Regulating microfinance banks

In view of their potential to generate employment and reduce poverty, microfinance banks (MFBs) have been given a lot of importance in the policy framework of most of the developing countries, including Pakistan, in the recent years.
However, while encouraging the MFBs, it is also necessary to regulate their activities properly in order to ensure their solvency and financial soundness on a long-term basis. Keeping this in view, the State Bank of Pakistan on 20th March, 2008 made certain amendments in its prudential regulations. According to the new instructions, the MFBs licensed to operate in a specified district will maintain a minimum paid-up capital, free of losses, of not less than Rs 100 million.
This requirement would be higher for the MFBs operating in a wider area. MFBs licensed to operate in a specified region, specified province and at the national level will maintain paid-up capital (free of losses) of Rs 150 million, Rs 250 million and Rs 500 million respectively.
However, in case any of the existing MFB does not meet the prescribed minimum paid-up capital requirement, it will make up the shortfall latest by December 31, 2008. The central bank has also directed the MFBs to maintain Capital Adequacy Ratio (CAR) equivalent to at least 15 percent of their risk weighted assets.
However, in order to meet this requirement, MFBs were allowed to raise subordinated debt in local currency, subject to prior written approval from the SBP. Besides, they could raise capital through term finance certificates (TFCs) to meet the revised 15 percent CAR.
The encouragement of MFBs under a proper discipline, in our view, is a wise policy in the prevailing socio-economic conditions in the country. Microfinance institutions mostly emerged in the 1970s as social innovators to offer financial services to the working poor - those who were previously considered un-bankable because of lack of collateral.
Their popularity increased because it was observed that once given the opportunity, not only did the clients of MFBs expand their businesses and replenish their incomes, but their higher repayment rates demonstrated that the poor were also capable of transforming their own lives given the chance. Microfinance sector in Pakistan has also recorded a substantial growth over the past few years due to the supportive behaviour and conducive environment provided by the government and now efforts are afoot to reach the target of three million households by 2010.
While others are also joining the field, Khushali Bank continues to lead and is the largest microfinance institution in terms of its network, clients and portfolio. However, sustainability of the system and its capacity to deliver would depend critically on the ability of the MFBs to meet their liabilities at all times and maintain strict financial discipline.
We hope that minimum paid-up capital requirements and CAR as prescribed by the State Bank under the revised regulatory framework would ensure that the MFBs would continue to be financially viable and contribute to alleviate poverty and reduce unemployment in the country.
After all, it is the responsibility of a central bank to regulate the overall financial sector of the country in a way so as to maximise its potential and ensure its viability on a long-term basis. However, we have not been able to comprehend the rationale of prescribing different slabs of minimum capital requirement according to the range of working areas of the MFBs.
In our view, such a requirement should have been linked to the size of the balance sheet represented in terms of aggregate assets and liabilities of an institution rather than its geographical coverage because, all other things remaining unchanged, the overall risk of an MFB would generally depend on the size of its total business activities.
Also, we would like to advise the State Bank to watch and monitor the recovery rates of various MFBs very closely. We say this because, contrary to the experience in other fields, some of the earlier schemes like yellow cabs, YIPs and green tractors could not gain ground due to very poor recovery rates and had to be ultimately discontinued after suffering losses of billions of rupees.