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As the Microfinance Industry Makes Headway in the Digital Age, What Regulatory Gaps Need to be Addressed?

More and more, technology has aided microfinance organisations to save time, reduce cost and reach individuals in rural areas who were once considered “unbankable”.  The mobile banking revolution, for example, has provided access to financial services through mobile phones, without the need for a developed local infrastructure.  This has reduced the risks of physically carrying around large sums of money and has streamlined loan repayment processes.  However, whilst new modes of banking have brought many benefits, they should also be accompanied by sufficient regulation, supervision and enforcement.  Yet regulators have struggled to keep up with the speed of digital transformation and have often failed to strike the right balance between enabling innovation to improve the lives of financially excluded populations while protecting the integrity of the financial system.  This is particularly the case in geographies where MFIs operate, since those jurisdictions are often under-developed and volatile.  There are limited regulations guiding MFIs on their daily operations and a regulation that exists in one jurisdiction may contrast that in another, making it increasingly difficult for lenders to comply and operate efficiently.

Let’s consider some of the key regulatory issues inhibiting lenders operating in this complex arena.

Regulation Cannot be a “One-Size-Fits-All” Solution

The conventional banking industry must, of course, be scrupulously monitored and regulated.  However, the microfinance sector houses a wide range of lenders and clients and is typically made up of a much larger volume of smaller, shorter-term and unsecured loans.  The fabric of this industry is therefore fundamentally different to that of conventional banking and should be treated as such in the eyes of the law.  MFIs also come in various sizes and formats including non-profit NGOs, investment funds and private companies and they operate according to diverse and varied lending practices and social missions.

For these reasons, applying overly draconian prudential regulation should generally be avoided, but softer legislation which accommodates the diversity in the microfinance industry is necessary to ensure consumer protection.  As things stand generally, lenders often face difficulty against existing prudential regulations since they fetter the ability of lenders to make microfinance loans.  For example, reporting requirements are often burdensome and it is not feasible to generate the same loan documentation and reporting required of commercial banks, as this will potentially drive lenders out of the market altogether.  Loan reporting and other prudential regulations must be simpler in the microfinance sector, unless the size and operations of an MFI justifies otherwise, to prevent barriers to entry.

 Consumer Protection Must Be Proportionate

A proportionate risk-based regulatory approach must balance financial inclusion and financial stability with consumer protection.  However, typically, the jurisdictions in which MFIs operate lack the relevant or adequate regulation.  Robust yet proportionate consumer protection requirements will protect groups of people who are new to formal financial services and relatively unsophisticated from potential abuse.

For example, data security risks must be managed appropriately.  Regulation should fous on operational or cyber threats, risk management rules for third party vendors (including cloud computing providers, data storage and data processing services) and should require a minimum standard of insurance against cyberattacks, business interruption and recovery.

Regulations governing data protection are also key for striking the correct balance between, on the one hand, protecting customer data from excessive collection and unauthorized disclosure and respecting customers rights to privacy and, on the other hand, driving innovation and client-centric product development based on digital data.

Proportionality within consumer protection frameworks must be achieved to avoid creating excessive compliance costs that could deter whilst offering comprehensive solutions for transparency, recourse, fair treatment, consumer funds protection and responsible lending.

Liquidity Requirements Should Offer Greater Flexibility

Due to the higher risks of failure with MFIs, regulators frequently impose higher minimum capital requirements (MCRs) on MFIs than those imposed on traditional commercial banks.  It is also common for MFIs to maintain a significant proportion of assets in liquid assets.  If set too low, these reserve requirements would jeopardise the overall financial soundness of the system, however, where reserve benchmarks are set too high, lenders are deterred from entering the sector and, ultimately, it is the poorer communities who are most harmed.  Where MCRs are high, MFI capital is largely funded by equity or subordinated debt.  This in turn severely limits flexibility and return on equity, ultimately stifling progress for MFI clients.

Microfinance has the potential to transform individual lives as well as the world economy.  The sector has also witnessed year-on-year growth and, with the world learning to adapt to a post-COVID reality and businesses returning to normal, this trend is likely to continue.  It is therefore vital that lenders operate comfortably within the jurisdictions that attract these kinds of schemes.  Now is the time for regulators to catch up and put appropriate rules and guidelines in place, including MFI-specific legislation, adequate consumer protection laws and greater flexibility on capital reserve requirements.





This article was written by: Robert Gross, Partner and Head of Finance