citing the cases of Bangladesh and Zambia, the report acknowledges that “the proportion of citizens they [MFIs] serve may be significant in some jurisdictions.”

By Trevor Kwong, Research Assistant

[1] Basel Committee on Banking Supervision (BCBS), 2006. Core Principles Methodology. Basel, 2006,?http://www.bis.org/publ/bcbs130.htm

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