PRUDENTIAL REGULATION OF MFIs

Prudential Standards and Ratios Presented by Fatou Deen-Touray, Deputy

Director, Microfinance Dept. Central Bank of The Gambia

1.INTRODUCTION

1. In many, if not most developing countries, microfinance has grown to a point where financial regulators see the need to develop policy frameworks to guide the operations of service providers and eventually to integrate some aspects of the microfinance spectrum into the framework of financial services institutions.

2. Prudential regulations as generally defined are the application of financial norms

and procedures by the regulator to guide the activities of financial institutions in the market. Regulations are implemented through supervisory instruments that provide oversight on the activities of the regulated institutions.

3. Sound regulatory policies not only promote adherence to standards based on

best practices but also promote the development of institutions and industry towards sustainability in the long run.

4. This is even more imperative as MFIs and particularly Credit Union portfolios

continue to grow faster than their institutional capacities to deliver financial services to its members. It is quite obvious that the six largest credit unions now control over 80 % of deposits mobilised through the credit union network.

Cont.

3. In determining the regulatory and supervisory structure to be applied to the microfinance markets, policy makers need to note the following issues:

i. That it is important to be clear about the rationale for regulating MFIs. There by, they can formulate a general approach to the regulatory framework and off-shoot guidelines to govern the various institutional types.

ii. It is important to define the market in terms of how MFIs

fit into a tiered financial services structure, how microfinance is defined and which kinds of institutions are regulated and by whom.

Cont.

iii. The general structure must be translated into specific prudential norms, supervision and reporting systems, and rules governing entry and operations of MFIs.

vi. Lastly the implementation of the set of norms and systems must be designed to make them easy to administer with the necessary resources available to ensure proper implementation.

2. RATIONALE FOR REGULATIONS

1. Generally commercial funders, shareholders and depositors clearly have an interest in monitoring what happens to their fund.

2. The excessive profit participation of owners and

management of financial institutions makes it risky to leave them entirely to market forces un-monitored, with losses when they occur are paid to their capital share.

3. Against this back-drop, depositor protection is introduced

as the most important overall aim of prudential regulation.

Cont.

4. Depositors can hardly distinguish between temporary illiquidity and severe solvency because of the asymmetry of information between financial institutions and savers. Hence once a significant number of depositors withdraw their funds it can lead to instability through a run or liquidity drainage on the financial institution as well as other institutions. The need to reduce systemic risk and ensure stability of financial institutions is an other rationale for prudential regulation.

Cont.

5. It is essential to regulate in order to ensure a competitive market structure which borders on the safety and soundness argument. A stable financial system is based on financial institutions striving for efficiency while competing for their customers with application of appropriate products and services in a level playing field.

3. THE LEGAL AND REGULATORY ENVIRONMENT FOR MFIs

1. The legal and regulatory environment is governed by:

i. The Constitution supercedes all legal pronouncements

ii. The financial sector Acts including the FIA Act 1992, Central Bank Act 2009, Macro-policies for NBFIs, Rules and Guidelines 1992, NBFI Bill 2008 (NBFI Act when ratified) governs NBFI operations and regulated deposit taking institutions.

iii. Cooperative Act governs cooperatives.

3. PRINCIPLES IN PRUDENTIAL REGULATION (Core Basel)

1. Powers for Authorisation: i. There should be clear mandates, responsibilities and

objectives for each authority in the regulation and supervision process, including operational independence, transparent processes, sound governance and adequate resources for it to be accountable in its discharge of duties.

ii. Regulators must have the power to enforce compliance

with relevant laws, safety and soundness and legal protection of supervisors. Authorities must have legal capacity to share information while protecting confidentiality of such information.

Cont.

2. Permissible Activities: i. Activities of licensed institutions subjected to supervision must be

clearly defined and terminology used to describe the institutions undertaking such activities (credit unions, SACCOs, Caise Populaires, VISACAs, etc) must be restricted and controlled by the regulatory authority.

ii. The supervisory authorities must have the power to enforce against the use of the restricted activities by unlicensed entities.

iii. Business powers and permissible activities should be proportional to the institution’s size and ability to manage the risks inherent in such services and compatible with its business.

Cont.

3. Criteria for licensing: i. Supervisory authorities must have the authority and

power to establish and enforce the required criteria for licensing entrants.

ii. At minimum, the licensing process should consider

ownership, governance, fitness and appropriateness of board members and senior management , strategy, risk management, etc.

iii. The list should consider additional criteria needed to

facilitate effective supervision in their jurisdiction.

Cont.

4. Ownership: i. Supervisory authority should ensure the

structure of any proposed institution complies with its principles (e.g. a cooperative, commercial, self-help, non-profit etc), recognising that some 2nd tier organisations have proportional voting for their members.

ii. It is not proper for any individual or group of

individuals to be in a position to exercise control from a minority position.

Cont.

5. Capital: i. Appropriate capital enforcement and compliance to the

framework for all regulated institutions. For cooperatives the rules should balance cooperative principles with the need to protect depositors.

ii. Regulators/supervisors will have to carefully consider what meets

criteria for capital and to ensure that capital instruments are able to absorb losses in the event of failure.

iii. To adopt Basel standards to the capital requirements of credit

unions, a simplified approach may be adopted for small credit unions that are not allowed to hold complex financial instruments as compliance with the most advanced risk techniques may be beyond their resources.

Cont.

iv. Three Capital regimes set by the CBG: • Minimum capital requirements for MFIs range from D100, 000

for VISACAs to D10 million for Finance Companies: serves as start-up for business and is adjusted in line with the level of deposits mobilised by the institution.

• Capital adequacy is the percentage of the institution’s risk

weighted assets (credit exposures) against equity. It measures the institution’s ability to absorb reasonable level of losses before becoming insolvent. The CBG recommend 16 % of total risk weighted assets for MFIs.

CAR= Total Risk Weighted Assets/ Total Equity

Cont.

• Gearing ratio: The gearing ratio indicates the leverage level, where debt is used to finance operations. A high gearing may lead to the institution not being able to meet loan repayments to lenders.

Gearing ratio = Long term debt + short term debt +

bank overdraft/Shareholder Equity.

The level of debt to equity (gearing) of the institution

should not be more than 10 times.

Cont.

v. Consequently regulators may look for additional capital to support the limited information that may be available to the supervisory authorities.

6. Risk Management:

Adequate and appropriate risk management

processes and systems to identify, monitor and

evaluate, manage and control different risks to

which the institution may be exposed.

Cont.

i. Credit risks: may be the most significant risk for cooperative financial institutions. Hence it should be ensured that regulated institutions have appropriate policies in terms of their accepted risks in specific activities and adequate strategies to manage such risks (monitoring of credit portfolio, appropriate lending policies, collection of distressed facilities, appropriate write-offs, etc).

The Portfolio at Risk is a useful measurement in assessing the quality of the

portfolio s measured by the outstanding portion that is overdue more than 30 days. PAR above 30 days due above 5-10 % is a sign of trouble in microfinance

PAR = Total unpaid principal balance of all loans with payments past due/ Total

gross outstanding loans. The Central Bank recommends a PAR of not more than 5% for MFIs. ii. Interest rate risks: regulated institutions must have management policies

especially on fixed rate lending portfolios.

Cont.

iii. Operational risks: risks management policies to mitigate operational risks including systems failures, technological, administrative constraints, fiscal and tax requirements etc. 7. Provisioning for loan losses: Institutions must adequately provision for loan losses and other impaired assets. The CBG recommends provisioning for loans that are 30 days overdue. The loan loss ratio is a percentage that reflects accumulated provision expenses (minus write-offs)

and gives an indication of the management’s expectations of future loan losses. It is a rough indicator of the overall quality of the portfolio.

Loan Loss ratio = Principal Amount Written-off during period/ Average Outstanding Loan Portfolio. 8. Large Exposures (Concentration risk): set rules and guidelines around the definition and limit of large exposures to which regulated institutions are exposed and the powers to intervene where such rules are breached. The CBG focuses on the level of exposure to the 10 largest depositors and 16 largest borrowers.

Cont.

9. Conflict of interest and related party exposures: Regulated institutions require rules on disclosure and reporting of such transactions to control breach of such prohibitions.

10. Liquidity Management: i. Regulated institutions must have strategies and contingency plans

including central bank borrowing, standby facilities and or liquidity reserves ( in a regulated central finance facility for Credit unions).

ii. Authorities must have the power to intervene when there are liquidity

risks including excessive funding or poor liquidity position.

iii. The CBG sets the liquidity ratio for MFIs at 15 - 40 %. Liquidity ratio = total liquid assets / total deposits.

Cont.

12. Appropriate level of Internal controls commensurate with the size of and complexity of the institution and its activities., including delegation of responsibilities, authorisations, segregation of duties, reconciliations.

13. Regulated institutions must have good policies and procedures including KYC rules to avoid being unintentionally being used for criminal activities including money laundering.

Cont.

14. Internal Audit: adequately qualified, independent and adequately resourced to carry out oversight function and must have direct access to the Board. The Internal auditing scope must look at efficacy of operations, reliability of financial reports, detering and investigating fraud, safe-guarding assets and compliance with laws and regulations.

Cont.

15. Regulators and supervisors must have unfettered access to all aspects of regulatory requirements and the power to enforce access where necessary.

16. The supervisory authorities must develop and maintain a thorough

understanding of the operations of individual regulated institutions and should deploy an effective and on-going combination of Off-site and On-Site supervision techniques. This needs adequate resources including qualified and independent staff to carry out supervisory functions.

17. The authorities should have the ability to collect, review and

analyse periodic submissions of financial and or statistical returns from regulated institutions. It should also have the ability to independently verify offsite returns.

Cont.

18.Regulated institutions should maintain adequate records that have been prepared in accordance with the relevant accounting laws in their jurisdiction. 19. An Adequate range of enforcement tools to facilitate timely corrective action should be at the disposal of supervisory authorities including legal orders, to revoke licenses or to recommend revocation, imposing restrictions on activities

and operations that contravene regulations.

SUMMARY

1. Legislation and regulation of financial institutions constitute the legal framework and governing principles of financial institutions in The Gambia.

2. They define the roles of the banking authority, Central Bank, set the rules for entry and exit of various institutional types, determine and limit their scope of operations and services and products, specify criteria and standards for the sound and sustainable development of the industry.

3. Regulation are not only limited to rules set by the state only but can include self regulations by networks, associations, apexes, etc.

Cont.

4. The need to protect depositors is a major reason for regulation. Since the interest of financial institutions and investors and savers are not congruent per se, it requires the intervention of a third party, the regulators to regulate and guide the soundness of a country’s financial system albeit the need for specific regulations for different institutional structures of the financial landscape. 5. It is important to note that regulation promotes financial sector development, but there needs to be a balance between the stability of financial markets on the one hand and the efficiency of the industry on the other.

6. In principle the BASEL Core Principles can be applied to the regulation and supervision to all kinds of financial institution. The Gambia implementation of CBG regulatory and supervisory framework is largely based on these Core principles especially large deposit taking MFIs financing operations from the mobilisation of public deposits.

CONCLUSION

1. Microfinance is unlikely to achieve its full potential unless it is done in a regulated or licensed environment. 2. The question about the role of regulation and supervision will

continue but in many developing countries the major problem for institutional viability and sustainability is not because of regulations rather is underpinned by the lack of adequate institutional capacities by the myriads of stakeholders especially MFIs.

3. Capacity building is therefore a sin qua non to the development of

the sector. Specialisation and the tapping of stakeholder comparative advantages will add more value to service delivery.

Cont.

4. The notion that regulation will automatically lead to sustainable institutions must be view cautiously. It is with this realisation that the Central Bank is encouraging stakeholder collaboration in building viable, sound and sustainable institutions including credit unions. 5. The regulatory anomalies that impede the development of

credit unions including lack of proper regulatory guidelines, lack of institutional capacity to regulate credit unions, poor governance and management of the unions and the management lapses of some of the largest credit unions has drawn real cause for concern by the regulators.

END OF PRESENTATION

THANKS FOR YOUR ATTENTION