Unregulated microfinance

Microfinance seems the flavour of choice among financial service providers today in Sri Lanka. Almost all financial service providers ranging from licensed commercial banks, finance companies, Non-Government Organisations, cooperatives, money lenders, pawn brokers, cheetu schemes (Rotating Savings and Credit Associations – ROSCAs), registered voluntary social service organisations, registered societies, etc. are all promoting themselves as providers of microfinance to the poor and the marginalised.

The other day even the Merchant Bank of Sri Lanka issued a lengthy press statement on how it was getting into microfinance to alleviate poverty in Sri Lanka. Whether all this deposit taking and lending is on the basis of savings generation and non-collateral, inter se guarantee-based lending, which forms the core of what is known as the ‘Grameen model’ of microfinance, is questionable.

Analysts have questioned whether the majority of them are just providing small amounts of money as loans against collateral at high interest and branding it as ‘micro credit’ to jump on the popularity bandwagon. The popularity of microfinance may have been triggered by Prof. Yunus of Bangladesh being awarded the Nobel Peace Prize for his work with the Grameen Bank of Bangladesh. Ironically, since then, the Government of Bangladesh through its Central Bank has ousted Prof. Yunus from Grameen Bank.

Sri Lanka’s history of microfinance

Sri Lanka has a very long history of microfinance; the first cooperative rural bank took in savings deposits and gave out its first small loan, what is today fashionably referred to as micro credit, in the early 1900s at Menikhinna, in the Kandy District.

The Government has from time to time promoted microfinance, for example through the Central Bank’s Isuru Project, the Janasaviya Trust Fund (JTF) and its successor the National Development Trust Fund (NDTF). The Sri Lanka Savings Bank now has a special window for wholesale lending to microfinance institutions, using the NDTF funds, after the latter was wound up.

The Lanka Microfinance Practitioners Association (LMFPA) a network has a membership of 69 members. There are many providers of microfinance who have not joined the LMFPA. The sector is very large, when one factors in the claimed out reach of the cooperative rural banks and the Samurdhi Banku Sangam. Microfinance has an important role to play in gender empowerment in Sri Lanka as it is estimated that over 70% of depositors and borrowers are women.

Spectacular lapses in prudential regulation

In Sri Lanka’s recent history of the financial services sector, there have been some spectacular lapses in prudential regulation which has resulted in depositors losing money. Starting from the crash of HPT, UTI, the collapse and takeover of Mercantile Credit, to Pramuka Bank, to Sakvithi, to Danduwan Mudalali and Dadi Danduwan Mudalali and to the Golden Key episode, the financial regulator has been found wanting.

The more recent fiasco of the National Savings Bank buying shares in The Finance Company at an alleged inflated price, with insider trading allegations thrown in, the Ministry of Finance purporting to cancel the transaction, the NSB refusing to pay Sampath Bank which had intermediated the sale and allegedly already paid the sellers, the SEC inquiry into the transaction, NSB’s unprecedented paper advertisement aimed at whitewashing itself, etc. also shows serious drawbacks in the overall regulatory regime. One commentator described the transaction as ‘obscene’.

The NSB, whose deposits are guaranteed by the Government through taxpayers’ money, has brought at inflated prices shares of a distressed finance company, without following required procedures.

Another controversy over the alleged plans of the Merchant Bank of Sri Lanka to divest itself of the former Ceylinco Savings Bank, at a knockdown price based on private negotiations, sorely lacking in transparency, has also been brought to light.

This lack of governance in the financial sector is also reflected in the startling allegation that the EPF has not appeared before the Public Accounts Committee of Parliament since 2006, making a mockery of public control of finance, the fundamental principle of a Westminster style of Parliamentary democracy.

Every individual who has violated a fiduciary responsibility, in all these transactions, should be fired forthwith and dealt with according to law, notwithstanding their genes or who their parents, spouses or children are. These are the incidents which hit the newspaper headlines. There have been a large number of localised Ponzi and Pyramid schemes which have cheated depositors out of their money, due to weaknesses in prudential regulation, which have not received that much publicity.

Microfinance Regulatory and Supervision Authority

While the Central Bank of Sri Lanka is the primary regulating authority for banking and financial services, the Commissioner of Cooperative Development at the centre and his provincial counterparts, the Registrar of Companies, the regulators under the laws governing ROSCAs (cheetu), money lenders, pawn brokers, insurers and all other legally recognised providers of financial services have designated regulators, under which the institutions under their purview have been set up. The efficiency and competence level of these regulators vary from nonexistent, to low levels of efficiency.

The 2011 Report of the Central Bank of Sri Lanka states on page 174, under the caption ‘Microfinance Institutions’: ‘The CBL was involved in preparing legislation for the regulation of microfinance institutions. There are several categories of microfinance institutions that are registered under various laws, but are not regulated or supervised according to prudential criteria. Hence, to safeguard the interest of depositors and customers and also to strengthen the governance and service delivery of these entities, it was decided to bring them under a common regulatory umbrella. Accordingly the proposed law will provide for the establishment of a separate regulatory authority for microfinance institutions.’

The CBSL website has a draft of a law to set up a Microfinance Regulatory and Supervision Authority (MR&SA). The quote from the CBSL annual Report seems to indicate that this law will be enacted soon. This is a welcome step.

In Sri Lanka although there is no legal definition as to what specifically falls with the definition of ‘microfinance’, the draft law provides a definition. In Part II section 10(2) of the draft law it is stated that ‘microfinance business’ is ‘the acceptance of deposits and providing financial accommodation any form and other financial services mainly to low income persons and micro enterprises’.

This is a very wide definition and most of the financial accommodations carried out by the entities listed out earlier, by entities operating under pre-existing laws will be caught up. How the MR&SA will relate to the regulators operating under those specific statutes will have to be worked out.

Finance Business Act restrictions

Further in terms of the Finance Business Act No. 42 of 2012, which places restrictions on the freedom to use the word ‘finance’ and all its derivatives in a company name, among other things, the Communications Department of the CBSL has issued a press release from the Department of Supervision of Non Bank Financial Institutions, stating among other things that, over and above the exemptions provided in the Act itself, by Section 10 (6): ‘The Monetary Board has approved that any company/organisation which has been carrying on microfinance business and registered under the following statutes as at the effective date of the Finance Business Act No. 42 of 2012 may continue to use the word ‘microfinance’ as a part of its name or description until such time the proposed Microfinance Act is enacted.’

The Finance Business Act does not provide for a provision under which such an order can be made by the Monetary Board, virtually negating its provisions. The statutes are (a) a company registered under the Companies Act No.07 of 2007, (b) any NGO registered under the Companies Act No. 7 of 2007 and Voluntary Social Services Organisations (VSSO) (Registration and Supervision) Act No. 31 of 1980, (c) any society registered under the Societies Ordinance (Chap,123) .

This amounts to virtually amending the act, and the legal basis for doing so is not explained. In any event the effect of this decision is to permit certain institutions which do not presently come within an acceptable framework of prudential regulation from an aspect of a provider of financial services to the general public to continue to undertake microfinance business (for want of a better guide) as defined in the draft law, cited above.

Given the weak and ineffective history of the regulators (including the NSB/The Finance fiasco) in Sri Lanka, this is a very high risk strategy, putting the public at large in jeopardy of being defrauded by unscrupulous elements.

For example, the VSSO and Societies Ordinances provide for a regulator but these bodies do not have the capacity to provide a sufficient level of prudential regulation of the financial services provided by these entities. It is hoped that the draft MR&SA law will be enacted very soon to cover up this high risk strategy and the lacuna in the law.

Much to be desired

However the draft MR&SA law has much to be desired. The weakness of the very imprecise definition of microfinance has been mentioned. In the Indian draft law, entities operating under specified existing laws have been exempted, by naming the statute, from the application of the new rules applying to microfinance transactions.

This avoids any confusion, which will result when in a case where steps are taken under the microfinance prudential regulations, a person or institution charged can take the defence that they are already covered by an existing law, and the new microfinance regulations do not apply to them.

Also the new MR & SA law, as is presently presented, does not catch up the Samurdhi Banku Sangam and the Cooperative Rural Banks, two huge players in the sector. It would be possible to claim that the principle of equal treatment and protection of the law to persons of the same class would be violated by microfinance institutions operating under the VSSO Act for example, being subjected to a higher level of prudential regulation than that which the Samurdhi Authority imposes on the Samurdhi Banku Sangam or that with the Commissioner of Cooperative Development imposes on the Cooperative Rural Banks.

Most providers of microfinance services such as Sarvodaya SEEDS, Sewa Lanka Finance, the National Youth Services Savings and Credit Cooperative (NYSCO) are already under some sort of prudential regulation; some by registering as finance companies, others under the Commissioner of Cooperative Development, etc.

But the standards of prudential regulation vary. Microfinance providers under other laws such as money lenders, pawn brokers and cheetu groups (ROSCAs), which are not presently exempted from the definition of microfinance in the draft law, will also cause confusion as to the specific entity entitled by law to regulate them. Dual control never works and will only cause confusion and consternation.

Indian example

The Indian example of specifically exempting certain pre-existing institutions from the new microfinance regulator will help. The Indian Microfinance Institution Development and Regulation Bill approved by Cabinet, by Section 42, says clearly that ‘this act will override other laws,’ further goes on ‘by way of explanation’ to state that ‘MF services extended by nay MFI registered with the Reserve Bank of India shall not be treated as a money lender for the purpose of any enactment relating to money lenders’.

This explicitly provides that an MFI in India after the law is enacted cannot claim any rights under the laws applying to money lenders. Such clarity is welcome and should be adopted in Sri Lanka too. There are many good ideas from the India legislation – such as the Reserve Bank itself being the microfinance regulator, instead of setting up a new authority.

An observer from another country who studied Sri Lanka Government Department and para statal institutional structure once told me: “Your country needs a new Government Authority, as badly as a person needs a new cancerous tumour!’

The Indian draft act recognises a distinction between large MFIs and smaller localised ones for regulatory purposes. It also sets up a Development Fund and an advisory body.

MFIs in Sri Lanka for decades received subsidised funding from the Janasaviya Trust Fund, and its successors the National Development Trust Fund and the Sri Lanka Savings Bank, but a new source of affordable money is required. In the last resort, even with all its weaknesses, the present MR&SA draft law should be enacted.

If possible, after changes are made in consultation with microfinance practitioners and their apex organisation, the Lanka Microfinance Practitioners Association (LMFPA), positive ideas from the draft Indian law can be incorporated. But at the end of the day, some law is better than no law!

Leaving the space for under-regulated or unregulated financial service providers is a very high risk strategy, jeopardising the rights and financial security of the general public and society at large. In its Annual Report, the CBSL itself admits that ‘several categories of microfinance institutions that are registered under various laws are not regulated or supervised according to prudential criteria’.

(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.)