Basel II standards tailored to microfinance

Once Basel II, an international agreement on banking regulation and supervision, is implemented, financial institutions in the signatory countries will have to increase their minimum capital requirements.

Although many microfinance institutions are unregulated and therefore not required to meet any standards, banks and other financial institutions that provide microfinance may eventually have to operate under a regulatory system that includes the Basel II standards.

For financial institutions with a large microcredit portfolio, however, the Basel II capital requirements are lower. According to regulatory expert Ximena Arteaga, under Basel II, financial institutions that lend to micro, small and medium-sized enterprises (MSMEs) will be subject to lower minimum capital requirements because the type of lending they do is weighted at a lower percentage than lending to large companies when their capital ratio is calculated. This is the basic approach used, explained Arteaga, not taking into account other factors.

Lending to MSMEs is subject to lower capital requirements than lending to large companies, said Arteaga. Loans below one million euros, she explained, will be weighted at a lower percentage. “So banks and financial institutions—which are not necessarily large companies—that primarily lend to MSMEs will have lower capital requirements.”

The purpose of Basel II, explained Arteaga, is to establish a more logical, more realistic correlation between the minimum working capital of a bank and the type of business it conducts.

The first draft of the Basel II standards applied to all financial institutions, prompting concern on the part of microfinance institutions and the enterprises that receive loans from them. That was one reason why the Basel Committee decided to establish two separate categories of lending, one for loans to large enterprises and one for loans to MSMEs.

For example, FINCA Ecuador is a financial institution whose portfolio consists exclusively of microcredits averaging around $300 each. If the Office of the Bank Examiner in Ecuador applies the Basel II standards, the minimum capital requirements for FINCA will be lower than the ones for a bank with no microfinance portfolio.

The road to Basel II in Latin America and the Caribbean

According to the 2005 Economic and Social Progress Report, entitled Unlocking Credit—The Quest for Deep and Stable Bank Lending , implementation of Basel II will not be considered mandatory in Latin American countries. The Basel Committee, the International Monetary Fund and World Bank have all suggested that developing countries will likely need more time to implement Basel II than the 2006 deadline established for developed economies, the report says.

The Basel II agreements, explained Arteaga, will be adopted by each country individually. “Each country will decide when to adopt the measures, but financial institutions can start adjusting to the requirements that are eventually going to be established,” she said.

Basel II cannot be imposed. Each country will subscribe to the agreement and adopt the proposed standards in accordance with its needs, said Arteaga, adding that the measures can also be phased in.

But there is keen interest in Basel II. Most of the countries want to adopt the new standards because otherwise their financial sectors will be less competitive in the global market, Arteaga pointed out. For example, at the VII Inter-American Forum on Microenterprise , held in September 2004 in Cartagena, Colombia, the Office of the Bank Examiner of Colombia reported that it was already preparing to implement the Basel II standards for supervision beginning in 2006.

However, the countries may vary in how quickly they adopt Basel II. It is important to bear in mind that the Group of Ten industrialized countries recently agreed to implement Basel II in 2006 and 2007. Latin America is likely to adopt the principles towards late 2006 and in 2007, said Arteaga.

Interestingly, she noted, in Ecuador and other countries even organizations like FINCA Ecuador are now conducting much more rigorous technical risk assessments, calculating both credit and operational risks according to official government standards. And Basel II precisely requires much more in-depth reviews, using technical measurements rather than a banker's intuition to draw conclusions.