Regulation of microfinance institutions

A recent briefing for the press on a recent cabinet meeting and the decisions taken referred to the introduction of legislation to regulate microfinance institutions to ensure financial stability in that sector.

This is the third attempt to have draft legislation prepared. The first attempt was totally rejected by stakeholders in the microfinance sector. At a Sanvadaya organised by the Pathfinder Foundation, the microfinance (MFI) practitioners condemned the draft, which among other things, attempted to delegate to Divisional Secretaries the power of regulating MFIs and contained many other proposals which were unacceptable.

The infusion of politics into the Divisional Secretariat, over the last few years, it was felt would result in the regulation of MFIs becoming totally politicised and the whole industry being jeopardised.

The Central Bank of Sri Lanka (CBSL), which presented the draft, then went back to the drafting board and came up with a second draft, which set up a Microfinance Regulation and Supervisory Authority. This draft was placed on the website of the Central Bank, and there was much stakeholder discussion in the public domain, including in this column, on the merits and demerits of the Bill.

The second draft had a number of weaknesses; it attempted to restrict the geographical area of operation of certain MFIs. It also attempted to curtail the MFIs’ access to foreign funds. It left out completely two big players in the sector: Samurdhi and the cooperatives. There was a great deal of public discussion on this second draft as it was available on the CBSL website, which was a very welcome step in the interest of transparency. Now this second draft has been dropped.

The third draft Bill

The Cabinet Spokesperson stated that in terms of the third draft Bill, a three-tier system of regulation is envisaged.

While the Monetary Board of the Central Bank of Sri Lanka (MB-CBSL) is the principal regulator, it is envisaged that only large-scale MFIs will come under the supervision and examination of the CBSL. Small MFIs will come under the supervision of CBSL-approved audit firms, which will support CBSL to take enforcement of regulatory action in respect of these small MFIs.



Thirdly, MFIs falling under the national and provincial Commissioners of Cooperative Development, the Commissioner of Agrarian Services and the Samurdhi Authority will be supervised by those institutions. However the CBSL has the power to set principles and standards from time to time in respect of the supervisions and regulation of these third category institutions. This is indeed welcome, for it is doubtful whether the Commissioners of Cooperative, Development, Agrarian Services and the Samurdhi Authority have any capacity in prudential financial regulation.



One analyst expressed trepidation that if there is a run on any of those financial institutions, the consequences would be drastic for the economy. The sooner they are brought under some strict prudential regulation the better; this is indeed a welcome step.



The original Samurdhi legislation exempts the financial institutions under the Samurdhi Authority from CBSL regulation. Currently it is proposed that these institutions be swallowed up by the Divi Neguma Development Bill and that the Samurdhi Banku Sangam will be relabelled Divi Neguma Banku Sangam. The constitutionality of the Divi Neguma legislation is being challenged before the Supreme Court.

Microfinance in Sri Lanka

At a recent seminar it was stated that there are around 16,400 MFIs operating in Sri Lanka today and of these approximately 3,750 are not under any sort of prudential financial regulation. A 2006 estimate was that there were approximately 14,000 MFIs active, whereas a 2007 GTZ Promis survey gave the number as 10,000. It is reported that around 60% of total MFI borrowers are women, 23 MFIs reported that they have 90% women borrowers, while a few others reported 100% women borrowers.



The World Banks’ Consultative Group to Assist the Poorest (CGAP) conducted a Country Level Effectiveness and Accountability Review (CLEAR) in 2005, in which they reported that in Sri Lanka ‘microfinance has achieved an impressive outreach, with more than five million deposit accounts and two million outstanding micro loans in 2004, from a population of 20 million people’.

Defining microfinance

The latest draft Bill defines microfinance in the interpretation section as: ‘Microfinance business’ means accepting deposits and providing: (a) financial accommodation in any form; (b) other financial services: or (c) financial accommodation in any form and other financial services, mainly for low income persons and micro enterprises in conformity with the Schedule of this Act.



Section 11(2) also permits the Monetary Board to gazette in new form of business not provided for in the Schedule. The said Schedule has a dozen items (a to l), including an omnibus clause: (l) ‘any other business which the Monetary Board may authorise a licensed MFI to engage in’. Section 16 authorises the Monetary Board to by rules under the Act determine who a ‘low income person’ is and what a ‘micro enterprise’ is. All such rules have to be gazetted.



In India the Reserve Bank has deemed that only the following categories of persons are eligible for MFI loans: in rural areas those with an annual income less than Indian Rs. 60,000, in urban areas those with an income of under Indian Rs. 120,000.



The application of the new draft Bill is further restricted by Section 3, which specifies the categories of persons who apply for a license in terms of the Act. They are (a) a company registered under the Companies Act no. 7 of 2007, which is not a private, off shore or overseas company, (b)an NGO registered under the Companies Act or the Voluntary Social Service Organisations (Registration and Supervision) Act, 31 of 1980, or (c) a Society registered under the Societies Ordinance (Cap123).



It is strange that Chapter 123, Volume VI of the Legislative Enactments of Sri Lanka 1980 Revised Edition, is ‘An Ordinance to Provide for the Licensing of Surveyors,’ while the Societies Ordinance is actually in Volume VII Chapter 141. This error was also made in the Second Draft Bill on regulating MFIs! It is repeated in Draft MFI Bill No. 03!

RoSCAs/Cheetus

Be that as it may, effectively therefore the operational area of MFI Bill Draft 03 is limited to certain prescribed entities, carrying out prescribed financial services. This is welcome as the Bill will not apply to pawn broking, Rotating Savings and Credit Associations (RoSCAs – cheetus); money lending, etc.

The importance of these established financial instruments should not be underestimated, as far back as in the 1930s, Sir Sorabji Pochchkanwala chairing the Banking Commission in India recommended that Rotating Savings and Credit Associations (RoSCA) or cheetu should be given a legal status. The only area of doubt is the omnibus clause in the schedule, which empowers the Monetary Board to approve ‘any other businesses’.

But it is possible to argue that this does not permit expansion into known areas of financial services which pre-exists the MFI Draft Bill No. 03 and are already regulated by other legal entities, since the legally permitted financial services are comprehensively listed out in the schedule.Draft MFI Bill No. 03 also provides by Section 29 that the Finance Business Act No. 42 of 2011 and Part IXA of the Banking Act shall not apply to any licensed microfinance institution. Since the Draft MFI Bill No. 03 permits licensed MFIs to accept deposits, this section is needed to avoid conflict with other existing laws.

Although the draft provides that the Finance Business Act will not apply, for the purpose of defining a ‘deposit’ the interpretation section, has recourse to the said same Finance Business Act!

Realistic interest rates

In Part IV by Section 14 of the Draft MFI Bill No. 03, the Monetary Board is empowered to ‘issue directions’ to licensed MFI. These directions include ‘the terms and conditions under which deposits may be accepted, maximum interest rates payable and the minimum amount that may be deposited with an institution’. Also the ‘terms and conditions under which any loan , credit facility of any type of financial accommodation may be granted by such institution, the maximum rates of interest that may be charged on such loans,’ etc.

There are provisions for ‘a deposit insurance fund, a reserve fund and a code of corporate governance,’ among other things. Of all these, the fixing of a maximum rate of interest for loans is very critical. MFIs lend to the marginalised and the poor. The Draft Bill No.03 allows them to accept deposits. The cost of funds for MFIs will mostly depend on the rate they have to pay as interest for deposited money.

Since Sri Lanka is now a lower middle income country, donor money for MFIs, which was liberally available just after the tsunami, has dried up. Since MFIs undertake collateral free lending, these are high risk financial services; the interest rate at which funds are lent has to cover the cost of money and operating costs. Operating costs are high because most MFIs provide credit plus services, extension support to borrowers groups through field staff. Unless realistic rates are fixed for deposits and loans, the MFIs operations will not be viable. The potential borrower has a large choice of options in Sri Lanka today. The cooperative rural banks, the Samurdhi Banku Sangams, the Sanasa branches, the commercial banks and finance companies, which are also in the micro credit business, traditional money lenders, Cheetu schemes, pawnbrokers, and other MFIs are competing for their business. Shopping around for the best deal is a deal option. So deposit rates and lending rates must be fixed in a market-sensitive manner.

Sri Lanka’s State-funded MFI wholesaler, the National Development Trust Fund (NDTF), imposed a cap of 15% on their partner organisations on lending to their borrowers, while providing the funds at 7%. This spread is considered inadequate by most MFIs. It is noteworthy that in India the Reserve Bank has removed the pricing cap on interest rates for MFIs but retained the margin cap at 10% for large MFIs and 12% for small MFIs.

Risk of over-borrowing

Another issue which is very relevant is the risk of over-borrowing. With so many choices and all the various lenders urging the borrower to access their money, there is a great risk that a micro borrower will over expose himself and take a plethora of loans, which he will be unable to repay.

Of course recourse to the Debt Conciliation Board under the Debt Reconciliation ordinance is possible. But today in Sri Lanka where every adult has a unique National Identity Number and a photo identity card bearing that number, the regulator can very easily ensure the preparation of a database of microfinance borrowers, to which licensed MFIs could be given access in order to get an idea of the indebtedness level of a potential borrower.

This is similar to the Credit Information Bureau which is available to banks and finance companies. It is indeed a pity that the Draft Bill No. 03 does not provide for this facility. The dangers of poor borrowers over-borrowing from a number of sources and being unable to repay was brought into focus by the farmer suicides in Andhra Pradesh, India, and had a very bad repercussion on the MF industry as a whole.

Sam Daly Harris, one time Director of the Microcredit Summit campaign, said at that time: “Microfinance in India, or at least in Andhra Pradesh, is in the midst of a near death experience.” The Reserve Bank in India has now enforced a regulation that only two MFIs can lend to a single borrower.

History of microfinance in Sri Lanka

When one looks back at the history of microfinance in Sri Lanka, from the traditional village money lender to this recent Draft MF Bill No. 03, the modern era began with the setting up of the first savings and loan cooperative in Menikhinna near Kandy in 1906.



In the late 1940s the Government provided subsidised credit for rural farmers through the Government departments servicing the agricultural sector. In 1967 the CBSL got involved in the exercise and refinance facilities and credit guarantees were provided for agricultural credit mainly to rice farmers. People’s Bank was implementing the program, through its branches and the Cooperative Rural Banks, which were created in 1964.



In 1973 the scheme was renamed the Comprehensive Rural Credit Scheme and expanded in 1973. The Bank of Ceylon also got involved through its sub offices located in the Agricultural Service Centres. Later private commercial banks led by the Hatton National Bank also got involved in cultivation loan schemes and microfinance through its Gami Pubuduwa project.



In the late 1970s Sarvodaya SEEDS began operations. So did the National Youth Services Savings and Credit Cooperative (NYSCO) specifically targeting young people. In the 1980s and ’90s, CBSL expanded these rural credit programs by providing the banking sector with subsidised interest rates and refinance facilities. The World Bank, Asian Development Bank and other international donors supported these initiatives.



In 1985 the Regional Rural Development Banks were created with the acceptance hat a regional focus by small local financial service entities will be more viable than large national schemes determined in Colombo and regulated by circular. Localism was at the forefront of this thought process, local issues need local solutions. Unfortunately this thinking is now not acceptable and Colombo centric planning, which has been the curse of this country, is back in vogue and these pioneering independent Regional Rural Development Banks have all been amalgamated and brought under a mandarin who issues orders from Colombo.



In the early 1990s the Government with the Janasaviya Trust Fund (JTF), supported by the World Bank, Germany’s KFW and UNDP among others supported non bank financial institutions for micro credit programs. Large numbers of Non Government Organisations, voluntary social service organisation and other people’s organisations were provided with capacity to undertake microfinance programs successfully as partner organisations of the JTF’s micro credit program.



The JTF was later rebranded as the National Development Trust Fund and later its credit program was handed over to the Sri Lanka Savings Bank. In 1991 the CBSL launched the Small Farmers and Landless Credit Program, also known as the Isuru Project with Japanese aid, which was a commercial microfinance program implemented through NGO microfinance institutions at the grass root level. This was a deviation from the subsidised credit which the CBL earlier offered. Later the Samurdhi Banku Sangam were created and also Farmers and Fisheries Banks.

The destruction caused by the tsunami was a catalyst for a number of international private donor organisations to step in to support reconstruction and rehabilitation to the small scale fishing and other traditional cottage industries in Sri Lanka’s coastal zones through established small scale microfinance organisations located in those areas. Large amounts of resources were made available and due to the local focus and the limited scale, there were many successful interventions.



The Government also launched the Gami Diriya project with a microfinance component. Shortly before this the Government had entered into an agreement with GTZ of Germany to implement the Promotion of Microfinance Project (ProMis), which was aimed at developing the microfinance industry in Sri Lanka. The issue of the need to regulate the industry came to the forefront as an important issue. ProMis supported an organisation of MFIs, the Lanka Microfinance Practitioners Network (LMFPA), which in time has become the leading voice of the sector, playing a lead role in voicing its views on the various drafts of the regulatory laws which were place in the public domain.

If the current MFI Bill Draft No. 03 is of real value, it is due to the constant dialogue which took place among all the stakeholders, facilitated by the LMFPA and ProMis. Also the LMFPA, with the support of ProMis, commissioned the leading law firm F.J. & G. de Saram to do a comprehensive study of all the laws relevant to microfinance on the Sri Lanka statue book. The report, which has been published, reported a total of 38 statutes. These are landmark initiatives which must be commended.

Great improvement

This third attempt to prepare legislation to regulate the MF industry in Sri Lanka is clearly a great improvement on the first two. The critical role civil society and the LMFPA has played in the ongoing dialogue on the first two drafts, which has beyond doubt resulted in this much improved MFI Draft Bill No. 03, should not be underestimated.



However, it is indeed a pity that there was no consultation with stakeholders before this MFI Draft Bill No. 03 was placed before the Cabinet of Ministers for approval. There has been a statement made that when subsidiary legislation is being prepared, there will be consultation. We trust that this will be honoured. All stakeholders look forward to quick enactment and implementation of this Bill so that Sri Lanka could achieve Total Financial Inclusion (TFL).TFL has been defined by the United Nations as:



Access at a reasonable cost of all households and enterprises to the range of financial services for which they are bankable, including savings, short and long term credit, leasing and factoring, mortgages, insurance, pensions, payments, local money transfers and international remittances.

Sound institutions guided by appropriate internal management systems, industry performance standards and performance monitoring by the market, as well as by sound prudential regulation where required.



Financial and institutional sustainability as a means of providing access to financial services over time.



Multiple providers of financial services, wherever feasible, so as to bring cost effective and a wide variety of alternatives to customers, which should include any number of combination of sound private, non profit and public providers.



(The writer is a lawyer, who has over 30 years experience as a CEO in both government and private sectors. He retired from the office of Secretary, Ministry of Finance and currently is the Managing Director of the Sri Lanka Business Development Centre.)