Rules put micro-lenders in better shape: study

MA Baqui Khalily

Government rules regulating microfinance institutions have made the micro-lenders cost-efficient, given them credibility and acceptability and paved the way for developing a market-based inclusive financial system, a study found.
"Considering the results, we strongly conclude that regulation does have a positive impact on cost efficiency," said Professor MA Baqui Khalily, executive director of Institute of Microfinance (InM), who led the study.
The study -- Regulatory Compliance and Impact of Regulation on Cost Efficiency of MFIs in Bangladesh -- attempted to assess the impact of regulations set by Microcredit Regulatory Authority (MRA) on the cost efficiency of the MFIs.
InM, a non-profit organisation established primarily to meet the research and training needs of national as well as of global microcredit and related poverty reduction programmes, conducted the study.
In 2006, Bangladesh became the first country in the world to establish a separate entity, MRA, under a separate act to license, monitor and oversee MFIs, as microfinance had been a private sector initiative all along and flourished without any formal regulatory entity from the government in most parts of the world.
Though Bangladesh has been the pioneer of microcredit, it lagged behind some countries in enacting a regulatory framework for this sector.
Since its inception, the state-run organisation has enacted a number of regulations.
The study report said prudential and non-prudential regulation in the microfinance sector can work for cost efficiency and it works better if MFIs possess some prior experience of regulatory procedures.
A system of regulation and supervision is an important step towards developing a market-based inclusive financial system, it said.
Dr Muhammad Abdul Latif, director of research and knowledge management of InM, Md Abdul Khaleque, senior research associate, Md Mehadi Hasan, senior research associate, and Syed Badruddoza, research associate, co-authored the study under the leadership of Dr Khalily.
A major argument for regulation is improving efficiency of the institutions, in addition to protecting the interests of the microfinance members and borrowers.
So far, MRA has enacted several prudential and non-prudential rules and regulations, with capping the interest rate at 27 percent being the most important.
The study, which examined data provided by 182 partner organisations out of the 649 MFIs who got the licence so far in Bangladesh for the period from 2006 to 2011, showed that all the MFIs had gained after the regulation.
The report said staff productivity, defined as the number of members per staff, has increased. Similarly, the average loan size has also increased compared to pre-regulation times.
Staff productivity and the average loan size were higher for the older licensed MFIs than the recently licensed ones.
The study found the inefficiency score to be higher for the newly licensed MFIs; older licensed MFIs were relatively less inefficient.
The average inefficiency score reduced for the MFIs licensed in 2007 and 2008 by about 36 percent at the end of 2010-11. It was 11 percent for the MFIs licensed in 2010.
"Similarly, we found that the extent of reduction in cost inefficiency was higher for the large MFIs," said Khalily.
The study found that regulation reduces cost inefficiency of MFIs by around 2.8 percent a year.
Regulation is likely to affect inefficiency through an improved organisational and operational environment and indirectly through an increase in productivity with cost efficiency by about 0.36 percent a year.
First, it does establish that regulation matters in better performance and MFI efficiency, but to develop a sustainable and competitive microcredit sector, regulation should be friendly so it is not counter-productive in the long-run.
Secondly, regulation has led to a change in the behaviour of the MFIs.
Since, the average loan size has increased since lending interest rates were capped and different deductions from loans were either restricted or withdrawn, an increase in the average loan size might indicate a shift from social objective to commercial objective in order to cope with the expected fall in revenue.
"If it does, this will be the indirect cost of regulation. There has to be a trade-off between social objective and commercial objective," said Khalily.
The third implication, the report said, is that regulation should make the microcredit market competitive.
"It is more likely that smaller MFIs will have a lesser ability to cope with regulatory requirements. They appeared to be relatively less cost efficient. Some smaller MFIs might be able to grow but there will be others that might falter."
"In such a situation, it will not be unlikely that a merger of some small MFIs might take place. While merger and acquisition should be allowed in the microcredit market, MRA should have a stated policy so that it does not have any bearing upon institutional lenders and members," said Khalily, who also teaches finance at Dhaka University.
The first major work in Bangladesh that has addressed the question of an impact of regulation on cost efficiency of MFIs in Bangladesh shows that regulation has caused a significant change in the practice of MFIs charging various fees from clients.
Prior to the MRA rules, few organisations followed the practice of charging a maximum of Tk 15 from a client at the time of granting a loan, charging a maximum of Tk 50 for non-judicial stamp fees for a micro-enterprise loan and allowing a rational rate of rebate for repayment of outstanding loans; but after the rules came into place, the number of institutions complying with the rules increased from 25 to 35 percent, from 22 to 75 percent and from 27 to 72 percent respectively.
The most remarkable change has occurred in the practice, procedure and term of micro loans.
The MRA regulation requires that the grace period must be 15 days. The practice of MFIs using the 15 day grace period has increased from 22 percent to 88 percent.
In the case of weekly repayment of loans, MRA has set the number of instalments at 46, and the proportion of MFIs allowing these instalments has increased from 45 percent to 87 percent.
The number of organisations who have shifted from the flat method of calculating interest rate to the declining balance method has dramatically increased to 77 percent from a paltry 4 percent.
Still, nearly 23 percent organisations are still sticking to the flat method, according to the study.
Due to the change in the calculating method, the overall interest rate has gone down to some extent after the MRA licensing.
"This is an important positive effect of the MRA regulation on the interest rate. This change has welfare implications for clients," said the Dhaka University professor.
The study said about 70 percent of the MFIs are currently following the rules on internal audit -- 7 percentage points higher than the pre-regulation era. Still, 30 percent organisations are not complying with the regulation.
However, the study finds poor compliance with rules on compulsory savings. Previously, the proportion of organisations doing no upfront deduction was 32 percent; now it has only increased to 40 percent.
Despite initial hue and cry from the MFIs over the MRA, most organisations perceive that the licensing has enhanced their reliability and social acceptability -- a very important aspect for the under-pressure industry like their global peers, as they are regularly accused of over-charging.
Khalily said compliance with MRA licensing also brought economic benefits for the MFIs, who have been able to receive more bank loans, grants and loans from Palli Karma-Sahayak Foundation, a state-run organisation, at reduced interest rates.
Khalily said MRA needs to hold regular dialogues with users, especially the MFIs, to make necessary revision in the existing rules to make them relevant and effective.
"The authorities also need to strengthen supervision over the organisations who still have not complied fully with all regulations."

[email protected]