The Guardians of Microfinance

How good supervision can assist microentrprises

If you are a microentrepreneur who runs a business out of your home, bank supervisors and financial regulators may seem like distant figures; people who spend their days leaning over large desks fussing with unfathomable numbers. In fact, when supervisors and regulators do their job right, they can save money for the microenterprises that provide a livelihood for millions of families in Latin America by creating conditions for interest rates and banking fees to drop and credit to expand.

Similarly, if you were one of thousands of small depositors in Latin America who had lost their life's savings in one of the scores of frauds and collapses of credit unions, cooperatives and savings institutions, you would prize good banking supervision because, when done right, it would protect and preserve your savings from mismanagement or outright theft.

As microfinance institutions have grown and evolved in the last decade, banking supervisors are focusing more attention on these small players in the finance industry, which include cooperatives, credit unions and microfinance institutions. The role of supervisors is to make banks safe for depositors and to improve banking services for clients.

The microfinance industry in Latin America stands to gain a lot from proper supervision carried out in the right regulatory environment. The watchful eyes of informed supervisors can strengthen good practices in microfinance; allowing microfinance institutions to continue expanding, remain solvent and become more competitive, offering better services for clients at reduced cost.

|interview| Ramón Rosales President of International Consulting Consortium of Hollywood, Florida...

In Latin America, supervision and regulations have a long way to go before they can create the nurturing environment that will allow microfinance to flourish and provide competitive services, says Ramón Rosales, president of International Consulting Consortium of Hollywood, Florida. "Supervisors need to open their minds to the specific requirements of financing informal businesses and non-salaried workers," says Rosales, himself a former banking supervisor in Peru. For their part, microfinance institutions must help educate supervisors about the lending culture and techniques that have worked successfully with their clients.

Microcredit is set apart from conventional banking by several unique features, and this makes it imperative that supervisors become familiarized with the peculiarities of banking at the lower reaches of the economic hierarchy. Microcredits are targeted to people in the informal sector of the economy, that is, non-salaried workers who cannot offer real guarantees and do not keep formal accounts of their economic activities. "Microfinance institutions (MFIs) gather information about their clients by making personal visits to microenterprises or their owners' homes to see first-hand the assets of the business, determine the cash flow and expenses and evaluate the character of the client," Rosales says. Another distinct feature of microfinance is that its operations are highly decentralized, with most credit decisions being taken by committees of loan officers and managers of branch offices located in poor neighborhoods or rural communities. In practical terms, this means that "supervision must focus on evaluating how the administration of MFIs identifies, measures, controls and monitors risk among their numerous clients on a daily basis," says Rosales.

At this time when supervisors and microlenders are still getting to know each other's business, Latin America presents a diverse array of regulations for microcredit—and quite a few gaps. Most countries have no regulations for microcredits: small, unsecured personal loans to people with no financial records or credit history, for amounts usually below $1,000. Some countries make a distinction between microcredit and consumer credit, some measure credit risk by looking only at delinquent loans while others consider that the size of delinquent loans must also be taken into account to determine the portfolio at risk. Another measure used in some places is to quantify loan restructurings and refinancing in the credit portfolio.

These gaps will have to be filled not only to make microfinance safe for depositors but also for the growing number of national development banks and commercial banks that make loans to finance the lending capital of MFIs. This would help put microfinance more in line with the worldwide trend in conventional finance towards a tightening of supervision.

|sidebar| Basel I and II The first international accord on bank regulation and supervision went into effect in 1988...

The agreements of Basel II, a set of principles adopted in June 2004 by many countries governments, sets a uniform method for all conventional commercial banks to measure risk. Basel II promotes a "culture of administration of risk, more effective supervision and market discipline," says Rosales. The agreements require that, by the end of 2006, banks and bank supervisors measure two types of risk: operational risk and market risk. Operational risk refers to deficiencies in systems of managerial and administrative information, deterioration of lending methodology and weaknesses in internal controls. Market risk refers to issues like long-term microcredits financed with volatile or short-term deposits. Controlling both types of risk is emphasized in Basel II.

While Basel II will not be required for microfinance institutions at least for some time, these principles will set a new standard for banking operations. Therefore, supervisors will be looking at microfinance with the perspective of the Basel II wide-ranging concerns about risk.