CHAPTER FIVE MICROFINANCE PRINCIPLES AND PRACTICE.

By the end of this chapter the learner should be able to:

i) Trace the development of microfinance

ii) Identify microfinance credit and savings principles
iii) Describe the institutional requirements financial self-sufficiency iii)
iv) Describe the various institutional structure that microfinance organizations can adopt
v) Identify the policies for promoting microfinance
vi) Describe the benefits of institutional savings

Introduction.
The term microfinance refers to the provision of financial services such as small collateral free
loans, deposits, pension and retirement, and insurance to low-income groups and their micro
enterprises. Microfinance institutions also frequently add to their portfolio of financial services
the provision of social services such as healthcare, literacy training or business development
consulting services. Microfinance institutions lend money to small scale business persons/firms.
Examples includes; K-Rep Bank, Faulu Kenya, Jami Bora, Pride Africa etc. Origins of Small
Lending Micro lending often starts in small villages, where family members and friends get
together in money-sharing groups. These savings clubs can be traced to all parts of the world
and have operated for centuries probably since the introduction of currency. From region to
region, these clubs developed their own names. In West Africa, they were known as "tontines;"
in Bolivia, "pasanaku;" and across Mexico and Central America, "tandas." Tanda means "shift" in
Spanish and works on the premise that members of the group contribute to a pool of money,
which shifts to a single member that has the most need. The tontines of West Africa can be
traced back to 17th-century and are named for the Italian banker Lorenzo de Tonti. (51 An early
version of micro lending was the Irish Loan Fund system, introduced in the early 1700s, by
writer and nationalist Jonathan Swift. Swift's early success helped the Irish when many were
living in impoverished conditions. Swift's original system was standardized in 1837, when
hundreds of independent loan funds were brought under the control of the Loan Fund Board.
By law, no loan could be more than £10 or run for longer than a 20-week term, with weekly
repayments. As with many contemporary micro credit institutions, interest rates were low – in
this case around 8 percent per year – much lower than those charged by local profiteers. The
Pioneers of Modern-Day Microfinance The concept of micro loans took a big leap in the 1960s
and 1970s, when groups such as ACCION International, in Venezuela, and Yunus's Grameen
Bank, in Bangladesh, began to institutionalize the process. By formalizing and expanding the
basic concept of sharing programs, these microfinance institutions helped to build capital for
small businesses rather than just loaning for basic necessities such as food, water and clothing.
Yunus first came across the idea of micro credit while studying the lives of poor entrepreneurs
in his native Bangladesh during the famine of 1974. He began by loaning to groups of women,
and his program soon proved that small loans could not only quickly improve lives but were
paid back with interest and on time. The next step was setting up a consistent on-the-ground
program. In the case of the successful institutions, this meant sending a representative, or "field
manager," to the prospective region to educate and advise and to oversee the loans locally.
After a few members of the group were accepted for a loan, the rest had to wait for that initial
loan to be repaid before they could obtain their own loans. "Peer pressure" from other
members of the group to repay the initial loan helped to set the bar high. In 1961, another early
pioneer, ACCION, opened its doors in Caracas, Venezuela, when law student Joseph Blatchford
raised $90,000 to start a community development program to help the poor jump-start their
own businesses. Over the next two decades, ACCION set up scores of independent microfinance
institutions and expanded across Latin America. It, too, offered people a choice besides the local
loan shark, who would charge rates as high as 500 percent a year and often pushed people into
permanent debt. Like the founders of ACCION, Yunus realized that if individuals who wanted to
start their own businesses could not free themselves from start-up debt, they would never be
able to grow. Since the Grameen Bank was founded, it has paid out more than $5.7 billion in
loans, and more than $5.1 billion of that has been repaid -- a recovery rate of approximately
98.9 percent. It has made more than 950,000 loans and has 6.7 million members, around 96
percent of whom are women. The Norwegian Nobel Committee has recognized Yunus's long-
term vision of eliminating poverty in the world. That vision cannot be realized by means of
micro credit alone. But Muhammad Yunus and Grameen Bank have shown that in the
continuing efforts to achieve it, micro credit must play a major part. Following the success of
these early institutions, other microfinance organizations began to launch throughout the
developing world. Among the largest is FINCA International, established by economist and
Fulbright scholar John Hatch. Hatch believed that using locals' knowledge rather than bringing
in outsiders was key to building successful local economies. Using an approach he has always
stood by, Hatch said, "Give poor communities the opportunity, and then get out of the way!" By
2005, FINCA had 400,000 clients in 21 countries across Latin America, Africa, Central Asia and
Eastern Europe. One year after the United Nations called 2005 the International Year of Micro
credit, the World Bank estimates that there are more than 7,000 microfinance institutions now
operating around the world. 5.1 Credit Principles Microenterprise lending programs now
operate in Asia, Latin America, and Africa. However much these programs differ from one
another, beneath these differences is a common thread that makes them effective credit
delivery systems. All have found ways to streamline their activities so that the costs of lending
are commensurate with the small size of the loans being made. The techniques employed
resemble, often by conscious adaptation, those that have developed in the informal financial
sector over many years.
The following three principles represent the core of the new techniques:

Know the market- the poor are willing to pay for access and convenience. The major service
need among the poor is credit for liquidity and working capital, with loan terms of one year or
less and with little attempt to direct credit to specific uses. Transaction costs for borrowers are
lowered by locating lending outlets near the client, providing simple application processes, and
disbursing quickly. Interest rates are high relative to prevailing rates in the formal financial
system, but they are low compared with typical informal-system rates.

Special techniques slash administrative costs. The simplest procedures are used for the
smallest loans. Loan applications are often no more than one page. Approvals are decentralized
and are based on readily verifiable eligibility criteria rather than business appraisal. Borrower
groups often handle much of the loan-processing burden.

Special techniques motivate repayments. Lenders substitute other techniques for security and
loan appraisals, such as group guarantees or pressure from social networks, the promise of
repeat loans in increasing amounts, and savings requirements. Although programs dealing with
larger microenterprises may require tangible collateral, most do not. Application of these
principles is the foundation for financial viability of a lending operation that serves poor
microenterprises. The essence of the difference between these techniques and commercial
banking practices is the use of a repayment incentive structure instead of costly information
gathering. This substitution enables lenders to serve micro enterprise at a reasonable cost.
Group formation is often employed by microenterprise programs, particularly for the poorest
clientele. The group plays a role in reducing the cost of gathering information about the
borrower, but its more important role in motivating repayments through shared liability for
default. Lenders can shift some of the loan-processing and loan-approval tasks onto groups
because the groups have better access• to information on the character and creditworthiness of
potential borrowers. When very poor clients care more about access to credit than the terms on
which it is offered groups can be used without significantly imp airing demand. Principles Just as
there, are proven principles of lending to the poor,

principles of savings

They have emerged from experiences in various places. 1ndictions are that when savings are
approached using the following principles, customers respond enthusiastically.

i) First, the most widely desired savings instruments offer safety, convenience, ready
access to money, and a positive real return.
ii) Second, more people want a good place to save than want loans. Thus, savings services
can reach deeper into the community. The opportunity to save should not be limited to
those who borrow.
iii) Last, lending to microenterprises can be financed to a significant extent by savings from
the same communities provided savings services are designed with customer needs in
mind.

Traditionally, most microenterprise programs with savings elements used some form of
compulsory savings, whereby borrowers were required to save a portion of the amount they
borrowed. Typically, under such programs, borrowers did not have access to their savings until
their loan was repaid. The savings mechanism thus functioned as asset storage in a very illiquid
form. A voluntary savings instrument, such as passbook savings with free access to deposits,
better meets savers’ requirements and has the potential to raise much larger amounts of funds.
The BRI Unit Banking system in Indonesia, is now fully savings financed, demonstrating this
potential. Nevertheless, the programs employing these principles should still be regarded as
incomplete. Their full potential to grow, spread, and achieve greater financial self-sufficiency has
not yet been reached.

Institutional Requirements

Financial Self-Sufficiency Financial self-sufficiency is a prerequisite for making financial services

widely available to microenterprises. A financially self-sufficient credit operation must cover the
following through fees and interest charges: operating costs, including loan loss reserves; the
cost of funds; and inflation. To achieve genuine commercial viability, it must also yield a profit to
owners.

Institutional performance can be analyzed in terms of four distinct levels of self-sufficiency.

Level One -The lowest level, level one, is associated with traditional, highly subsidized
programs. At this level, grants or soft loan cover operating expenses and establish a revolving
loan fund. When programs are heavily subsidized and performing poorly, however, the value of
the loan fund erodes quickly through delinquency and inflation. Revenues fall short of operating
expenses, resulting in a continuing need for grants. Many microenterprise credit programs
operate at this level.

Level Two -Most programs that use the proven principles described here can attain the second
level of self-sufficiency. At level two, programs raise funds by borrowing on terms near, but still
below, market rates, Interest income covers the cost of funds and a portion of operating
expenses, but grants are still required to finance some aspects of operations. Most programs at
this level are quite proud of their breakthrough, as they should be, because the subsidy
required is significantly smaller than the one required at level one.
Level Three -At level three, most subsidies are eliminated, but programs find it difficult to
eradicate a persistent dependence on some element of subsidy. This is the level associated with
most of the well-known credit programs, and it is probably necessary to reach at least this point
in order to achieve large-scale operations. Programs at this level are rarely required to take the
next step, because both they and their sources of support are pleased with performance at this
level.

Level Four -The final level of self-sufficiency, level four, is reached when the program is fully
financed from the savings of its clients and funds raised at commercial rates from formal
financial institutions. Fees and interest income cover the real cost of funds, loan loss reserves,
operations, and inflation. The only major microenterprise programs to have reached this level
are those of the credit union movement in certain countries and the BRI Unit Desa system in
Indonesia.

Programs should be judged less by their current level of achievement than by their progress
toward higher levels. By analyzing each type of cost as well as fee and interest income, we can
determine how credit programs move from one level to the next.

Operating Costs- Traditional credit programs at level one typically have very high operating
costs; it is not uncommon for programs to spend a dollar to lend a dollar, particularly among
smaller programs. Programs at higher levels of self-sufficiency achieve most of their movement
toward viability by using methods that cost far less, that is, by adopting the principles outlined
above, which brings them to level two. Once these methods are adopted, however, changes
come incrementally from increasing efficiency and scale economies in operations. Efficiencies
may come from marginal improvements in processes, computerization of management
information, improved financial management, and the like. Staffing and physical plant are major
costs that must be addressed on a case-by- case basis. Therefore, continued streamlining is not
the primary strategy for moving to higher levels of self-sufficiency.

Loan Losses- Programs that have adopted the principles outlined here have achieved
substantially better repayment rates than traditional programs, often reaching levels that
compare favorably with commercial bank operations. One can observe many programs,
particularly at levels two and three, that claim losses at or below 3 percent of principal.
Delinquency and default cannot be eliminated, but they can be maintained at a level that does
not threaten the financial integrity of the institution.

Cost of Funds- Lending operations must pay to raise funds, either by borrowing or by generating
savings. Programs operating on grants and very soft loans are spared this cost: Donors bear it.
Dependence on soft sources of funds is a limiting factor, as soft sources are in short supply.
Institutions at level two may still use them, but by level three the transition to commercial or
nearly commercial sources should have been made. This is, in fact, one of the key distinctions
between the two levels.

Inflation- All programs bear the costs of inflation, whether they recognize them or not. In a
well-functioning financial system, the inflation factor is built into the interest rate paid on funds
raised or offered to depositors. This practice returns the real value of the funds to the suppliers
and therefore maintains that value in the financial system. However, when programs use
concessional funds, they are not charted this inflation factor. Despite an appearance of self-
sufficiency, the real value of the loan fund dwindles, and the programs are able to serve fewer
clients. If hyperinflation sets in, virtually all progress toward self-sufficiency is destroyed.
Microenterprise programs have a good chance of reaching levels three and four only if they
operate in countries where inflation is kept to moderate levels.

Fee and Interest Income- Traditional loan programs have been reluctant to charge full-cost
interest rates to microenterprises. in many level-one programs, the rate charged is negative in
real terms.

Appropriate Institutional Structure.

The expansion financial services for microenterprises outlined above can be realized through
the following institutional arrangements.

i) Linking Non-Governmental Programs to Sources of Finance. Many of the

microenterprise credit programs run by NGOs are not in a position to become true
financial institutions that finance their lending largely from deposits. They may
face legal restrictions on deposit taking, or they may decide not to take on the
added responsibilities that come with handling individual deposits. The future of
such programs depends on their ability to forge funding relationships with formal
financial institutions. The simplest arrangement is for microenterprise programs
to finance their lending by borrowing from commercial banks. In order to be able
to borrow in this way, microenterprise programs must meet two stringent criteria:

First, they must be able to repay borrowed funds at a rate acceptable to the bank.
Second, programs must be able to assure banks that they are creditworthy. Very few
microenterprise programs have as yet been able to meet these tests on their own.

ii) Transforming Programs into Specialized Financial Institutions. Microenterprise

programs are carried out by a variety of institutions, from grant-oriented NGOs to
those striving for self-sufficiency. These institutions must undergo several changes
to become financial institutions that engage in lending and capturing deposits. At
 the structural level, these institutions must reorganize to provide both savings and
credit in a manner that will allow for expansion. At the first opportunity, the
organizational structure must be modified to support the capturing of deposits
and the provision of credit. The functions and the makeup of each department, as
well as the relationship among departments, must also be reorganized. A second
structural change required is for the organization to use some form of franchise or
branch office system to continue expanding its operations. Therefore, the
organizational structure would require information systems adequate for a
decentralized operation. Legal considerations are a key factor in defining how
these institutions will change internally. The legal framework in a country
determines whether an institution can take deposits. In some countries, the law
permits organizations outside the banking system to capture savings directly. In
most countries, however, this is not the case. Institutions may modify themselves
in order to fit within the existing law, for example, by creating a cooperative or a
credit union arm.
iii) Specialized Operations within Commercial Financial Institutions. A handful of
commercial banks have shown interest in taking on the microenterprise client
group. Yet it is possible for such an arrangement to succeed, as demonstrated by
the tremendous success of the BRI Unit Banking system, which is run by a large
government owned bank and serves over eight million savers and two million
borrowers. Major advantages of placing microenterprise operations in commercial
banks include the infrastructure available to banks through branch networks,
access to liquidity, and commercial orientation. Banks must be educated in the
special techniques described above, however, for no bank can succeed with
microenterprises by applying its standard operating procedures. At this time,
banks are generally unaware of these techniques, of the promise these
techniques may hold for serving microenterprises commercially, and of the
changes required to make microenterprise lending successful.

Policies for Promoting Microfinance Governments.

In many countries are moving toward including informal-sector enterprises in their

national agendas. The sectors that must review their policies include national, regional,
and local governments; financial institutions; and multilateral and bilateral donor
organizations.

The policies should:

i) Make it easier for programs offering specialized financial services to microenterprises
to become financially self-sufficient.
ii) Support the efforts of NGO-based programs to gain access to commercial sources of
funds.
iii) Support the efforts of NGO-based programs to become specialized financial
institutions.
iv) Encourage mainstream financial institutions to develop specialized microenterprise
operations of their own. In addressing each of these tasks, the first priority should be
interest rate deregulation. The ability to charge full-cost interest rates is the best
strategy microenterprise lending programs have for becoming financially self-
sufficient, after they have adopted the lending techniques advocated here.
v) Governments, lenders, and donors can lead the way in changing attitudes by making
and following firm policy determinations to require full-cost pricing policies from any
organization that requests financing or special assistance from them. vi) Interest
rates on deposits should also be allowed to rise, in order to provide appropriate
incentives for microenterprises to use savings rather than credit to finance lending
operations.
vi) Regulations governing acceptance of deposits must also he reviewed, although this
will be a thorny issue. In many countries, NGO programs are prevented from
accepting deposits by banking laws.
vii) Governments have a responsibility to both depositors and financial institutions to
ensure that depositor confidence is not violated. Therefore, when non-financial
institutions begin to accept deposits, governments are legitimately concerned. This
was thought very remote in the past but has started taking root in some countries
such as Kenya.
viii) The donor organizations, together with successful microfinance institutions, should
take the lead in, advocating a financial systems perspective toward microenterprise
development by demanding better performance from the programs they fund
promoting learning across countries, and encouraging governments to adopt more
supportive interest rate and regulatory policies.
ix) Macroeconomic Management-Good macroeconomic management and rural
development are requirements for the sustainable development of a successful rural
banking system operating on a large scale, there must be rural development,
inflation must be controlled, deposits must be mobilized, and financial institutions
must be permitted to set interest rates that will enable institutional profitability. In
some circumstances, local financial institutions may function well in the absence of
some of these criteria, but all are crucial for sustainable large-scale systems of rural
banking.
x) Political Stability-A reasonable level of political stability is required so that people
have trust in the broad continuity of institutions and policies. Viable financial
institutions serving the local level are dependent on savings mobilization, the success
of which depends heavily on trust. Thus, reasonable macrostability is required for
voluntary savings mobilization, which, in turn, is required for profitable rural
banking.
xi) Market Analysis and Staff Training-Analysis of markets and the training of
institutional staff in Understanding the markets they finance are essential for the
design and implementation of successful financial instruments and services and for
the development of sustainable financial institutions, Successful rural banking is
founded on analysis of rural markets and their inter-linkages, understanding
changing social and economic conditions, and knowledge of the financial
requirements and aspirations of microfinance clients who control different economic
resources and whose households are at different stages in the developmental cycle
of domestic groups.
xii) Leadership- Effective leadership and management are essential for selection of the
priorities required for the development of viable microfinance institutions and for
the successful implementation of appropriate services and instruments.
xiii) Coordinated Planning- Lending and deposit instruments and the spread in their
interest rates should be planned in conjunction with each other. These need not be
implemented simultaneously (for example, an institution may need to build up trust
through lending before mobilizing voluntary savings), but if one is planned without
regard for the other, the system cannot be sustainable over the long term.
xiv) Rural-Urban Financial Intermediation- In a country undergoing significant rural
development, there is likely to be substantial demand for rural-urban financial
intermediation. In addition, banking instruments and services that work in rural
areas can be adapted for urban neighborhoods, and vice versa. Given the recent
large-scale rural-urban migrations and the widespread communications facilities that
link urban and rural areas in developing countries, the economics of rural
organization cannot be considered apart from the wider context. Under these
circumstances, there is considerable opportunity for the expansion of successful
methods of rural financial intermediation into urban areas.
xv) Social and Economic Profitability- The Indonesian experience demonstrates that a
spread between lending and savings interest rates can be set that permits bank
profitability while offering loans at interest rates significantly below those of informal
commercial lenders and providing savers with generally positive real rates of return
on their deposits. The fundamental lessons from Indonesia are that institutional
viability, rural development, enterprise finance, and improvement in equity can be
 achieved simultaneously; and this can happen only if savings mobilization is
transformed from the forgotten half to the sustaining half of rural finance.

Savings Mobilization and Microfinance .

Throughout the world and across many cultures and income groups, people save for
varied purposes this includes:

i) Emergencies
ii) Investment
iii) Consumption
iv) social obligations
v) education of children
vi) pilgrimages vii) sickness
vii) disability
viii) retirement

Extensive household savings have been reported from developing countries around
the world for at least three decades. Neither the reality of extensive liquidity among
households in many rural and urban areas of developing countries nor the
importance of savings mobilization for local financial markets and enterprise
development has yet been sufficiently understood. One consequence is that few
financial institutions provide appropriate deposit instruments in rural areas of
developing countries, and few policymakers or donor agencies have made savings
mobilization at the local level a high priority for economic development. Savings has
rightly been called the forgotten half of rural finance.

However this notion is being debunked by experiences such as that of Equity Bank in
Kenya.

The Myths .

Two widespread myths prevail with regard to household savings in developing

countries, particularly in rural areas.

i) The first is the myth of pervasive rural under savings.

ii) The second is the assumptions that demand for financial savings instruments is
low in most rural areas of developing countries.

Such misguided assumptions are often extended to middle-and lower-income urban

households as well. It has been widely assumed that low institutional deposits in rural
area is a demonstration that rural households cannot save because they are too poor,
will not save because they prefer to use their incomes for consumption, or choose to
save in other forms. Since there is no significant demand for financial savings
instruments, the argument goes, why develop financial institutions with savings
programs?

REASONS FOR LACK OF DEPOSITS.

The reasons for low institutional deposits, however, are often neither under savings
nor lack of demand for financial savings instruments, but the structure of services and
institutions. The majority of projects for local finance are still concerned only with
credit, usually subsidized credit. The low interest rates that characterize subsidized
credit programs discourage savings mobilization. Organizations dispensing subsidized
credit normal either are forbidden to mobilize savings or do not collect voluntary
savings because financial regulations make deposit mobilization unprofitable.

Shattering the Myths.

Indonesia’s rural banking system administered by the Bank Rakyat Indonesia (BRI) and
experiences such as that of Equity Bank in Kenya have recently debunked the myth by
mobilizing massive savings within short time spans .

Types of non-financial Savings;

i) Grain ii) Animals

ii) Jewelry
iii) precious stones
iv) Land etc

Financial Savings at the Local Level.

Household, enterprise, and group savings in financial form may be held in ways that
are informal, quasi-formal, or formal. Informal financial markets are ubiquitous.
Although they are largely unregulated and unreported, it has long been recognized
that these markets are not unorganized.

They form part of the local political economy; financial channels and market shares of
lenders are inextricably related to the local distribution of wealth and power, market
inter linkages, political alliances, information flows, and so forth.
 The extent and character of the interactions among formal, quasi-formal and informal
financial markets in rural areas can vary considerably, depending on the degree of
regulation in the formal sector; the extent of monetization in the rural areas; the
public’s confidence in the government in general and in the available financial
institutions in particular; the ease of customer access to formal financial services; the
activities of parallel and black markets; and a variety of geographic, economic, cultural,
and other factors .

Benefits of Institutional Savings.

Well-designed and well-delivered deposit services can simultaneously benefit

households, enterprises, groups, the participating financial institutions, and the
government. Good savings programs can contribute to local, regional, and national
economic development and can help improve equity.

The benefits from institutional savings at local levels may include the following:

Benefits to Households: Institutional savings provide numerous benefits to

households, including the following:

Liquidity- Rapid access to at least some financial savings is considered essential by

many households in monetized or partially monetized economies. Liquidity is crucial
for mobilizing household savings. The demand for deposit instruments permitting an
unlimited number of withdrawals is high because people save for emergencies and for
investment opportunities, which may arise at any time. Thus, in areas characterized by
economic growth and development and by a reasonable level of political stability,
potential household demand for liquid deposit instruments in financial institutions
may he unexpectedly high.

Returns on deposits- Positive real returns on deposits are typically not available at low-
risk outside financial institutions. When such institutions offer appropriate deposit
instruments, the interest can be used by the household as an income flow or as
savings. Fixed-deposit accounts featuring lower liquidity and higher returns, especially
when held in conjunction with liquid accounts, are suitable in various ways for the
types of savings mentioned below,

Savings for consumption- Households with uneven income streams ‘(from agriculture,
fishing, and enterprises with seasonal variations) can save for consumption during low-
income periods.
Savings for investment- Saving for development of household enterprises is discussed
below. Households also tend to save for other kinds of investment, such as children’s
education, house construction, and electrification.

Savings for social and religious purposes and for consumer durables-Social ceremonies
birth, puberty rites, weddings, and funerals) and religious donations or pilgrimages are
some of the long-term goals for which people frequently save. Others are consumer
durables; depending on household income level, these vary from cooking pots to
automobiles.

Savings for retirement, ill health, or disability- Saving for old age or disability may take
the form of building retirement savings or helping to establish junior members of the
household, who will then have the responsibility of caring for their elders.

Savings instead of or in addition to credit- Households save in order to self-finance

investments and to avoid paying what are often very high interest rates in the informal
commercial credit market, Self-financed investments are particularly important for
middle- and lower-income households, which often do not have access to institutional
credit.

Savings to build credit ratings and as collateral- Institutional savers may also use their
deposits to build credit ratings and as collateral for loans. These features are especially
important for those who do not own land.

Benefits to Enterprises:

Many of the benefits gained from institutional savings by households are also
applicable to enterprises (security, returns, self-finance of investment, and so on).
Enterprises at all scales tend to have high demand for liquidity many also have high
demand for transfer facilities. Household savings are typically the main source of small
and microenterprise finance, but in many cases small entrepreneurs must also borrow
on the informal credit market. Therefore, small and microenterprises can benefit from
institutional savings programs both directly, through the encouragement of self-
finance of investment, and indirectly, through the expanded volume of institutional
lending at much lower rates than are otherwise available.

Benefits to Local Groups.

Organizations, and Institutions: Deposit instruments that permit savings to be held in

the name of organizations and institutions provide significant benefits to the
depositors. The provision that savings accounts may he held in the name of a group,
organization, or institution opens a large new market for rural deposits derived from
 village treasuries, government offices, schools, religious institutions, development
programs disbursing funds for rural projects, and a plethora of local organizations (for
example, employees’, women, youth, and sports associations; informal savings and
loan associations; and voluntary agencies). Institutional savings also provide groups
with the opportunity to earn returns on their deposits.

Benefits to Financial Institutions:

Deposits mobilized in conjunction with commercial credit programs enable sustainable

financial institutions.

Benefits to the Economy, Development, and Equity:

Local savings mobilization benefits the economy directly by increasing the resources
available for productive investment. Effective savings mobilization is crucial for local
development because it encourages self-finance of investments; it permits the supply
of a large demand for credit at commercial interest rates; which typically range from 5
to 50 percent of the rates charged by informal commercial lenders; and it enables the
growth of sustainable financial institutions.

Review Questions

i) Trace the historical origins and development of microfinance

ii) Explain microfinance credit and savings principles
iii) Describe the myths surrounding savings among the poor and hoe the debunking of
these myths has helped in the development of microfinance
iv) Describe the levels of and institutional requirements of financial self-sufficiency
v) Describe the various institutional structure that microfinance organizations can adopt
vi) Identify the policies that may be adopted by governments and individual institutions in
promoting the development of microfinance
vii) Describe the benefits of institutional savings

Suggested Further Reading Maria O, and Elisabeth R, (2003), The New World of
Microenterprise Finance: Building Health Financial Institutions for the Poor, Kumarian
Press. Lee, Nirmala, (2008), Principles of Lending, Global Professional Publishing Ltd David
Lawrence and Arlene Solomon, Managing a Consumer Lending Business, Solomon
Lawrence partners Downloaded by Nathan Kipchumba (kipchumbanathan030@[Link])
lOMoARcPSD|50379713 68
CHAPTER SIX; THE PROCESS OF INSTITUTIONAL DEVELOPMENT .

By the end of this chapter the learner should be able to:

i) Illustrate the framework for institutional development

ii) Describe the components of the framework for institutional development
iii) Describe the stages of the framework for institutional development
iv) Explain the relationships between the components and the stages of the framework
for institutional development 6.0

Introduction.

Institutional development is a complex process touching on values, mission, program, and

intended goals. Contained in its definition are four important concepts:

Process- Institutional development is not static, it is organic and evolving. It affects all
facets of an organization and it implies learning, adaptation, and change.

Capacity- Institutional development involves human resources as well as organizational

structure and systems. Both need to be strengthened in concert.

Sustainability- The aim of institutional development is an organization that can sustain the
flow of valued benefits and services to its members or clients over time.

Impact- Institutional development is not a goal. It is a means to solve problems, create a

more favorable economic or policy environment, and improve the quality’ of people’s lives.

Framework for Institutional Development.

Institutional development is a dynamic process of becoming a learning organization

capable of influencing and adapting to a continually changing environment. It is a two-way
street, strengthening both partner organizations, it leads to financial, material and human
resource autonomy and self-reliance. Institutional development is a complex concept
because the life of an organization is a complex process. A framework that expresses the
fundamental ideas and concepts and permits an analysis of the principal elements involved
is a useful approach to addressing the complexity.

A Framework for Institutional Development of

Microenterprises
 DEVELOPMENT SUSTAINABILITY EXPANSION
VISION
CAPACITY
RESOURCE
CAPABILITY
LINKAGES

STAGE DEVELOPMENT SUSTAINABLITY EXPANSION VISION CAPACITY RESOURCE CAPABILITY

LINKAGES 6.1.1 Components Vision-Vision is the ability to think creatively and critically
about the organization. Vision is guided and formed by basic principles and beliefs that
define the mission and purpose of an organization. It articulates a picture of the world that
would result from the successful achievement of an organization’s goals It is important that
vision grow out of, and respond to, locally defined needs. Finally, it should reflect the social
and moral principles, and contain principles of cost-consciousness, sustainability,
autofinancing of credit, growth, and expansion. Capacity- Capacity is the ability to move
thinking to action. It is the institution’s ability to organize itself to achieve its mission
effectively and efficiently. Capacity requires a structure through which people can channel
their energy and creativity, which anchors the organization in the mold of the vision,
supports the organizations activities, is responsive to program and client needs, ensures
that decisions get made at appropriate levels, and engenders appropriate forms of
participation. Systems and procedures that ensure that the structure operates smoothly,
that there is a timely flow of accurate information and that staff and clients are treated
fairly. A staff with the skills and motivation to implement the programs and manipulate the
systems to achieve the objectives of the organization, a methodology that is an organized
set of tactical steps that allows the organization to carry out its mission. Resource
capability- Resource capability is the ability to earn or raise sufficient funds to cover
expenses without compromising vision or program design. An organization operating
efficiently has achieved an assured flow of money that matches client demand and
operational need. In addition to acquiring funds, organizations must be able to do financial
planning and management and ensure accountability. Key factors include fundDownloaded
by Nathan Kipchumba (kipchumbanathan030@[Link]) lOMoARcPSD|50379713 70
raising policies and practices, credit policies budgeting and accounting systems1 financial
projection and cash flow analysis, and portfolio management. Linkage- Linkage is the ability
to develop productive relationships with t wide variety of organizations. Linkage includes
regular communication, interaction, and exchange of information and resources. To he an
effective implementer of its activities, an organization must be perceived by the community
in which it works, and by external entities, as carrying out activities that meet community
needs in socially and culturally appropriate ways. Additionally, it must be seen as
contributing to the overall improvement of the community. This legitimacy strengthens an
organization and further supports the accomplishment of its mission. Each component of
the framework represents a distinctive organizational ability and involves an integral set of
roles, policies, procedures, and tasks that need to be accomplished in systematic ways. The
nature of the issues faced in each component and their importance and impact on the
organization change over time and thus require constant attention. Failure to appropriately
address any of these issues has the potential to seriously weaken an organization and
reduce its ability to serve its client population. 6.1.2 Stages The three stages identified in
the framework present new challenges to be mastered. Development Stage- The
development stage begins at the initial point when an organization decides to undertake a
small enterprise activity. During this stage, the organization makes major strides in crafting
its methodology and begins structuring itself to carry out its mandate. The discussion of
this stage is relevant for both new organizations in the process of establishing themselves
and existing organizations. This stage can he further divided into the preparation phase,
during which planning is carried out and the foundation is laid for an organization and its
program methodology; the startup phase, when the program model is tested and modified;
and the implementation phase, which involves the execution of a program ample enough
to achieve visible levels of impact.
Sustainability Stage- This second stage is the period during which an organization achieves a
certain amount of maturity, becomes an efficient implementer, attains a degree of financial
viability, and can grow. It is during this stage that an organization makes the transition from
effective implementation in accordance with predetermined impact targets, to a consolidation
phase of more efficient delivery of services to clients, to a growth phase where the organization
is increasingly capable of reaching larger numbers of clients with greater effect. Expansion
Stage- In the expansion stage, an organization makes a structural transformation in order to
scale up its operations to reach a significantly greater number of people. Indicators that the
threshold has been crossed include the clear existence of an organizational choice to reach
larger numbers and the consequent decision to embark upon some form of structural change in
the organization to make that goal a reality. This framework, like any analytic tool, is an
abstraction of reality, reflecting and highlighting key elements to facilitate understanding. The
actual process of institutional development is much less continuous than the logical progression
the framework implies.

Review Questions .

i) Illustrate the framework for institutional development ii) Describe the components of the
framework for institutional development

iii) Describe the stages of the framework for institutional development

iv) Explain the relationships between the components and the stages of the framework for
institutional development

Suggested Further Reading Maria O, and Elisabeth R, (2003), The New World of
Microenterprise Finance: Building Health Financial Institutions for the Poor, Kumarian Press.
Lee, Nirmala, (2008), Principles of Lending, Global Professional Publishing Ltd David Lawrence
and Arlene Solomon, Managing a Consumer Lending Business, Solomon Lawrence partners
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50379713 72

CHAPTER SEVEN THE MERGING ROLE OF NGOs IN FINANCIAL INTERMEDIATION By the end of
this chapter the learner should be able to: i) Identify the reasons why NGOs choose to the path
of financial intermediation ii) Describe the characteristics for NGOs engaging in financial
intermediation iii) Challenges for NGOs choosing path financial intermediation 7.0 Introduction
There are a growing number of examples of microenterprise in development organizations that
have decided to move toward financial intermediation. The decision to engage in financial
intermediation brings with it the need for a fundamental transformation in the approach to
microenterprise development. NGOs that have made this decision believe that such a
transformation is the only way to address the demand for financial services over the long term
and in a viable in manner. Financial intermediation is the route taken by NGOs that have
decided to specialize in financial services, scale up their microenterprise lending activities, and
reach tens of thousands of borrowers. Expansion of lending activities becomes the vision that
drives these NGOs forward, influences their operations, and ultimately differentiates their work
from that of other NGOs. These organizations become specialized lending institutions whose
primary objectives are to improve the quality and efficiency of their lending operations and
expand them significantly. Once an NGOs decides to follow this “expansion-led’ app roach, its
potential area of coverage becomes the whole country. 7.1 Characteristics for NGOs Engaging in
Financial Intermediation i) Governance and Boards The governance function and the
composition of boards under the expansion-led approach are crucial considerations because the
board will decide whether the NGOs should move toward financial intermediation. Key factors
are at play in this decision, in particular the increased level of effort the board members must
accept to make it happen Downloaded by Nathan Kipchumba
(kipchumbanathan030@[Link]) lOMoARcPSD|50379713 73 and the much higher level of
risk that they assume, both for themselves and for the institution. Perhaps the first way in which
NGOs link into the financial systems in their countries is by choosing private-sector individuals,
business-people and bankers as board members. Private-sector board members create access
to institutions and sources of finance that are otherwise unreachable. They also outline a vision
for the NGO that can take it toward financial viability and intermediation. They provide the
technical financial expertise necessary to prepare for expansion and institutional
transformation. They become a priceless and essential resource for the expansion process. ii)
Clients Reached The scaling up of operations is the characteristic that most clearly differentiates
the NGOs that are moving toward financial intermediation. Scaling up refers to gradual but
consistent expansion of operations to reach thousands of small-scale entrepreneurs. Scaling up
leads programs to develop a market perspective and to focus on financial services that respond
to the preferences of their clients. NGOs must maintain clarity about their ultimate oh1ective:
provision of services to the poor. Two indicators assist in determining whether they are lending
to the smallest and neediest borrowers. The average size of a loan indicates who is borrowing.
Small loans tend to reach smaller businesses. Gender is a second indicator. Those NGOs
reaching a significant percentage of women are providing services to the poor, since women
predominate at the bottom of the pyramid of microenterprise production. NGOs coverage must
shift from local to regional and eventually, where feasible, to national Most NGOs open
branches or regional offices in different cities, developing decentralized systems of operation
that resemble bank branches. iii) Sources of Capital The shift from being a donor-funded
organization to being one that blends grants and soft loans with funds borrowed from banks
constitutes the most dramatic change for NGOs. The objective of these organizations is to
eliminate subsidies gradually for their lending operations NGOs moving in this direction
currently borrow part of their funds from banks and still rely on grants and soft money.
Expansion into new areas, for example, continues to require subsidized money. Downloaded by
Nathan Kipchumba (kipchumbanathan030@[Link]) lOMoARcPSD|50379713 74 Access to
borrowed money and the capacity to use it fundamentally change the relationship between
NGOs and donors and between NGOs and financial-sector institutions in their countries, the
challenge for these NGOs is to find effective ways to link up with commercial at sources of funds
and to work with donors and commercial and institutions to overcome the internal and external
barriers that constrain Nods from gaining access to adequate sources of capital. iv)
Methodology and Operations Management The techniques for providing financial services to
the poor pro1iferated in the 1980s, various NGOs demonstrated that one can lower transaction
costs and in maintain high repayment rates while reaching large numbers of people. To move
toward financial intermediation, NGOs must perfect their lending methodology and concentrate
only on financial services. As NGOs move toward financial intermediation, their objective is to
improve efficiency and increase the size of their lending operations rather than experiment with
new methodologies. v) Self-Sufficiency and Financial Standing NGOs on the expansion-led track
are concerned not only with operational selfsufficiency (covering their costs with income
earned) but also with taking on the financial costs of borrowed money The high unit cot of
making very small loans is reflected in the interest rates they charge, which in some successful
programs is 10 to 12 percent above the market rate. The ability to operate at or near level three
of self-sufficiency is one of the most important determining factors an NGOs capacity to borrow
from commercial sources. vi) Financial Management For expansion-led organizations,
investment in effective financial management is essential for continued growth and any move
into financial intermediation. Information systems are at the heart of good financial
management (Christen 1990), An NGO must allocate substantial resources so that its system
provides timely and accurate information, conducts needed analysis of performance, and
generates projections for future planning. vii) Personnel and Staff Development Staff training is
essential to maintain clear objectives, motivate performance, and increase skills. The closer an
NGO gets to financial intermediation, the greater the need Downloaded by Nathan Kipchumba
(kipchumbanathan030@[Link]) lOMoARcPSD|50379713 75 to train its staff. Also, the NGO
will have to combine staff from social science disciplines with finance professionals. Training
must provide both the technical and the social framework to work with the poor in financial
intermediation. The most useful approach to staff training integrates training into ongoing
operations to ensure that staff members receive training in a structured and systematic way. In
addition to training staff in topics related to their specific responsibilities, the NGOs should
upgrade financia1 skills for all staff and in prove their financial management skills. Financial
intermediation requires all staff members to move up the learning curve in these areas.
Program expansion brings with it rapid growth in staff size. 7.2 Challenges for NGOs Choosing
Financial Intermediation Three of the most important challenges are: i) The Social Development
versus Profit Dilemma The NGOs work as development organizations is based on a strong
foundation built on social development and equity considerations. Their priority continues to be
increasing the poor’s access to financial services. In the process, they are entering the world of
financial intermediation in settings where financial systems lack the capacity to reach this
population. By assuming this role, NGOs are incorporating the basic thinking of financial
institutions making loans while reducing risks and charging an interest rate that reflects the
costs of lending into their own social objectives of reaching the poor. The conflict that arises is
quickly apparent. These organizations seek to maintain their social development objectives and
combine them with the profit objective of a financial institution. One challenge for these
organizations is to maintain the integrity of this duality of purpose and not allow one part to
overtake the other. The ownership profile-who invests in these institutions and what values they
bring a shareholders will either safeguard or compromise the social commitment of the
institution. ii) Savings Mobilization Capturing savings is an essential part of financial
intermediation. NGOs have not developed expertise in this area for two reasons. First, they have
always conceived of their programs as lending operations and have concentrated on perfecting
their methodology in this area. Second, as mentioned above, regulatory policies in many
Downloaded by Nathan Kipchumba (kipchumbanathan030@[Link]) lOMoARcPSD|
50379713 76 countries prevent nonprofit organizations from capturing sayings. Finally, some
organizations believe that accepting savings should be a second step because an organization
must first establish itself as a competent lender before it can safeguard the funds it accepts. The
experience of some successful programs shows that savings can be introduced as a compulsory
feature of lending activity. Savings mobilization must become an integral part of an NGOs move
toward financial intermediation. Chose institutions that for legal reasons cannot capture savings
can nevertheless facilitate their clients’ access to formal savings services. Those NGOs that
choose to become financial institutions must recognize that savings should become their major
source of capital. iii) Institutional Sustainability The long-term viability of an organization
becomes much more difficult when donor funds are not the source of capital. Although all
microenterprises NGOs aspire to sustainability, this goal is traditionally seen in the context of
available donor monies. In the case of expansion-led organizations, however, sustainability must
be discussed in the context of decreasing grant funding and increasing borrowed monies or
deposits. If an NGOs borrows money to lend, its continued operation will depend on its capacity
to pay back its loans. Very close supervision of lending operations becomes an important
ingredient for institutional sustainability. The role of the board in this supervisory function is
essential. Review Questions i) Identify the reasons why NGOs choose to the path of financial
intermediation ii) Describe the characteristics for NGOs engaging in financial intermediation iii)
Challenges for NGOs choosing path financial intermediation Suggested Further Reading Maria
O, and Elisabeth R, (2003), The New World of Microenterprise Finance: Building Health Financial
Institutions for the Poor, Kumarian Press. Lee, Nirmala, (2008), Principles of Lending, Global
Professional Publishing Ltd Downloaded by Nathan Kipchumba
(kipchumbanathan030@[Link]) lOMoARcPSD|50379713 77 CHAPTER EIGHT PRINCIPLES OF
REGULATION AND PRUDENTIAL SUPERVISION AND THEIR RELEVANCE FOR MICROFINANCE
ORGANIZATIONS By the end of this chapter the learner should be able to: vii) Define and
differentiate the terms Regulation, Prudential financial regulation, financial repression, Financial
intermediary supervision and Internal control viii) Explain the rationale for regulating depository
financial intermediaries ix) Explain the principles for the regulation and supervision of
depository financial intermediaries x) Describe the frequently adopted instruments of
prudential regulation xi) Discuss the risks of financial intermediation xii) Describe the unique
characteristics of MFOs that require specialized regulation 8.0 Introduction Regulation refers
most broadly to a set of enforceable rules that restrict or direct the actions of market
participants and, as a result, alter the outcomes of those actions. In this sense, regulation may
be performed by the market itself, without government intervention or participation of other
external forces. Efficient markets regulate economic actors by rewarding or penalizing them for
their performance. In principle, an efficient market guarantees that actors who make incorrect
choices eventually go bankrupt. The ability of markets to regulate actions and enforce contracts
should he taken into account in the design of government regulations. The more regulation by
governments imitates regulation by efficient markets, the more effective it will be. Optimal
regulation seeks to replicate the mechanisms of a perfect market. Enforceable public regulation
substitutes the mandates of the government for market incentives. In this context, financial
regulation becomes the coercive imposition of a set of rules that affect the behavior of agents in
financial markets. The replacement of market incentives with government rules that restrict
certain behavior may have either beneficial or harmful effects on the performance of the
economy. Since financial markets have been among the most regulated economic activities in
every country in the world, it Downloaded by Nathan Kipchumba
(kipchumbanathan030@[Link]) lOMoARcPSD|50379713 78 is easy to observe examples of
both beneficial and harmful regulations on the basis of their effects on market efficiency.
Prudential financial regulation refers to the set of general principles or legal rules that aim to
contribute to the stable and efficient performance of financial institutions and markets. These
rules represent constraints placed on the actions of financial intermediaries to ensure the safety
and soundness of the system. This type of government intervention should serve three basic
policy goals: i) The first one, macroeconomic in nature, is to ensure the solvency and financial
soundness of all intermediaries, in order to protect the stability of the country’s payments
system. ii) The second objective is to provide consumer (for example depositor) protection
against undue risks that may arise from failure, fraud, or opportunistic behavior on the part of
the suppliers of financial services. iii) The third goal of financial regulations is to promote the
efficient performance of institutions and markets and the proper working of competitive market
forces. Achievement of the first two objectives of prudential financial regulation is
simultaneous. Once the authorities provide depositors with reasonable protection, the stability
of the payments system is guaranteed. The objective of promoting efficiency, however, implies
increased competition and the possibility that inefficient firms will exit the market. This means,
in turn, that some consumers may be exposed to deposit losses and that some degree of
instability may arise. These seemingly conflicting objectives must be balanced in a system that
allows the market mechanism to work while keeping the system safe. We refer to financial
repression as those forms of regulation that distort financial markets and reduce the efficiency
of their performance. Financial repression encompasses the set of government-imposed rules
whose purpose is to tax or to subsidize financial transactions, thereby redirecting resources
away from market- determined uses. Important tools of financial repression are confiscatory
reserve requirements; interest rate ceilings, inflation tax, overvaluation of the domestic
currency, and excessive restrictions on entry to the market. Other examples are credit subsidies,
through loans Downloaded by Nathan Kipchumba (kipchumbanathan030@[Link])
lOMoARcPSD|50379713 79 granted at below- market interest rates; mandatory credit
allocations that target loans for particular sectors; and usury restrictions, Frequently, some of
the most repressive regulations have been adopted with the best of intentions. In other words,
badly conceived prudential regulations may become repressive. For instance, excessive barriers
to entry into the financial industry are frequently raised with the intent of promoting a safe and
resilient system. Such barriers may shield existing inefficient organizations from competition
from new, more efficient intermediaries. The observed negative consequences of financial
market repression suggest that inappropriate regulation may frequently be more dangerous
than no regulation at all. Financial intermediary supervision consists of the examination and
monitoring mechanisms through which the authorities verify compliance with and enforce
either financial repression or prudential financial regulation. Supervision includes the specific
procedures adopted in order to determine the risks faced by an intermediary and to review
regulatory compliance. Supervision of compliance with rules that promote stability and
efficiency is both desirable and a key component of financial progress. Internal control refers to
the activities undertaken by the owners of a given financial institution in order to prevent,
detect, and punish fraudulent behavior by the organization’s personnel; to ensure that the
financial policies adopted by the owners are properly imp1emented; and to ensure that the
owners’ equity is protected. Internal control activities are, in general, in the private interest of
the intermediary’s owners and normally should not be an overriding concern for the
supervisory authorities. It is important to maintain the distinction among the concepts of
regulation, supervision, and internal control, since each leads to separate policy issues.
Regulation requires, in most cases, a legal framework. Once the appropriate regulation is in
place, supervision may be more discretionary. Although these activities are complementary
(regulation without supervision would be useless), one should be able to identify the separate
virtues and defects of each set of activities in order to focus any corrective actions.
Microfinance organizations (MFOs) are organizations that offer credit and sometimes savings
services to microenterprises and others in poor communities. The Downloaded by Nathan
Kipchumba (kipchumbanathan030@[Link]) lOMoARcPSD|50379713 80 main types of
microfinance organizations include nongovernmental organizations (NGOs) running solidarity
group or transformation lending programs; NGOs sponsoring village banking programs; credit
unions; specialized government banks; and private commercial banks. Regulation and
supervision of each of these MFOs depend first on the types of services they offer, particularly
the nature of their savings services, and second on their ownership and management structure.
8.1 The Rationale for Regulating Depository Financial Intermediaries Depository intermediaries-
banks may be distinguished from other financial institutions by three characteristics. On the
liabilities side of the business, banks issue fixed-value claims, more commonly known as
deposits, to their customers. They carry large amounts of debt, in the form of deposits, as
compared to equity. On the assets side, banks hold a substantial portion of their portfolios as
nonmarketable and risky securities, in particular business and personal loans. The fact that
fixed-value deposit claims are backed by risky loans makes the regulation and supervision of
depository intermediaries necessary (all loans are risky by virtue of their nature as promises to
deliver at a future date). Imperfections in financial markets arise from information asymmetries
among depositors, the financial institution, and borrowers about the likelihood of the promises
being kept. Depositors cannot know as much as bankers about the safety of their deposits, and
banks cannot know as much as borrowers about the likelihood of loans, being repaid. Excessive
risks threaten some of the crucial functions of banks, including the safety of deposits, the
allocation of credit in the economy, the management of the payments system, and the ability to
provide portfolio management and risk-sharing services. Depository financial intermediaries are
particularly important in developing countries, where other dimensions of financial markets are
undeveloped or absent. The nature of the contracts between depositors and the owners of
financial organizations provides ample occasion for opportunistic behavior by depository
institutions. Banks can take advantage of depositors by, for example, investing in excessively
risky loans. Once depositors have supplied the funds, bank managers and equity holders may be
encouraged to greater risk taking, since they keep any extra Downloaded by Nathan Kipchumba
(kipchumbanathan030@[Link]) lOMoARcPSD|50379713 81 rewards while depositors bear
the additional risk. Because deposits carry fixed interest rates, the owners of the depository
institution keep any extraordinary profits if the loans or investments turn out well, but they can
go bankrupt and walk away from losses, This problem is referred to as Moral hazard, which can
be defined as the incentive by someone (an agent) who holds an asset belonging to another
person (the principal) to endanger the value of that asset because the agent bears less than the
full consequence of any loss. This problem of moral hazard is also present between a bank and
its borrowers. This is precisely why banks impose requirements on their borrowers-an example
of regulation through the market. These requirements are voluntarily agreed-to loan covenants
designed to ensure-or at least increase the probability-that borrowers will behave responsibly.
All forms of collateral are examples of such loan covenants. For microenterprises, regulation
through the market often takes the form of collateral substitutes such as group guarantees, the
promise of future loans, or the value of the borrower’s reputation. The market failure that
results from the asymmetry of information between banks and depositors and the associated
moral hazard on the part of banks is significant enough to warrant government intervention.
The difficult question is how best to intervene. A second type of concern that originates from
opportunistic or morally hazardous behavior relates to spillover effects that go beyond the
direct (private) costs faced by the depositors and the owners of a failed depository intermediary
to other depositors and other institutions. There are several ways these spillover effects can
take place. For example, an intermediary that lends to very risky clients would be likely to
charge and receive a high rate of interest on loans. This depository intermediary would, in turn,
be willing to pay higher rates of interest on its deposits. In a competitive market, other
intermediaries would be forced to match the increased deposit rates, covering the increase by
higher interest rates on loans. This price race might escalate the level of risk in the system as a
whole. Alternatively, the failure of one intermediary may cause a panic or run on the deposits of
other intermediaries that otherwise have healthy financial situations. Runs on deposits are
sudden, massive, and unexpected withdrawals that endanger prudent and Downloaded by
Nathan Kipchumba (kipchumbanathan030@[Link]) lOMoARcPSD|50379713 82 imprudent
Institutions alike. Even depositors who have informed themselves about the financial health of
their intermediaries may find it rational to suddenly withdraw their deposits in the expectation
that others are doing so or are about to do so. Q Why it is necessary to restrict potentially
opportunistic behavior and other forms of mismanagement by depository institutions
(preventive regulation) rather than punish them afterwards through the judicial system
(remedial action), as is the case with most transactions in the economy? The combination of the
limited liability and high levels of financial leverage that characterize banks implies that the
amount owners stand to lose is rather small, especially when compared with the size of
potential damages (deposits lost). This supports the case for regulation. The case is even
stronger when the costs from instability of the system are considered as well. In addition, the
lower the likelihood that remedial action will be taken by a court of justice, the more the system
should rely on regulation. There wi1l usually be a multitude of comparatively small depositors,
who may find it too costly to organize together to bring suit. Moreover, the cause of morally
hazardous behavior in bank failures may be difficult to establish in a court of law. When these
general criteria for prudential regulation-from the point of view of consumer protection-are
applied to MFOs, the argument for a solution closer to the preventive end of the scale is even
stronger. It may even imply that some MFOs should be regulated more closely than other types
of depository intermediaries. This is so because in some MFOs, those in control do not own the
capital of the organization, and any negligent action on their part leading to the loss of deposits,
would be punished, at most, with the loss of their jobs. 8.2 Principles for the Regulation of
Depository Financial Intermediaries Economic theory has yet to offer standard principles for the
determination of the optimal degree of regulation. They are very specific in terms of time,
location and institutional structure of the organization being regulated. We can however
present the general principles of regulation as follows: Downloaded by Nathan Kipchumba
(kipchumbanathan030@[Link]) lOMoARcPSD|50379713 83 i) Regulation should attempt to
allow a competitive balance among financial intermediaries- this principal of competitive
neutrality requires, other things that the regulatory environment provides all market players
with a level playing field. ii) The negative effects of regulation upon the efficiency of the
financial system should be minimized- Allocative efficiency requires that resources flow to the
units that offer the highest prospective risk adjusted rates of return. Operational efficiency
requires that the costs of financial intermediation be as low as possible. Finally dynamic
efficiency requires that intermediaries adapt over time to the needs of the users of the system.
Thus good regulation should minimize distortion in each of the areas. iii) The regulation of
financial markets should not be used to promote the achievement of social objectives (for
example poverty alleviation) or to substitute particular sectors of the population or priority
industries- Most often such regulation falls into the category of financial repression because it
taxes the financial system or some of its participants in order to subsidize other sectors of the
economy. iv) The purpose of regulation should not be to avoid bank failures at all costsSuch a
policy objective may not be achievable and to pursue it may induce severe negative effects.
Financial intermediaries that cannot withstand competition or adapt to changing environments
should be allowed to exit without damaging their depositor’s interests r the stability of the
market the objective of regulation and supervision should be to avoid unnecessary bank failures
and to minimize the negative effects of failures that must take place. v) Regulation must rely, as
much as possible, on the self-interest of economic agents- Government regulation should
simulate, as much as possible, the ability of the market to enforce contracts; In general, there
are two possible ways to prevent opportunistic behavior. The first is to keep the discretionary
powers of the intermediary within narrow and closely supervised limits. The second is to rely on
the self-interest of the intermediary by introducing incentives that induce banks to reduce
excessive risk taking. Downloaded by Nathan Kipchumba (kipchumbanathan030@[Link])
lOMoARcPSD|50379713 84 vi) The regulatory framework should not be static; it must recognize
that there will inevitably be innovations adopted to avoid the original regulationEfforts to alter
market solutions through coercive regulation induce innovations to avoid the initial regulation,
such as new products and services (for example, off-balance sheet liabilities or product
substitution. The efficiency of the process of prudential regulation is reduced as such
innovations spread in the market. vii) The regulatory framework should be flexible enough to
regulate different intermediaries in a different manner when necessary- The differences that
may be important for regulatory purposes have to do with the environment in which the
intermediaries operate, the market niches they serve, and their institutional design-property
rights and rules of control over the organization’s assets. For example, a cooperative’s assets are
controlled by the one-personone-vote system, while the corresponding rule for a commercial
bank is one share one vote. The need for flexibility arises because such differences may imply
different types of exposure to risk-idiosyncratic risks-for different intermediaries. 8.2.1
Frequently Adopted Instruments of Prudential Regulation The types and scope of government
regulation of depository intermediaries vary significantly across countries. Preventive regulation
attempts to control the risk exposure of the system in order to reduce the probability of failure
in the aggregate. Protective regulation focuses on assuring depositors that they, as individuals,
will not face losses if a particular intermediary experiences financial difficulties. a) Preventive
Regulation i) Licensing of Financial Intermediaries- Almost every government has restricted the
entry of firms into the formal financial industry by requiring them to obtain a license or legal
charter. From a purely regulatory perspective, the only purpose of any licensing requirement
should be to ensure adequate capitalization and the availability of sound management
Downloaded by Nathan Kipchumba (kipchumbanathan030@[Link]) lOMoARcPSD|
50379713 85 (competence and moral standing), not to limit entry and reduce competition. ii)
Capital Adequacy-The first dimension of requirements dealing with capital adequacy is a pre-
established minimum level of capital required for entry. This is an absolute amount of money.
The second dimension is to require the maintenance of some solvency or leverage ratio; this is a
minimum proportion of the assets of the intermediary. Capital plays two roles. The first one is to
absorb losses on the income account. For moderate losses, capital would allow depositors to
redeem their claims at full value. Nevertheless, due to high levels of debt relative to capital on
the liability side of depository intermediaries) capital does not represent a significant
protection. Even losses that are small as a percentage of assets may wipe capital out. The
second, authentic function of capital in terms of consumer protection is to perform the role of a
deductible, in the sense of an insurance policy. Equity capital is the amount that would be lost
by the owners of the bank in the event of bankruptcy. The larger the deductible (expected
owner losses), the more cautious the behavior of the intermediary (less risk assumed). iii)
Prohibitions on Loans to insiders- One common and very important regulation of financial
intermediaries is to limit the amount of loans that may be, granted to bank insiders (large
shareholders, related companies, employees). Insider loans are usually not properly
collateralized. More importantly, credit to insiders may be used by the intermediary’s owners to
recapture their equity capital, thereby eliminating its function as a deductible. In the event that
insiders receive loans equivalent to a large portion of their capital, they are able to escape their
share of the losses from bankruptcy by falling in default on the loans they have received.
Restrictions on credit to insiders are necessary for the successful enforcement of any capital
adequacy regulation. iv) Diversification Rules- This regulatory constraint is aimed at preventing
an intermediary’s loan or investment portfolio from being concentrated around a few individual
customers or a group of customers that face Downloaded by Nathan Kipchumba
(kipchumbanathan030@[Link]) lOMoARcPSD|50379713 86 similar economic risks, such as
farmers growing the same’ crop. In such a situation, many investments or loans may fail at the
same time, causing sudden deep losses to a system designed to cope with small, regularly
occurring losses. This is a problem for the long-run stability of many MFOs. v) Regulations About
Admissible Activities- Some countries have tried to separate banking activities from non-
banking areas of business. The practical implementation of the regulation has been to prohibit
or restrict stock market and other equity investments by depository intermediaries. However,
direct investment can also pose problems. Credit cooperatives in developing countries, for
example, have invested in and managed all sorts of businesses (for example, grocery stores) side
by side with their financial intermediation operations. This has been an important source of
financial distress for these organizations. Multiple activities seriously endanger the effectiveness
of supervision and risk assessment of financial intermediaries, and hence endanger depositors.
vi) General Powers for the Enforcement of Regulations-The regulatory framework should
provide the supervisory agency with enough authority’ to perform its mandate. Among the
most frequently observed—and needed—general powers granted to regulators are the abilities
to require standard formats for the reporting of financial performance, to restrict or suspend
dividend payments, and to force intermediaries to create appropriate reserves. b) Protective
Regulation The main purpose of protective interventions is to avoid runs on deposits by
removing the incentive for a depositor to be the first one to withdraw funds from a troubled
intermediary. i) Government as a Lender of Last Resort- Governments, most frequently through
central banks, may intervene in financial markets to provide liquidity loans to troubled
intermediaries. This is different from the openmarket operations of the central bank aimed at
increasing the liquidity of the Downloaded by Nathan Kipchumba
(kipchumbanathan030@[Link]) lOMoARcPSD|50379713 87 entire system for
macroeconomic reasons. The idea behind the lender-oflast-resort facility is that there may be
intermediaries that are temporarily illiquid but are solvent and fit for long-term survival. ii)
Deposit Insurance- The main purpose of deposit insurance is to remove the depositor’s
incentive to be the first one to withdraw funds from a troubled intermediary, thereby
preventing mass runs by depositors. This is thought to increase the stability of the system.
However the establishment of protective measures in the absence of prudential regulation and
supervision remove discipline from the market and encourages risks that may be greater than
those resulting from the absence of regulation. It is better to have no regulation than to adopt
protective regulation alone. 8.3 Principles for the Prudential Supervision of Depository Financial
Intermediaries Prudential supervision refers to the process of enforcing the regulatory
framework. Efforts are aimed at monitoring and directing individual intermediaries to ensure
that they obey regulatory requirements and do not behave imprudently. There is little
advantage in having good regulatory policies in the absence of efficient enforcement
mechanisms. There basic principles of prudential supervision include: i) Supervisory activities
should not be used to enforce rules different from those related to prudential regulation- In
some countries, bank supervisors are, asked to verify compliance with tax laws, foreign
exchange controls, central bank reserve requirements, and the like. Additional mandates affect
the ability of supervisors to concentrate on their main task of risk assessment and control
activities, while creating additional incentives for the regulated ones to hide information. ii)
Supervisory authorities should not manage intermediaries- Supervisory activities and
management tasks should be kept separate. Supervision should attempt to make intermediaries
comply with a comparatively small number of clear rules. It should have nothing to do with
personnel management, pricing policies, or even technical operational advice to financial
intermediaries. Downloaded by Nathan Kipchumba (kipchumbanathan030@[Link])
lOMoARcPSD|50379713 88 iii) Supervision requires frequent monitoring- There should he no
extended intervals between supervisory activities. Given that financial contracts involve
maintaining and honoring promises over time, the risks involved in banking change constantly.
Thus, the probability that an intermediary will be able to honor its deposits may change at any
time. iv) Supervision of financial intermediaries should have a significant component of
prediction- The assessment of the risk levels faced by an intermediary should not be based on
past performance alone. Effective supervision requires a better predictive ability than that
provided by the traditional methods of bank monitoring. One suggestion is to undertake
simulations about the performance of intermediaries under different reasonable scenarios, such
as changes in market interest rates. v) Prudential supervision, as the process of enforcing the
law and regulations, should show a high degree of flexibility and neutrality toward charter
arrangements and the market segments served by particular intermediariesQuestions such as
how does a bank examiner estimate the necessary provisions for loan losses in an intermediary
whose portfolio is backed by character references only suggest the need to differentiate across
organizations. Similarly, regulators should be flexible enough to understand that appropriate
delinquency rates may vary with the nature of the clientele and the loan product. 8.3.1 The
Methodology of Supervision An efficient mechanism for the surveillance of financial
intermediaries should have two basic components. The off-site component should be an early-
warning system based on analysis of data reported to the supervisory authority by the
intermediaries themselves. Its main purpose is to provide a frequent depiction of the financial
health and risks of each intermediary. The on-site component involves actual visits to the
intermediaries. On-site supervision is necessary to make those inspections that cannot be
performed by an offDownloaded by Nathan Kipchumba (kipchumbanathan030@[Link])
lOMoARcPSD|50379713 89 site analysis (for example, quality of internal control) and to verify
that the data fed to the off-site surveillance system are correct. 8.4 Risks of Financial
Intermediation There are several common sources of insolvency for financial intermediaries. i)
Credit Risk Whenever a financial intermediary acquires an earning asset, it bears the risk that
the borrower will default, that is, not repay the principal and interest according to the contract.
Credit risk is the potential variation in the intermediary’s net income and in the value of its
equity’ resulting from this lack of or delayed payment. Different types of assets exhibit different
probabilities of default. Typically, loans carry the greatest credit risk. ii) Interest Rate Risk This
risk results from the potential variability in income and equity capital due to changes in the level
of market interest rates. Interest rate risk, together with lack of appropriate diversification, is
the most common source of bank failure in developed countries. This risk originates from the
mismatch of the term to maturity of assets and liabilities with fixed interest rates (that is, from
term transformation). When interest rates rise, intermediaries must pay more for deposits and
short-term liabilities while not necessarily being able to raise their income on longer-term loans
or other long-term assets. iii) Liquidity Risk Liquidity refers to the owner’s ability to convert
assets into cash with minimal loss, that is, the ability to sell an asset quickly without incurring
significant losses. Typically, liquidity is needed to meet variation in depositor demand for
withdrawals. iv) Internal Control or Fraud Risk Internal control risk refers to the variation in
income and equity capital that results from misappropriation of, theft of, or processing errors
against the intermediary’s assets by a customer or employee. Downloaded by Nathan
Kipchumba (kipchumbanathan030@[Link]) lOMoARcPSD|50379713 90 v) Special Risks
Associated With Donors Excessive levels of the risks described above are the most frequently
observed causes of failure among traditional financial intermediaries, as widely discussed in the
literature on finance. All these risks affect traditional intermediaries and MFOs alike. The
literature on finance does not recognize, however, risks that are characteristic of organizations
supported by external donors. One example that is frequent in MFOs but hardly observable in
traditional intermediaries is what may be called subsidy-dependence. Such a risk occurs in an
MFO that is largely dependent on subsidies but mobilizes savings from the public as well. The
problem, from a supervisory perspective, is that reductions in the annual flow of subsidies may
endanger the stability of the intermediary and, therefore, the savings of its depositors. The
supervisor should be concerned with the degree of dependence that a given intermediary has
on volatile and uncertain subsidies (for example, government transfers and donor grants) and
with the potential impact of their reduction or elimination. Another example of these
differences in risk between MFOs and traditional intermediaries is the result of the external
influence exercised by donors or governments. MFOs are often flooded with cheap donor hinds,
accompanied by demands that these funds be allocated quickly. Frequently, donors target
particular clientele without concern about creditworthiness, severely reducing the
organization’s degree of freedom in credit screening. All this imposes severe credit risks on the
organization as it has to abruptly increase its pool of borrowers, frequently from a narrowly
defined subset of the population. Rapid and disproportionate growth in the number of
borrowers is highly correlated with portfolio kisses from default. 8.5 Regulation of Microfinance
Organizations Depository institutions are defined in terms of the structure of their liabilities (for
example, large debt as compared to equity), the fixed-value nature of their debt (for example,
deposits), and the predominance of nonmarketable loans among their assets, Clearly, whenever
microenterprise finance organizations introduce significant savings elements, they resemble
depository financial intermediaries and share many of the characteristics that make regulation
necessary. Downloaded by Nathan Kipchumba (kipchumbanathan030@[Link])
lOMoARcPSD|50379713 91 Thus, as MFOs seek to enhance their savings mobilization efforts,
they must prepare themselves to be regulated and seek dialogue with regulators concerning
appropriate forms of regulation. MFOs have a series of special needs arising first from the type
of financial services they offer, and to whom, and second-from their institutional structures.
Unique characteristics of MFOs that require specialized regulation: i) Collateral and Credit Risk
Many microenterprise loan programs do not require formal collateral. Instead, character-based
loans, group loans and the promise of subsequent larger loans are the main motivators for
repayment. Instead of collateral, the best indicators of portfolio value would be past
performance of the portfolio and current status of arrears. Recent experience has shown that
sound microenterprise loan operations need not generate high delinquency or default rates, but
allowable levels of delinquency and default may need to vary from those sought in more
standard commercial lending. ii) Insufficient Diversification Most MFOs have found it necessary
to specialize in providing one loan product to a limited client group. Specialization has helped
MFOs hone their programs to reach greater operational efficiency, but specialization may also
increase risk, particularly in areas where geographic coverage is limited and risks are highly
synchronized. Village banking programs are highly exposed to this type of risk, followed closely
by credit unions (which are not quite as limited in terms of number of members and which offer
loans for a wide variety of purposes). The benefits of such diversification must be balanced
against the increased difficulty of managing a wider array of activities. In general, the best way
for regulators to deal with the difficulty of diversifying in most microenterprise programs is to
require higher emergency reserves than would be required for standard bank lending. iii)
Ownership and Capital Adequacy As discussed above, equity capital plays the central role in
ensuring that owners have a stake in the solvency of the financial institution, and hence in the
safety of deposits. In most countries, lack of investor capital prevents NGOs from taking savings
(other than limited forced savings from borrowers). This restriction should probably not
Downloaded by Nathan Kipchumba (kipchumbanathan030@[Link]) lOMoARcPSD|
50379713 92 be relaxed unless NGOs are required to maintain extraordinarily high capital
reserve-toasset ratios that can protect against large losses and are subject to stringent
monitoring of their internal controls. For credit unions and village banks the ownership issue is
different. In these organizations, capital is jointly owned by all members. These types of
organizations, the different interests of savers and borrowers have been the source of conflicts.
Particularly when borrowers are the dominant force, decisions may be made that are in the
short-term interest of borrowers, but because they discourage savers, they work to the long-
term detriment of all parties and may threaten the viability of the financial institution. These
conflicts may make these organizations particularly unstable warranting outside regulation and
supervision. iv) Liquidity Risk Small MFOs are likely to be exposed to high levels of liquidity risk,
particularly seasonal liquidity risk. If they are financially solvent and operating in a relatively
healthy financial system, they should be able to deal with this risk through short-term
borrowing and lending. Non-creditworthy MFOs will not be able to solve liquidity problems.
Regulators must ensure that MFOs permitted to accept deposits are able to handle liquidity
risks. v) Costs and Information Practical problems surrounding regulation of MFOs may be
serious. They include the need for regulated MFOs to provide regular, high-quality financial
information and the high cost of supervision (relative to assets protected) of MFOs. vi) Donor-
Related Risks As discussed above, MFOs receiving grants or concessional loans from donors are
exposed to special types of risk, including those arising from subsidy dependence and donor
influence. This list of potential regulatory issues facing NGOs suggests that many MFOs need to
implement significant structural and operational changes before accepting deposits. It also
suggests that some NGOs should decide not to become depository institutions. As more MFOs
reach this threshold, regulatory authorities will also need to consider the changes they can
safely make to respond to the special characteristics of microenterprise finance. Downloaded by
Nathan Kipchumba (kipchumbanathan030@[Link]) lOMoARcPSD|50379713 93 Review
Questions i) Differentiate the following concepts a) Regulation b) Prudential financial regulation
c) Financial repression d) Financial intermediary supervision e) Internal control ii) What is the
rationale for regulating depository financial intermediaries iii) Explain the principles for the
prudential regulation of depository financial intermediaries iv) Explain the principles for the
prudential supervision of depository financial intermediaries v) Describe the frequently adopted
instruments of prudential regulation vi) Discuss the risks of financial intermediation vii) Describe
the unique characteristics of MFOs that require specialized regulation Suggested Further
Reading Maria O, and Elisabeth R, (2003), The New World of Microenterprise Finance: Building
Health Financial Institutions for the Poor, Kumarian Press. Lee, Nirmala, (2008), Principles of
Lending, Global Professional Publishing Ltd David Lawrence and Arlene Solomon, Managing a
Consumer Lending Business, Solomon Lawrence partners Downloaded by Nathan Kipchumba
(kipchumbanathan030@[Link]) lOMoARcPSD|50379713 94 Sample Papers Mt Kenya
University DEPARTMENT OF BUSINESS AND SOCIAL STUDIES Main Examination - May - August,
2010 (Evening Program) BED2202: CO-OPERATIVE AND MCROFINANCE MANAGEMENT Time: 2
Hrs Instructions to Candidates: Answer question 1 (Compulsory) and any other TWO questions.
QUESTION 1 a) Explain microfinance saving principles (6mks) b) Describe the principles of co-
operatives (6mks) c) Briefly explain the institutional structures that organizations may adopt for
microfinancing (6mks) d) Explain the meaning of “prudential financial regulation” and describe
its goals (6mks) e) What are the qualifications for a membership to a co-operative society
according to the Co-operative Societies Act No. 12 of 1997 as amended, in 2004? (6mks)
QUESTION 2 a) Describe the elements and division of responsibility in co-operative
management (6 mks) b) Explain the role of government in co-operative development (14mks)
QUESTION 3 a) Describe the principles of prudential regulation of depository financial
intermediaries (12mks) b) Explain the benefits of institutional saving to households (8mks)
QUESTION 4 a) Discuss the framework for institutional development for microenterprises
(10mks) b) Discuss the role of the government in microfinance development (10mks) QUESTION
5 a) Explain the various marketing decisions that a manager of a local co-operative has to make,
in managing the it’s daily operations (12mks) b) Describe the role of various types of co-
operative meetings (8mks) Downloaded by Nathan Kipchumba
(kipchumbanathan030@[Link]) lOMoARcPSD|50379713 95 Sample Papers Mt Kenya
University DEPARTMENT OF BUSINESS AND SOCIAL STUDIES Special/Supplementary
Examination - May - August, 2010 (Evening Program) BED2202: CO-OPERATIVE AND
MCROFINANCE MANAGEMENT Time: 2 Hrs Instructions to Candidates: Answer question 1
(Compulsory) and any other TWO questions. QUESTION 1 a) Explain microfinance credit
principles (6mks each) b) Explain the role of the extraordinary general meeting of a co-operative
society (6mks) c) What reasons may be attributed to the low savings in rural areas? (6mks) d)
What are the duties of the management committee of a co-operative society (6mks) e) What
are the obligations of a member of a co-operative society according to the Co-operative
Societies Act No. 12 of 1997 as amended, in 2004? (6mks) QUESTION 2 c) Describe the
principles of prudential regulation of depository financial intermediaries (10mks) d) Explain the
functions of an annual general meeting of a co-operative as spelt out by the Co-operative
Societies Act No. 12 of 1997 as amended, in 2004? (10mks) QUESTION 3 a) Explain the various
decisions that a manager of a regional co-operative has to make, in managing the it’s daily
operations (12mks each) b) Describe the risks associated with financial intermediation (8mks)
QUESTION 4 a) Describe the unique risks faced by microfinance institutions (12mks) c) Discuss
the components of the framework for institutional development for microenterprises (8mks)
QUESTION 5 a) Explain the role of co-operatives in social economic development(12mks) b)
Describe the powers and responsibilities of membership in a co-operative society