How microfinance regulation is different from normal finance regulation?

An interesting paper from M. Sahoo, Renuka Sane, Susan Thomas.

They say there are two basic differences between normal and micro-finance.  These differences are credit recovery and the credit risk of the Microfinance institution (MFI), when credit access is enabled  through the structure of the joint liability group (JLG).

First, the issues wrt credit recovery.  In normal credit things are clear,  borrower has the obligations and the service provider (the lender) has the rights. So regulation looks at two issues – of consumer protection and debt collection. In microfinance because of JLG, things get complicated:

This becomes more complicated when credit is given through a JLG structure. Here, the code of conduct needs to account for more than just the link between the service provider (the MFI as the lender) and the customer (the borrower who is an individual in a JLG). There are two more links to account for, which are:

  • The link between the member of the JLG and the JLG itself, and
  • The link between the MFI and the other members of the JLG, when one member defaults.

Hence you need protection at three levels:

  • The rights of the borrower against the MFI,
  • The rights of the JLG against the MFI, and
  • The rights of the individual borrower against the JLG, either individual members like the group leader, or as a whole.
In terms of credit risk, lenders look at creditworthiness  etc of  borrower. Here again because of JLG things get complex:

The first relates to correlated defaults associated with homogenous credit quality. It can be argued that there will always be a higher degree of homogeneity when lending to di fferent members in a group { whether the members are from the same cultural background, physical location, risk preferences, political preference etc. The commonality of these factors in a group can lead to correlated changes in the level of default, as was seen in the case of wilful defaults among micro-borrowers of the same community in the Kolar district in 2007. These defaults caused a rise simultaneously in all the MFIs that were operating in this district at the time.

The second path through which the JLG structure of lending could enhance the systemic risk of the MFI industry is because a group could be an easier channel for political action to be eff ective deployed. Previous episodes have all shown that the greatest source of vulnerability of the MFI industry is the political risk that is faced by rms working with the poor. In such cases, political action has been known to influence the micro-borrower to default on their contract without fear of action from the lender, the MFI. Just as the JLG can engender better credit behaviour from their members, the structure can be equally e ffective in encouraging group-level default. This is a core risk that the MFI industry will inevitably face, and needs to be monitored through JLG level tracking by the regulator using data from the credit information bureaus.

These two ideas credit recovery and risk need to be embedded in the new law. They propose a new bill and a new regulatory agency to help get this micro-credit market kicking again…

Hmm… Brings some clarity to the micro-finance sector issues…But then I think the sector also became a bit of too much excesses…It has got a reality check and with proper regulation and guidance, the sector could help. But then the biggest think to remember is there is no one remedy to alleviate poverty. You need many other measures to address poverty and micro-credit is just one of them…

Somewhere down the line the recent issues with microfinance sector show that effective regulation is important. Now I am not arguing for an AP govt kind of regulation but a more centralised regulatory system. SKS microfinance case shows that corporate governance failure could ruin what was once seen as a path-breaking company. The regulators need to wake up before some bigger crisis happens in the industry…

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One Response to “How microfinance regulation is different from normal finance regulation?”

  1. Amelie Says:

    Spot on with this write-up, I honestly think this amazing site needs a great deal more attention.

    I’ll probably be back again to read more, thanks for the information!

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