Dealing with regulatory pitfalls in microfinancing

The changing operating environment and the velocity of these changes have made it imperative for me to call attention to some inherent dangers in these changes as well as their implications for effective regulation of the microfinance industry. Even at the best of times, microfinance institutions face considerable risk of loan loss. And this is particularly so when operators adopt business models that are at best unsuitable and at worst indeterminate. Clearly, if there is anything in dire need of clarification in the microfinance industry today, it is the appropriateness of their business models. There is an important research question that needs to be answered in that area for the benefit of all.

Part of the challenge in this regard stems from the way many stakeholders view delinquency and default. Without getting unnecessarily technical, let me take a cursory peep at the core of these very important terms as a pedestal for our analysis. First, some stakeholders need to understand that the loss of a loan is not an event. It is a process, which begins with loan delinquency. And there appears at times to be confusion as to when delinquency begins. When actually do we say that a loan is delinquent? A loan is delinquent when a payment is due but not received. That is to say the payment is past due. It may come but at a later date. Unfortunately, from being late, the payment may eventually fail to come, if the chances of receiving the payment thin out to the minimum. When this happens, a delinquent loan transmutes to a defaulted loan. A default is therefore the failure to pay back a loan. Second, we need not wait for the client to fail to pay entire loan before we declare the loan in default. Indeed it may not even be the failure to make a payment on terms but a violation of a covenant in the loan terms. Finally, when a loan cannot be collected, it is lost, concluding the process that began with delinquency. At this point, the only needful is to be sure that this eventuality was provided and then call in the recovery team.

Essentially, we find that a loan loss is a process that begins with delinquency; goes through default and finally crystalizes in a loss. Once we accept that a loan loss is a process, then we are able to take action to short-circuit the process and avoid the occurrence or at least mitigate its impact. And the remedy begins with a proper understanding and use of correct measures of delinquency. There is therefore, need for a proper understanding of measures of delinquency,as adopted by clients. It is also important to be aware that regulators could go astray in their supervisory duties if they fail to understand clearly the implications of the elements of delinquency adopted by an operator. This is because the policy of an MFB regarding delinquency has important influence on the portfolio quality ratios of the operator. The moment a regulator misreads these ratios, he may understate the risk carried by the operator. This may amount to inadvertently helping the operator to kill itself.

An understanding of the elements in the measures of delinquency is critical to regulators, especially now that they are implementing the risk-based supervision system. Risk-based supervision is one that attaches weight to the portfolio based on the perceived Inherent risk. A misunderstanding of the ratios could imply adopting wrong weights for the elements of the loan portfolio. This could mask and amplify the inherent risk to an operator. The relevance of this is that some microfinance banks may have the wrong internal criteria for classifying loans. The way we classify or define a past due obligation has important implications for the usefulness of the Portfolio Quality Report. A wrong classification or definitionmay render the portfolio quality analysis a nullity.

For instance, a microfinance bank may decide that a loan becomes past due only at the end of the loan term. This means that until the tenor expires the loan will not be classified as past due, even if some payments have become due but not received. And we should be aware that loan tenor has nothing to do with the length of time part of it has been outstanding. Such a classification will mask the risk to which the loan has been exposed, and unsuspecting regulators may be misled. Regulators must therefore ensure that loan classification criteria, with regard to delinquency, are based on the agreed repayment schedule and not the tenor of the loan.

Some dilemmas also face regulators in this market. The microfinance subsector is more fragile and essentially weaker than the universal banking sector. The operators have smaller financial and human capital capacity. The industry generally deals with the lower, more risky and largely informal end of the financial market, with higher risk factors, worsened by the volatility of the environment. Ordinarily, it may appear that the players in this sector should be supported to survive by lowering regulatory standards applicable to them to compensate for their higher risk. In other words, microfinance banks should be regulated with the understanding that they are disadvantage and deserve less stringent regulation. Unfortunately no. They actually call for more rigorous supervision. Doing otherwise would be contrary to effective regulation, especially in view of the nature of their transactions. The question is how to ensure that regulation of MFBs is adequate all things considered.

Clearly, regulators must understand that the higher risk inherent in microfinance banking calls for higher regulatory standards and even higher competence on their part. They must also understand the enormity of the inherent risks and fragility of the industry, especially at these times. Essentially therefore, regulator must strike that delicate but imperative balance between the fragility and high risk quotient of microfinance banking on the one hand and the insoluble need to protect and promote an infant industry on the other.

 

Emeka Osuji