GUIDING PRINCIPLES
ON REGULATION
AND SUPERVISION
OF MICROFINANCE
Microfinance
Consensus Guidelines
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Building financial systems that work for the poor
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by
Robert Peck Christen
Timothy R. Lyman
Richard Rosenberg
GUIDING PRINCIPLES ON
REGULATION AND SUPERVISION
OF MICROFINANCE
Microfinance
Consensus Guidelines
English Español Français

© 2003 by CGAP/The World Bank Group
1818 H Street, N.W., Washington, D.C. 20433 USA
All rights reserved
Manufactured in the United States of America
First printing June 2003
The English version begins on page 1.
La versión en español este texto empleza en página 39.
La version française commence à la page 81.

by
Robert Peck Christen
Timothy R. Lyman
Richard Rosenberg
GUIDING PRINCIPLES ON
REGULATION AND SUPERVISION
OF MICROFINANCE
Microfinance
Consensus Guidelines

ACKNOWLEDGMENTS
These Guiding Principles were formally adopted by CGAP’s 29
member donor agencies in September 2002. The document
was written by Robert Peck Christen, Timothy R. Lyman, and
Richard Rosenberg, with input from more than 25 commenta-
tors who have worked on regulation and supervision of microfi-
nance in every region of the world. Mr. Christen and Mr.
Rosenberg are senior advisors to CGAP. Mr. Lyman is president
and executive director of the Day, Berry & Howard Foundation
and chairs its Microfinance Law Collaborative.

ACKNOWLEDGMENTS iv
INTRODUCTION 1
I TERMINOLOGY AND PRELIMINARY ISSUES 2
What is “Microfinance?” 2
Vocabulary of Microfinance Regulation 2
Prudential vs. Non-Prudential Regulation, and
Enabling Regulation 3
Regulation as Promotion 4
“Special Windows” and Existing
Financial Regulation 5
Regulatory Arbitrage 6
II NON-PRUDENTIAL REGULATORY ISSUES 6
Permission to Lend 7
Consumer Protection 7
Protection against Abusive Lending and
Collection Practices 7
Truth in Lending 8
Fraud and Financial Crime Prevention 8
Credit Reference Services 9
Secured Transactions 10
Interest Rate Limits 10
Limitations on Ownership, Management, and
Capital Structure 11
Tax and Accounting Treatment of Microfinance 11
Taxation of Financial Transactions and Activities 11
Taxation of Profits 12
Feasible Mechanisms of Legal Transformation 12
TABLE OF CONTENTS

III PRUDENTIAL REGULATION OF MICROFINANCE 13
Objectives of Prudential Regulation 13
Drawing the Line: When to Apply Prudential
Regulation in Microfinance? 13
Timing and the State of the Industry 13
Sources of Funding 14
Rationing Prudential Regulation, and
Minimum Capital 16
Drawing Lines Based on Cost-Benefit Analysis 17
Regulate Institutions or Activities? 18
Special Prudential Standards for Microfinance 18
Minimum Capital 19
Capital Adequacy 19
Unsecured Lending Limits, and Loan-Loss
Provisions 20
Loan Documentation 21
Restrictions on Co-Signers as Borrowers 22
Physical Security and Branching Requirements 22
Frequency and Content of Reporting 22
Reserves against Deposits 22
Ownership Suitability and Diversification
Requirements 22
Who Should These Special Standards Apply to? 24
Deposit Insurance 24
IV FACING THE SUPERVISORY CHALLENGE 24
Supervisory Tools and Their Limitations 25
Costs of Supervision 26
Where to Locate Microfinance Supervision? 27
Within the Existing Supervisory Authority? 27
“Self-Regulation” and Supervision 28
Delegated Supervision 29
V KEY POLICY RECOMMENDATIONS 29
NOTES 32

GUIDING PRINCIPLES ON
REGULATION AND SUPERVISION
OF MICROFINANCE
Microfinance Consensus Guidelines
Regulation and Supervision 1
INTRODUCTION
Many developing countries and countries with transitional
economies are considering whether and how to regulate micro-
finance. Experts working on this topic do not agree on all points,
but there is a surprisingly wide area of consensus. CGAP1
believes that the main themes of this paper would command
general agreement among most of the specialists with wide
knowledge of past experience and current developments in
microfinance regulation.
We hope this paper will provide useful guidance not only to
the staff of the international donors who encourage, advise, and
support developing- and transitional-country governments, but
also to the national authorities who must make the decisions,
and the practitioners and other local stakeholders who partici-
pate in the decision-making process and live with the results. On
some questions, experience justifies clear conclusions that will be
valid everywhere with few exceptions. On other points, the expe-
rience is not clear, or the answer depends on local factors, so that
no straightforward prescription is possible. On these latter
points, the best this paper can do for the time being is to suggest
frameworks for thinking about the issue and identify some fac-
tors that need special consideration before reaching a conclusion.
Part I of the paper discusses terminology and preliminary
issues. Part II outlines areas of regulatory concern that do not
call for “prudential” regulation (see the definition and discussion
below). Part III discusses prudential treatment of microfinance
and MFIs. Part IV briefly looks at the challenges surrounding
supervision, and Part V summarizes some key policy recommen-
dations.

2 Microfinance Consensus Guidelines
I TERMINOLOGY AND PRELIMINARY ISSUES
“What is “Microfinance?”
As used in this paper, “microfinance” means the provision of
banking services to lower-income people, especially the poor and
the very poor. Definitions of these groups vary from country to
country.
The term “microfinance” is often used in a much narrower
sense, referring principally to microcredit2 for tiny informal busi-
nesses of microentrepreneurs, delivered using methods devel-
oped since 1980 mainly by socially-oriented non-governmental
organizations (NGOs). This paper will use “microfinance” more
broadly.
The clients are not just microentrepreneurs seeking to finance
their businesses, but the whole range of poor clients who also use
financial services to manage emergencies, acquire household
assets, improve their homes, smooth consumption, and fund
social obligations.
The services go beyond microcredit. Also included are savings
and transfer services.3
The range of institutions goes beyond NGOs and includes
commercial banks, state-owned development banks, financial
cooperatives, and a variety of other licensed and unlicensed non-
bank institutions.
Vocabulary of Microfinance Regulation and Supervision
Varying terminology used in the discussion of microfinance reg-
ulation sometimes leads to confusion. This paper uses the fol-
lowing general definitions:
Microfinance institution (MFI)—A formal organization whose
primary activity is microfinance.
Regulation—Binding rules governing the conduct of legal enti-
ties and individuals, whether they are adopted by a legislative
body (laws) or an executive body (regulations).
Regulations—The subset of regulation adopted by an executive
body, such as a ministry or a central bank.
“Banking” law or regulations—For the sake of simplicity, the
paper uses “banking” in this context to embrace existing laws or
regulations for non-bank financial institutions as well.
Prudential (regulation or supervision)—Regulation or supervi-
sion is prudential when it governs the financial soundness of
licensed intermediaries’ businesses, in order to prevent financial-
system instability and losses to small, unsophisticated depositors.
Supervision—External oversight aimed at determining and
enforcing compliance with regulation. For the sake of simplicity,
“supervision” in this paper refers only to prudential supervision.

Regulation and Supervision 3
Financial intermediation—The process of accepting repayable
funds (such as funds from deposits or other borrowing) and
using these to make loans.
License—Formal governmental permission to engage in finan-
cial-service delivery that will subject the license-holding institu-
tion to prudential regulation and supervision.
Permit—Formal governmental permission to engage in non-
depository microlending activity that will not subject the permit-
holding institution to prudential regulation and supervision.
Self-regulation/supervision—Regulation or supervision by a body
that is effectively controlled by the entities being regulated or
supervised.
Prudential vs. Non-Prudential Regulation, and Enabling Regulation
Regulation is “prudential” when it is aimed specifically at
protecting the financial system as a whole as well as protect-
ing the safety of small deposits in individual institutions.
When a deposit-taking institution becomes insolvent, it cannot
repay its depositors, and—if it is a large institution—its failure
could undermine public confidence enough so that the banking
system suffers a run on deposits. Therefore, prudential regula-
tion involves the government in overseeing the financial
soundness of the regulated institutions: such regulation aims
at ensuring that licensed institutions remain solvent or stop col-
lecting deposits if they become insolvent. This concept is empha-
sized because great confusion results when regulation is dis-
cussed without distinguishing between prudential and non-
prudential issues.4
Prudential regulation is generally much more complex, diffi-
cult, and expensive than most types of non-prudential regulation.
Prudential regulations (for instance, capital adequacy norms or
reserve and liquidity requirements) almost always require a spe-
cialized financial authority for their implementation, whereas
non-prudential regulation (for instance, disclosure of effective
interest rates or of the individuals controlling a company) may
often be largely self-executed and can often be dealt with by other
than the financial authorities.
Thus, an important general principle is to avoid using bur-
densome prudential regulation for non-prudential purpos-
es—that is, purposes other than protecting depositors’ safe-
ty and the soundness of the financial sector as a whole. For
instance, if the concern is only to keep persons with bad records
from owning or controlling MFIs, the central bank does not have
to take on the task of monitoring and protecting the financial
soundness of MFIs. It would be sufficient to require registration
and disclosure of the individuals owning or controlling them, and
to submit proposed individuals to a “fit and proper” screening.

4 Microfinance Consensus Guidelines
Some non-prudential regulation can be accomplished under gen-
eral commercial laws, and administered by whatever organs of
government implement those laws, depending on the relative
capacity of those agencies.
Even where it has hundreds of thousands of customers,
microfinance today seldom accounts for a large enough part of a
country’s financial assets to pose serious risk to the overall bank-
ing and payments system. Thus, the rest of this discussion
assumes that at present the main justification of prudential regu-
lation of depository microfinance is protection of those who
make deposits in MFIs. (On the other hand, the development of
the microfinance is not static. Wherever depository microfinance
reaches significant scale in a particular region or country, sys-
temic risk issues must be taken into consideration, in addition to
depositor protection issues. The failure of a licensed MFI with
relatively small assets but huge numbers of customers could be
contagious for other MFIs.)
Certain regulation is aimed at correcting perceived abuses in
an existing industry. Other regulation is “enabling”: its purpose
is a positive one—to allow the entry of new institutions or new
activities. Most of the microfinance regulation being proposed
today is enabling. But what is the activity being enabled? Where
the purpose is to enable MFIs to take deposits from the public,
then prudential regulation is generally called for, because the
return of depositors’ money cannot be guaranteed unless the
MFI as a whole is financially solvent. If, on the other hand, the
regulation’s purpose is to enable certain institutions to con-
duct a lending business legally, then there is usually no rea-
son to assume the burden of prudential regulation, because
there are no depositors to protect.5
The general discussion of microfinance regulation worldwide
tends to emphasize prudential issues—how to enable MFIs to
take deposits. However, in some countries, especially formerly-
socialist transitional economies, the most pressing issues are non-
prudential—how to enable MFIs to lend legally.
Regulation as Promotion
For some, the main motivation for regulatory change is to
encourage formation of new MFIs and/or improve performance
of existing institutions. In the case of both prudential and non-
prudential regulation, providing an explicit regulatory space for
microfinance may very well have the effect of increasing the vol-
ume of financial services delivered and the number of clients
served. The right type of non-prudential regulation can fre-
quently have the desired promotional effect with relatively low
associated costs (see, for example, the discussion of permission to
lend on page 7). In the case of prudential regulation, however,
experience to date suggests that opening up a new, less burden-

Regulation and Supervision 5
some regulatory option—particularly if existing MFIs are not yet
strong candidates for transformation—can sometimes result in a
proliferation of under-qualified depository institutions, and create
a supervisory responsibility that cannot be fulfilled. In several
countries, a new prudential licensing window for small rural
banks resulted in many new institutions providing service to areas
previously without access, but supervision proved much more dif-
ficult than anticipated. As many as half of the new banks turned
out to be unsound, and the central bank had to devote excessive
resources to cleaning up the situation. Nevertheless, many of the
new banks remained to provide rural services. Whether the final
outcome was worth the supervisory crisis is a balancing judgment
that would depend on local factors and priorities.
Any discussion of providing an explicit new regulatory space
in order to develop the microfinance sector and improve the per-
formance of existing MFIs should weigh carefully the potential
unintended consequences. For instance, the political process of
regulatory change can lead to reintroduction or renewed
enforcement of interest rate caps (see the discussion of interest
rate limits on page 10). In addition, over-specific regulation
can limit innovation and competition.
“Special Windows” and Existing Financial Regulation
Discussion and advocacy regarding microfinance regulation often
focuses on whether or how to establish a “special window”—that
is, a distinct form of license and/or permit—for microfinance.
The range of regulatory approaches possible, whether or not they
are understood as special windows for microfinance, is limited. It
is important to be clear about which of these is being pursued:
• Enabling non-bank microlending institutions, which should
not require prudential regulation and supervision
• Enabling non-bank financial intermediaries taking retail
deposits, which generally does require prudential treatment
• Enabling a combination of these two
If a new special window is to be established, should it be done
by amendment of the existing financial sector laws and regula-
tions, or should separate legislation or regulation be proposed?
As a general proposition, incorporation within the existing
framework will better promote integration of the new license
and/or permit into the overall financial system. This approach
may increase the likelihood that the regulatory changes are prop-
erly harmonized with the existing regulatory landscape.
Inadequate attention to harmonization has often led to ambigu-
ities about how the various pieces of regulation fit together.
Moreover, adjusting the existing framework may be technically
easier, and may be more likely to facilitate the entry of existing

6 Microfinance Consensus Guidelines
financial institutions into microfinance. However, local factors
will determine the feasibility of this approach. In some countries,
for example, policymakers may be reluctant to open up the bank-
ing law for amendment because it would invite reconsideration
of a whole range of banking issues that have nothing to do with
microfinance.
Regulatory Arbitrage
In any event, the content of the regulation involved is likely to
be more important than whether it is implemented within exist-
ing laws and regulations, or whether it is specifically designated
as new “microfinance regulation.” In either case—but particu-
larly if new categories of institution are added to the regulatory
landscape—critical attention must be paid to the interplay
between the new rules and the ones already in place. If the new
rules appear to establish a more lightly or favorably regulated
environment, many existing institutions and new market entrants
may contort to qualify as MFIs. Such regulatory arbitrage can
leave some institutions under-regulated.
Several countries have carefully crafted a special regulatory
window for socially-oriented microfinance, only to find that the
window is later used by types of businesses that are very differ-
ent from what the framers of the window had in mind. This is
particularly the case with consumer lending, which generally
goes to salaried workers rather than self-employed microentre-
preneurs. In some cases, these lenders could easily have gotten a
banking license, but they opted to use the microfinance window
instead because minimum capital and other requirements were
less stringent.
II NON-PRUDENTIAL REGULATORY ISSUES
Most of the current discussion of microfinance regulation focuses
on prudential regulation. Nevertheless, this paper will treat non-
prudential issues first, to underscore the point that there are many
regulatory objectives that do not require prudential treatment.
Non-prudential (“conduct of business”) regulatory issues,
relevant to microfinance, span a wide spectrum. These issues
include enabling the formation and operation of microlending
institutions; protecting consumers; preventing fraud and finan-
cial crimes; setting up credit information services; supporting
secured transactions; developing policies with respect to interest
rates; setting limitations on foreign ownership, management,
and sources of capital; identifying tax and accounting issues; plus
a variety of cross-cutting issues surrounding transformations
from one institutional type to another.

Regulation and Supervision 7
Permission to Lend
In some legal systems, any activity that is not prohibited is
implicitly permissible. In these countries, an NGO or other unli-
censed entity has an implicit authorization to lend as long as
there is no specific legal prohibition to the contrary.
In other legal systems, especially in formerly-socialist transi-
tional countries, an institution’s power to lend—at least as a pri-
mary business—is ambiguous unless there is an explicit legal
authorization for it to conduct such a business. This ambiguity is
particularly common in the case of NGO legal forms. In still
other legal systems, only prudentially licensed and regulated
institutions are permitted to lend, even if no deposit taking is
involved. Where the legal power to lend is either ambiguous or
is prohibited to institutions that are not prudentially licensed, a
strong justification exists for introducing non-prudential regula-
tion that explicitly authorizes non-depository MFIs to lend.
Where the objective is to enable lending by NGOs, modification
of the general legislation governing them may be needed.
Regulation of permission to lend should be relatively sim-
ple. Sometimes not much more is needed than a public registry
and permit-issuing process. The scope of documents and infor-
mation required for registration and the issuance of a permit
should be linked to specific regulatory objectives, such as pro-
viding a basis for governmental action in case of abuse (see the
discussion of fraud and financial crime prevention on page 8) and
enabling industry performance benchmarking.
Consumer Protection
Two non-prudential consumer-protection issues are particularly
relevant to microfinance and are likely to warrant attention in
most, if not all, countries: protecting borrowers against abusive
lending and collection practices, and providing borrowers with
truth in lending—accurate, comparable, and transparent infor-
mation about the cost of loans.
Protection against Abusive Lending and Collection Practices
There is often a concern about protecting microcredit clients
against lenders who make loans without enough examination of
the borrower’s repayment capacity. This can easily lead to bor-
rowers becoming over-indebted, resulting in higher defaults for
other lenders. In a number of countries, consumer lenders have
proved particularly susceptible to this problem, and governments
have found it necessary to regulate against such behavior. In addi-
tion, there is often concern about unacceptable loan-collection
techniques. Regulation in these areas does not necessarily have to
be administered by the prudential supervisory authority.

8 Microfinance Consensus Guidelines
Truth in Lending
As discussed in the section on interest rate limits (page 10), the
administrative cost of disbursing and collecting a given amount
of portfolio is much higher if there are many tiny loans than if
there are a few large loans. For this reason, microlending usual-
ly cannot be done sustainably unless the borrowers pay interest
rates that are substantially higher than the rates banks charge to
their traditional borrowers. Moreover, different combinations of
transaction fees and interest-calculation methods can make it dif-
ficult for a borrower to compare interest rates of lenders. In
many countries, lenders are required to disclose their effective
interest rates to loan applicants, using a uniform formula man-
dated by the government. Should such truth-in-lending rules be
applied to microcredit? Microlenders usually argue strongly
against such a requirement. It is easy to be cynical about their
motives for doing so, and certainly the burden of proof should
lie with anyone who argues against giving poor borrowers an
additional tool to help them evaluate a loan’s cost—especially
when this tool will promote price competition. Moreover, the
mandated discipline of disclosing effective interest rates may help
to focus microlenders on steps they can take to increase their effi-
ciency and thus lower their rates.
So there ought to be a presumption in favor of giving bor-
rowers full and usable information about interest rates. But the
issue is not always simple. In many countries, the public prejudice
against seemingly exploitative interest rates is very strong. Even
where high interest rates on tiny loans make moral and financial
sense, it may still prove difficult to defend them when they
are subjected to broad (and uninformed) public discussion, or
when politicians exploit the issue for political advantage. Micro-
borrowers show again and again that they are happy to have
access to loans even at high rates. But if MFIs are required to
express their pricing as effective interest rates, then the risk of
a public and political backlash becomes greater, and can threaten
the ability of microlenders to operate.
Obviously, the seriousness of this risk will vary from one
country to another. In some places, this risk can be dealt with
through concerted efforts to educate the public and policy mak-
ers about why loan charges in microfinance are high, and why
access is more important than price for most poor borrowers.
But public education of this sort takes significant time and
resources and will not always be successful.
Fraud and Financial Crime Prevention
Two types of concern related to fraud and financial crimes pre-
dominate in connection with microfinance regulation: (1) con-
cerns about securities fraud and abusive investment arrangements
such as pyramid schemes, and (2) money-laundering concerns.

Regulation and Supervision 9
In addressing these, the same rules should apply to MFIs as to
other economic actors. It should not be assumed automatically
that the best body to deal with these concerns is the one respon-
sible for prudential regulation. In many countries, the existing
anti-fraud and financial crime regulation will be adequate to
address abuse in the case of MFIs, or will need amendment only
to add any new categories of institution to the regulatory land-
scape. Often the most pressing need is to improve enforcement
of existing laws.
Credit Reference Services
Credit reference services—called by a variety of names including
credit bureaus—offer important benefits both to financial insti-
tutions and to their customers. By collecting information on
clients’ status and history with a range of credit sources, these
databases allow lenders to lower their risks, and allow borrowers
to use their good repayment record with one institution to get
access to new credit from other institutions. Such credit bureaus
allow lenders to be much more aggressive in lending without
physical collateral, and strengthen borrowers’ incentive to repay.
Depending on the nature of the database and the conditions of
access to it, credit information can also have a beneficial effect on
competition among financial service providers.
In developed countries, the combination of credit bureaus and
statistical risk-scoring techniques has massively expanded the
availability of credit to lower-income groups. In developing coun-
tries, especially those without a national identity-card system,
practical and technical challenges abound, but new technologies
(such as thumbprint readers and retinal scanners) may offer solu-
tions. Experience suggests that when MFIs begin to compete
with each other for customers, over-indebtedness and default will
rise sharply unless the MFIs have access to a common database
that captures relevant aspects of their clients’ borrowing behavior.
Does the government need to create a credit bureau or
require participation in it? The answer will vary from country to
country. A common pattern in developing countries is that mer-
chants participate voluntarily in private credit bureaus, but
bankers are more reluctant to share customer information unless
the law requires them to do so.
Especially when banks participate in them, credit information
services raise privacy issues. Sometimes these issues can be han-
dled simply by including in loan contracts the borrowers’ author-
ization for the lender to share information on their credit per-
formance with other lenders. In other circumstances, laws will
need to be amended.
Credit information services can provide clear benefits, but
such data collection can entail risks. Corrupt database managers
may sell information to unauthorized parties. Tax authorities

10 Microfinance Consensus Guidelines
may want to use the database to pursue unregistered microen-
terprises. Borrowers can be hurt by inaccurate information in the
database, although guaranteeing them access to their own credit
histories can lower this risk.
For donors wanting to help expand access to financial
services for both poor and middle-class people, development
of private or public credit information systems that include
micro-borrowers could be an attractive target of support in
countries where the conditions are right. Among these condi-
tions are a national identity system or some other technically fea-
sible means of identifying clients, a fairly mature market of MFIs
or other firms that lend to low-income borrowers, and a legal
framework that creates the right incentives for participation as
well as protecting fairness and privacy.
Secured Transactions
Borrowers, lenders, and the national economy all benefit when
not only real estate but also moveable assets can be pledged as
collateral for loans. But in many developing and transitional
economies, it is expensive or impossible to create and enforce a
security interest in moveable collateral. Sometimes there are also
constraints that make it hard for lower-income people to use
their homes and land as collateral. Legal and judicial reform to
support secured transactions can be very worthwhile, although
these matters tend to affect the middle class more than they do
the poor. Such reform typically centers on the commercial and
judicial laws, not the banking law.
Interest Rate Limits
To break even, lenders need to set loan charges that will cover
their cost of funds, their loan losses, and their administrative
costs. The cost of funds and of loan loss varies proportionally
to the amount lent. But administrative costs do not vary in
proportion to the amount lent. One may be able to make a
$20,000 loan while spending only $600 (3 percent) in admin-
istrative costs; but this does not mean that administrative
costs for a $200 loan will be only $6. In comparison with the
amount lent, administrative costs are inevitably much higher
for microcredit than for conventional bank loans.6 Thus,
MFIs cannot continue to provide tiny loans unless their
loan charges are considerably higher in percentage terms
than normal bank rates.
Legislatures and the general public seldom understand this
dynamic, so they tend to be outraged at microcredit interest rates
even in cases where those rates reflect neither inefficiency nor
excessive profits.7 Therefore, if the government takes on control
of microcredit interest rates, practical politics will usually make it
difficult to set an interest rate cap high enough to permit the

Regulation and Supervision 11
development of sustainable microcredit. Interest rate caps, where
they are enforced, almost always hurt the poor—by limiting serv-
ices—far more than they help the poor by lowering rates.
Some international donors assume too easily that the argu-
ment over high interest rates for microcredit has been won. But
recently there have been backlashes in many countries. Before
donors and governments commit to building an enabling
regulatory framework for microfinance, they need to con-
sider the possibility that the process may unavoidably entail
political discussion of interest rates, with results that could
damage responsible microcredit. Experience shows that this
risk is real, although it is certainly not relevant in all countries.
Limitations on Ownership, Management, and Capital Structure
In many legal systems, citizenship, currency, and foreign-invest-
ment regulations create hurdles for some forms of MFI.
Common problems include prohibitions or severe limitations on
the participation of foreign-equity holders (or founders or mem-
bers in the case of NGOs), borrowing from foreign sources, and
employment of non-citizens in management or technical posi-
tions. In many countries, the microfinance business will not
attract conventional commercial investors for some years yet.
Since alternative sources of investment—particularly equity
investment—tend to be international, limitations on foreign
investment can be especially problematic.8
Tax and Accounting Treatment of Microfinance
Taxation of MFIs is becoming a controversial topic in many
countries. Local factors may call for differing results, but the fol-
lowing approach is suggested as a starting point for the analysis.
It is based on a distinction between taxes on financial transac-
tions and taxes on net profits arising from such transactions.
Taxation of Financial Transactions and Activities
With respect to taxes on financial transactions, such as a value-
added tax on lending or a tax on interest revenue, the critical
issue is a level playing field among institutional types. In some
countries, favorable tax treatment on transactions is available
only to prudentially licensed institutions, even though the favor-
able tax treatment bears no substantive relationship to the objec-
tives of prudential regulation. In other countries, financial-trans-
action taxes affect financial cooperatives differently from banks.
Absent other considerations, favorable transaction tax treatment
should be based on the type of activity or transaction, regardless
of the nature of the institution and whether it is prudentially
licensed. To do otherwise gives one form of institution an arbi-
trary advantage over another in carrying out the activity.

12 Microfinance Consensus Guidelines
Taxation of Profits
It can reasonably be argued that not-for-profit NGO MFIs
ought to be treated the same as all other public-benefit NGOs
when the tax in question is a tax on net profits. The reason for
exemption from profits tax is the principle that the NGO is ren-
dering a recognized public benefit and does not distribute its net
surpluses into the pockets of private shareholders or other insid-
ers. Rather, it reinvests any surplus to finance more socially-
beneficial work. To be sure, there are always ways to evade the
spirit of this non-distribution principle, such as excessive com-
pensation and below-market loans to insiders. However, these
potential abuses probably occur no more commonly in NGOs
engaged in microlending than in other types of NGOs.
For any institution subject to a net income or profits tax, rules
for tax deductibility of expenses (such as reasonable provisioning
for bad loans) should apply consistently to all types of institu-
tions, regardless of whether they are prudentially licensed.
Moreover, if it is appropriate to provision a microloan portfolio
more aggressively than a conventional loan portfolio, then the
microlender’s profits tax deduction should also vary accordingly.
For licensed institutions, prudential regulation will normally dic-
tate the amount of loan-loss provisioning. In the case of unli-
censed lending-only institutions, the tax authorities may need
to regulate allowable amounts of provisioning in order to pre-
vent abuse.
Feasible Mechanisms of Legal Transformation
Legal transformations in microfinance—from one institutional
type to another—raise a variety of crosscutting non-prudential
regulatory issues. The simplest and most common type of trans-
formation occurs when an existing MFI operation is transferred to
the local office of an international NGO as a new, locally-formed
NGO. Such a transfer can face serious regulatory obstacles,
including limits on foreign participation, ambiguous or prohibi-
tive taxation of the portfolio transfer, and labor law issues creat-
ed by the transfer of staff. A second, increasingly common type
of legal transformation involves the creation of a commercial
company by an NGO (sometimes together with other investors),
to which the NGO contributes its existing portfolio (or cash
from the repayment of its portfolio) in exchange for shares in the
new company. Such transformations often raise additional issues,
including how to recapture or otherwise make allowance for tax
benefits that the transforming NGOs have received; restrictions
on the NGO’s power to transfer what are deemed “charitable
assets” (its loans) to a privately-owned company; and restrictions
on the NGO’s power to hold equity in a commercial company,
particularly if this will become its principal activity as a result of
the transformation.

Regulation and Supervision 13
Ordinarily, these disparate bodies of regulation do not con-
template, and have never been applied to, microfinance transfor-
mations. Harmonizing their provisions and creating a clear path
for microfinance transformations can be an important enabling
reform. On the other hand, such reform may be a lower priority
if there are only one or two microfinance NGOs who are likely
candidates for transformation.9
III PRUDENTIAL REGULATION OF MICROFINANCE
Objectives of Prudential Regulation
The generally agreed objectives of prudential regulation include
(1) protecting the country’s financial system by preventing the
failure of one institution from leading to the failure of others,
and (2) protecting small depositors who are not well positioned
to monitor the institution’s financial soundness themselves. If
prudential regulation does not focus closely enough on these
objectives, scarce supervisory resources can be wasted, institu-
tions can be saddled with unnecessary compliance burdens, and
development of the financial sector can be constrained.
Drawing the Line: When to Apply Prudential Regulation in
Microfinance?
Timing and the State of the Industry
New regulatory windows for microfinance are being considered
in many countries today. In a few of these countries, a somewhat
paradoxical situation exists. The expectation is that, over the
medium term, the new window will be used mainly by existing
NGO MFIs that want to change to deposit-taking status. But at
the same time, none or almost none of the existing MFIs have
yet demonstrated that they can manage their lending profitably
enough to pay for and protect the deposits they want to mobi-
lize. In such a setting, the government should consider the
option of waiting and monitoring microlenders’ performance,
and open the window only after there is more and better experi-
ence with the financial performance of the MFIs. Developing a
new regulatory regime for microfinance takes a great deal of
analysis, consultation, and negotiation; the costs of the process
can exceed the benefits unless a critical mass of qualifying insti-
tutions can be expected.
In this context, the actual financial performance of existing
MFIs is a crucial element that often gets too little attention in
discussions of regulatory reform. Whenever there is an expec-
tation that existing MFIs will take advantage of a new regu-
latory window, there should be a competent financial analy-
sis of at least the leading MFIs before decisions are made

14 Microfinance Consensus Guidelines
with respect to that window. This analysis should focus on
whether each MFI’s existing operations are profitable enough so
that it can pay the financial and administrative costs of deposit-
taking without decapitalizing itself. Naturally, this analysis will
have to include a determination of whether the MFI’s account-
ing and loan-tracking systems are sound enough to produce reli-
able information.
Sources of Funding
Prudential regulation's two objectives, to prevent risk to the
financial system and to protect depositors, are served
when retail deposits of the general public are protected.
Thus, raising funds from this source will usually call for pruden-
tial regulation. Are MFIs that fund their lending from other
sources of capital also engaged in financial intermediation that
needs to be prudentially regulated? This question needs close
analysis, and its answer will often depend on local factors.10
Donor grants. Historically, donors of one type or another,
including bilateral and multilateral development agencies, have
supported MFIs with grants. The justifications for prudential
supervision do not apply in the case of MFIs funded only by
donor grants. The government may have an interest in seeing
that donor funds are well spent, but microfinance is no different
in this respect from any other donor-supported activity.
Cash collateral and similar obligatory deposits. Many MFIs
require cash deposits from borrowers before and/or during a
loan, in order to demonstrate the borrower’s ability to make pay-
ments, and to serve as security for the repayment of the loan.
Even though these deposits are often called “compulsory
savings,” it is more useful to think of them as cash collateral
required by the loan contract, rather than as a true savings serv-
ice. This cash collateral is sometimes held by a third party (such
as a commercial bank), and thus is not intermediated by the MFI.
Even where the MFI holds its clients’ obligatory deposits,
and even if it intermediates them by lending them out, the
question of whether to apply prudential regulation should
be approached from the standpoint of practically weighing
the costs and benefits. If cash collateral is the only form of
deposit taken by the MFI, then most of its customers owe more
to the MFI than the MFI owes to them, most of the time. If the
MFI fails, these customers can protect themselves by simply ceas-
ing repayment of their loan. It is true that some of the MFI’s
customers will be in a net at-risk position some of the time, so
that the MFI’s failure would imperil their deposits, but this rela-
tively lesser risk needs to be weighed against the various costs of
prudential supervision—costs to the supervisor, to the MFI, and
to the customer. Several countries have taken a middle path on
this issue, requiring prudential licensing only for MFIs that hold

Regulation and Supervision 15
and intermediate their clients’ cash collateral, but not for MFIs
that keep such collateral in low-risk securities or in an account
with a licensed bank.
Borrowing from non-commercial sources, including donors or spon-
sors. Increasingly, donors are using loans rather than grants to sup-
port MFIs. Although the loan proceeds are intermediated by the
MFI, their loss would pose no substantial systemic risk in the host
country, and the lenders are well-positioned to protect their own
interests if they care to. The definition of deposit-taking that trig-
gers prudential regulation should therefore exclude this type of
borrowing.
Commercial borrowing. Some MFIs get commercial loans from
international investment funds that target social-purpose invest-
ments, and from locally licensed commercial banks. Here, too,
the fact that commercial loan proceeds are intermediated by
the MFI should not lead to prudential regulation of the bor-
rowing MFI. Where the lender is an international investment
fund, the loss of its funds will not pose systemic risk, and the
lender should be able to look out for its own interests. Where the
lender is a locally-licensed commercial bank, it should itself
already be subject to appropriate prudential regulation, and the
fact that an MFI borrows from the bank does not justify pru-
dential regulation of the MFI any more than would be the case
for any other borrower from the bank.11
Wholesale deposits and deposit substitutes. In some countries, MFIs
can finance themselves by issuing commercial paper, bonds, or
similar instruments in the local securities markets. Similar issues
are presented by the direct issuance of large certificates of
deposit. Unlike deposits from the general public, all these instru-
ments tend to be bought by large, sophisticated investors. There
is not a consensus on how to regulate such instruments. Some
argue that the buyers of these instruments ought to be able to
make their own analysis of the financial soundness of the issuing
business. Therefore, they would subject the issuer only to normal
securities regulation, which generally focuses on insuring com-
plete disclosure of relevant information, rather than giving any
assurance as to the financial strength of the issuer. Others, less
impressed by the distinction between wholesale and retail
deposits or skeptical about the local securities law and enforce-
ment, insist that any institution issuing such instruments and
intermediating the funds be prudentially regulated.
Members’ savings. Much of the current discussion of microfi-
nance regulation focuses, implicitly or explicitly, on NGO MFIs
that have begun with a credit-based model and now want to
move to capturing deposits. But in large parts of the world, most
microfinance is provided by financial cooperatives that typically
fund their lending from members’ share deposits and savings. It

16 Microfinance Consensus Guidelines
is sometimes argued that, because these institutions take deposits
only from members and not from “the public,” they need not be
prudentially supervised. This argument is problematic. In the
first place, when a financial cooperative becomes large, its mem-
bers as a practical matter may be in no better a position to super-
vise management than are the depositors in a commercial bank.
Secondly, the boundaries of membership can be porous. For
instance, financial cooperatives whose common bond is geo-
graphical can capture deposits as extensively as they want by the
simple expedient of automatically giving a membership to any-
one in their area of operations who wants to make a deposit.
Often such financial cooperatives are licensed under a special
law, and their supervision may be lodged in the government
agency that supervises all cooperatives, including cooperatives
focused on production, marketing, and other non-financial activ-
ities. While these agencies may be legally responsible for pru-
dential supervision of the safety of depositors, they almost never
have the resources, expertise, and independence to do that job
effectively. Absent strong local reasons to the contrary, financial
cooperatives—at least large ones—should be prudentially
supervised by a specialized financial authority. In countries
with a large existing base of financial cooperatives, securing
effective regulation and supervision of these cooperatives may be
a more immediate priority than developing new windows for
NGO microfinance.
Rationing Prudential Regulation, and Minimum Capital
As discussed below, prudential supervision is expensive. When
measured as a percentage of assets supervised, these expenses are
higher for small institutions than for large ones. Furthermore,
supervisory authorities have limited resources. As a practical mat-
ter, there is a need to ration the number of financial licenses that
will require supervision. The most common tool for this
rationing is a minimum capital requirement—the lowest amount
of currency that owners can bring to the equity account of an
institution seeking a license.
In theory, setting of minimum capital could be based on
economies of scale in financial intermediation: in other words,
below a certain size, an intermediary cannot support the mini-
mum necessary infrastructure and still operate profitably.
However, there is an increasing tendency to downplay the utility
of minimum capital as a safety measure and instead to treat it more
straightforwardly as a rationing tool. The lower the minimum cap-
ital, the more entities will have to be supervised.
Those who see regulation of microfinance primarily as pro-
motion will want low minimum-capital requirements, making it
easier to obtain new licenses. On the other hand, supervisors who
will have to oversee the financial soundness of new deposit-
taking institutions tend to favor higher capital requirements,

Regulation and Supervision 17
because they know there are limits on the number of institutions
they can supervise effectively. To put the point simply, there is a
trade-off between the number of new institutions licensed and
the likely effectiveness of the supervision they will receive. The
most common tool for drawing the balance is minimum capital.
However, minimum capital is not necessarily the only tool
available to limit new market entrants. For example, licensing
decisions can be based in part on qualitative institutional assess-
ments—though qualitative standards leave more room for abuse
of official discretion.12
Whatever rationing tools are used, it would seem reasonable
to err on the side of conservatism at first, as long as the require-
ments can be adjusted later, when the authorities have more
experience with the demand for licenses and the practicalities of
microfinance supervision. Obviously, such flexibility is easier if
the requirements are placed in regulations rather than in the law.
Drawing Lines Based on Cost-Benefit Analysis—
The case of small community-based intermediaries
Some member-owned intermediaries take deposits but are so
small, and sometimes so geographically remote, that they cannot
be supervised on any cost-effective basis. This poses a practical
problem for the regulator. Should these institutions be allowed
to operate without prudential supervision, or should minimum-
capital or other requirements be enforced against them so that
they have to cease taking deposits?
Sometimes regulators are inclined to the latter course. They
argue that institutions that cannot be supervised are not safe, and
therefore should not be allowed to take small depositors’ sav-
ings.13 After all, are not small and poor customers just as entitled
to safety as large and better-off customers?
But this analysis is too simple if it does not consider the actu-
al alternatives available to the depositor. Abundant studies show
that poor people can and do save. Especially where formal
deposit accounts are not available, they use savings tools, such as
currency under the mattress, livestock, building materials, or
informal arrangements like rotating savings and credit clubs. All
of these vehicles are risky, and in many if not most cases, they are
more risky than a formal account in a small unsupervised inter-
mediary. Closing down the local savings and loan cooperative
may in fact raise, not lower, the risk faced by local savers by forc-
ing them back to less satisfactory forms of savings.
Because of these considerations, most regulators facing the
issue have chosen to exempt community-based intermediaries
below a certain size from requirements for prudential regulation
and supervision. The size limits are determined by number of
members, amount of assets, or both. (Sometimes the exemption
is available only to “closed bond” institutions whose services are
available only to members of a pre-existing group.) Once the

18 Microfinance Consensus Guidelines
limits are exceeded, the institution must comply with prudential
regulation and be supervised.
If small intermediaries are allowed to take deposits without
prudential supervision, a good argument can be made that their
customers should be clearly advised that no government agency
is monitoring the health of the institution, and thus that they
need to form their own conclusions based on their knowledge of
the individuals running the institution.
These issues presented by very small intermediaries illustrate
a more general principle that applies to many of the topics dis-
cussed in this paper. Depositor protection is not an absolute
value that overrules all other considerations. Some rules that
lower risk can also lower poor people’s access to financial services,
an equally important value. In such cases, the regulator’s objec-
tive should be, not the elimination of risk, but rather a prudent
balancing of safety and access.
Regulate Institutions or Activities?
When trying to open up regulatory space for microfinance, there
is a natural tendency to think in terms of creating a new, special-
ized institutional type. In some settings this is the best option.
But alternatives should be considered, including the possibility
of fine-tuning an existing form of financial license. There is some
danger that too exclusive a focus on a particular institutional
form may cramp innovation and competition, encourage regula-
tory arbitrage, or impede the integration of microfinance into
the broader financial sector.
These considerations lead some in the field to argue that pol-
icy makers should focus more on regulating microfinance as a set
of activities, regardless of the type of financial institution carry-
ing them out, and less on particular institutional forms. This is a
healthy emphasis. The following section discusses special regula-
tory adjustments needed for microfinance; almost all of these
adjustments would be applicable no matter what type of institu-
tion is doing microfinance. At the same time, a few of the nec-
essary regulatory adjustments will have to do with the type of
institution rather than the activity itself. For instance, microlend-
ing arguably presents a lower risk profile when it is a small part
of the portfolio of a diversified full-service bank, compared to
microlending that constitutes the majority of a specialized MFI’s
assets; thus, it can reasonably be argued that these two institu-
tional types ought to be subject to different capital-adequacy
rules.
Special Prudential Standards for Microfinance
Some regulations common in traditional banking need to be
adjusted to accommodate microfinance. Whether microfinance
is being developed through specialized stand-alone depository

Regulation and Supervision 19
MFIs, or as product lines within retail banks or finance compa-
nies, the following sets of regulations will commonly need reex-
amination, at least for those products that can fairly be catego-
rized as “micro.” Other rules may require adjustment in some
countries, but the list below includes the most common issues.
Minimum Capital
The kind of investors who are willing and able to finance MFIs
may not be able to come up with the amount of capital required
for a normal bank license. Furthermore, it might take a special-
ized MFI a long time to build a portfolio large enough to lever-
age adequately the amount of equity required for a bank. The
trade-offs involved in setting minimum capital requirements for
microfinance were discussed on page 16.
Capital Adequacy14
There is controversy as to whether the capital adequacy require-
ments for specialized MFIs should be tighter than the require-
ments applied to diversified commercial banks. A number of fac-
tors argue in the direction of such conservatism.
Well-managed MFIs maintain excellent repayment perform-
ance, with delinquency typically lower than in commercial banks.
However, MFI portfolio tends to be more volatile than com-
mercial bank portfolio, and can deteriorate with surprising
speed. The main reason for this is that microfinance portfolio is
usually unsecured, or secured by assets that are insufficient to
cover the loan, once collection costs are included. The borrow-
er’s main incentive to repay a microloan is the expectation of
access to future loans. Thus, outbreaks of delinquency in an MFI
can be contagious. When a borrower sees that others are not
paying back their loans, that borrower’s own incentive to con-
tinue paying declines, because the outbreak of delinquency
makes it less likely that the MFI will be able to reward the bor-
rower’s faithfulness with future loans. Peer dynamics play a role
as well: when borrowers have no collateral at risk, they may feel
foolish paying their loans when others are not.
In addition, because their costs are high, MFIs need to
charge high interest rates to stay afloat. When loans are not being
paid, the MFI is like any bank in that it is not receiving the cash
it needs to cover the costs associated with those loans. However,
the MFI’s costs are usually much higher than a commercial
bank’s costs per unit lent, so that a given level of delinquency will
decapitalize an MFI much more quickly than it would decapital-
ize a typical bank.
Another relevant factor is that in most countries, neither
microfinance as a business nor individual MFIs as institutions
have a very long track record. Management and staff of the MFIs
tend to be relatively inexperienced, and the supervisory agency
has little experience with judging and controlling microfinance

20 Microfinance Consensus Guidelines
risk. Furthermore, many new MFIs are growing very fast, which
puts heavy strain on management and systems.
Finally, as will be discussed below, some important super-
visory tools do not work very well for specialized MFIs.
For all these reasons, a prudent conservatism would seem to
suggest that specialized MFIs be subject to a higher capital-
adequacy percentage than is applied to normal banks, at least
until some years of historical performance have demonstrated
that risks can be managed well enough, and that the supervisor
can respond to problems quickly enough, so that MFIs can then
be allowed to leverage as aggressively as commercial banks.
Others argue that applying a higher capital-adequacy require-
ment to MFIs, or an equivalent risk-weighting requirement to
microloan portfolios in diversified institutions, will tend to lower
the return on equity in microlending, thus reducing its attrac-
tiveness as a business and creating an uneven playing field. On
the other hand, the demand for microfinance is less sensitive to
interest rates than is the demand for normal bank loans, so that
microlenders have more room to adjust their interest-rate spread
to produce the return they need, as long as all microlenders are
subject to the same rules and the government does not impose
interest rate caps.
Applying capital-adequacy norms to financial cooperatives
presents a specific issue with respect to the definition of capital.
All members of such cooperatives are required to invest a mini-
mum amount of “share capital” in the institution. But unlike an
equity investment in a bank, a member’s share capital can usually
be withdrawn whenever the member decides to leave the coop-
erative. From the vantage of institutional safety, such capital is
not very satisfactory: it is impermanent, and is most likely to
be withdrawn at precisely the point where it would be most
needed—when the cooperative gets into trouble. Capital built
up from retained earnings, sometimes called “institutional capi-
tal,” is not subject to this problem. One approach to this issue is
to limit members’ rights to withdraw share capital if the cooper-
ative’s capital adequacy falls to a dangerous level. Another
approach is to require cooperatives to build up a certain level of
institutional capital over a period of years, after which time cap-
ital adequacy is based solely on these retained earnings.
Unsecured Lending Limits, and Loan-Loss Provisions
In order to minimize risk, regulations often limit unsecured
lending to some percentage—often 100 percent—of a bank’s
equity base. Such a rule should not be applied to microcre-
dit because it would make it impossible for an MFI to leverage
its equity with deposits or borrowed money.
Bank regulations sometimes require 100-percent loan-loss
provisions for all unsecured loans at the time they are made, even
before they become delinquent. However, this is unworkable

Regulation and Supervision 21
when applied to microcredit portfolios. Even if the provision
expense is later recovered when a loan is collected, the accumu-
lated charge for current loans would produce a massive under-
representation of the MFI’s real net worth.
To meet these two problems, a common regulatory adjust-
ment is to treat group guarantees as “collateral” for purposes
of applying such regulations to microcredit. This can be a con-
venient solution to the problem if all microlenders use these guar-
antees. However, group guarantees are less effective than is often
supposed. Many MFIs do not enforce these guarantees, and there
is no evidence that group-guaranteed microloans have higher
repayment rates than nonguaranteed individual microloans. The
most powerful source of security in microcredit tends to be the
strength of an institution’s lending, tracking, and collection pro-
cedures, rather than the use of group guarantees.
Whatever the rationale used to justify the adjustment, com-
petent lenders should not be required to automatically provision
large percentages of microcredit loans as soon as they are made.
But once such loans have fallen delinquent, the fact that they are
unsecured justifies requiring them to be provisioned more
aggressively than conventionally collateralized portfolio. This is
especially true in countries where microlending tends to be
short-term. After sixty days of delinquency, a three-month unse-
cured microloan with weekly scheduled payments presents a
higher likelihood of loss than does a two-year loan secured by
real estate and payable monthly.
In some countries, MFIs are effectively prevented from bor-
rowing from banks because the MFIs cannot offer qualifying col-
lateral, and without such collateral the bank would have to pro-
vision 100 percent of the loan. In such countries, consideration
should be given to adjusting the banking rules so that the loan
portfolio of an MFI with a strong track record of collection can
qualify as collateral for a bank loan.
Loan Documentation
Given the nature of microfinance loan sizes and customers,
it would be excessive or impossible to require them to gen-
erate the same loan documentation as commercial banks.
This is particularly true, for instance, with collateral registration,
financial statements of borrowers’ businesses, or evidence that
those businesses are formally registered. These requirements
must be waived for micro-sized loans. On the other hand, some
microlending methodologies depend on the MFI’s assessment of
each borrower’s repayment ability. In such cases, it is reasonable
to require that the loan file contain simple documentation of that
assessment of the client’s cash flow. However, when it makes
repeated short-term (for instance, three-month) loans to the
same customer, the MFI should not be required to repeat the
cash-flow analysis for every single loan.

22 Microfinance Consensus Guidelines
Restrictions on Co-signers as Borrowers
Regulations sometimes prohibit a bank from lending to someone
who has co-signed or otherwise guaranteed a loan from that
same bank. This creates problems for institutions using group-
lending mechanisms that depend on all group members co-sign-
ing each others’ loans.
Physical Security and Branching Requirements
Banks’ hours of business, location of branches, and security
requirements are often strictly regulated in ways that could
impede service to a microfinance clientele. For instance, client
convenience might require operations outside normal business
hours, or cost considerations might require that staff rotate
among branches that are open only one or two days a week.
Security requirements such as guards or vaults, or other normal
infrastructure rules, could make it too costly to open branches in
poor areas. Branching and physical security requirements merit
reexamination—but not necessarily elimination—in the microfi-
nance context. Clients’ need for access to financial services has to
be balanced against the security risks inherent in holding cash.
Frequency and Content of Reporting
Banks may be required to report their financial position fre-
quently—even daily. In many countries, the condition of trans-
portation and communication can make this virtually impossible
for rural banks or branches. More generally, reporting to a super-
visor (or a credit information service) can add substantially to the
administrative costs of an intermediary, especially one that spe-
cializes in very small transactions. Reporting requirements
should usually be simpler for microfinance institutions or
programs than for normal commercial bank operations.
Reserves against Deposits
Many countries require banks to maintain reserves equal to a
percentage of certain types of deposits. These reserves may be a
useful tool of monetary policy, but they amount to a tax on sav-
ings, and can squeeze out small depositors by raising the mini-
mum deposit size that banks or MFIs can handle profitably. This
latter drawback should be factored into decisions about reserve
requirements.
Ownership Suitability and Diversification Requirements15
The typical ownership and governance structure of MFIs tends
to reflect their origins and initial sources of capital. NGOs, gov-
ernmental aid agencies, multilateral donors, and other develop-
ment-oriented investors predominate over those who have the
profit-maximizing objectives of typical bank shareholders. The
individuals responsible for these development-oriented invest-

Regulation and Supervision 23
ments are usually not putting at risk money from their own pri-
vate pockets. Investors of this kind, and their elected directors,
may have weaker personal incentives to monitor the risk-taking
behavior of MFI management closely. This does not imply that
private, profit-maximizing owners of commercial banks always
do a good job of supervising commercial bank management. But
experience does indicate that such owners tend on the average to
watch the management of their investments more carefully than
do the representatives of donors and social investors.
Typical banking regulation mandates the nature of per-
missible shareholders, as well as the minimum number of
founding shareholders and a maximum percentage of own-
ership for any shareholder. Both types of rules can pose
obstacles for depository MFIs, given their ownership and
governance attributes.
These rules serve legitimate prudential objectives. Mandates
as to the nature of permissible shareholders aim to assure that the
owners of a depository financial institution will have both the
financial capacity and the direct interest to put in additional
funds if there is a capital call. Ownership diversification require-
ments aim at preventing “capture” of bank licenses by single
owners or groups, and building checks and balances into gover-
nance. But together these requirements can cause serious prob-
lems in the common case, where the assets of the new licensed
MFI come almost entirely from the NGO that has been con-
ducting the microfinance business until the creation of the new
institution.
First, laws or regulations sometimes prohibit an NGO from
owning shares in the licensed institution. While such a prohibi-
tion may serve a legitimate purpose, it generally poses too heavy
an obstacle to the eventual licensing of microfinance that origi-
nated in an NGO: consideration should be given to amending it.
Even if the NGO is permitted to own shares of the new institu-
tion, diversification requirements may pose an additional chal-
lenge. For instance, a five-owner minimum and a 20-percent
maximum per shareholder would force the transforming NGO
to seek out four other owners whose combined capital contribu-
tion would be four times as much as the NGO is contributing.
This can be an impractical burden for a socially-oriented business
whose profitability is not yet strong enough to attract purely
commercial equity. The only alternative has sometimes been to
distribute shares to other owners who have not paid in an equiv-
alent amount of equity capital. This arrangement does not tend
to produce good oversight by the other owners.
Given the legitimate objectives of shareholder suitability and
ownership diversification requirements, there is no easy or uni-
versal prescription for how to modify these types of rules to
accommodate MFIs. However, the solution may in some
instances be as simple as permitting the licensing agency the dis-

24 Microfinance Consensus Guidelines
cretion to consider the particular situation of microfinance appli-
cants and their proposed backers, and waive shareholder suit-
ability and diversification requirements on a case-by-case basis.
Who Should These Special Standards Apply to?
It is worth reiterating that most of the adjustments mentioned
in this section should ideally apply, not only to specialized
MFIs, but also to microfinance operations in commercial
banks or finance companies. Some of them are also relevant to
unsecured lending by financial cooperatives.
Even if a country’s commercial banks have no interest in
microfinance at present, those attitudes can change once special-
ized MFIs credibly demonstrate the profit potential of their busi-
ness. If a full-service bank decides to offer microfinance prod-
ucts, or to partner with an MFI to offer those products, it should
have a clear regulatory path to do so; otherwise, continued frag-
mentation of the financial sector is guaranteed. Regulators and
supervisors should have a special incentive to encourage such
developments: when microcredit is a small part of a diversified
commercial-bank portfolio, the risk and cost of supervising the
microfinance activity become much lower. Moreover, a level
playing field in terms of the prudential standards applied to an
activity helps to stimulate competition.
Deposit Insurance
In order to protect smaller depositors and reduce the likelihood
of runs on banks, many countries provide explicit insurance of
bank deposits up to some size limit. Some other countries pro-
vide de facto reimbursement of bank depositors’ losses even in
the absence of an explicit legal commitment to do so. There is
considerable debate about whether public deposit insurance is
effective in improving bank stability, whether it encourages inap-
propriate risk-taking on the part of bank managers, and whether
such insurance would be better provided through private mar-
kets. In any event, if deposits in commercial banks are insured,
the presumption ought to be that deposits in other institutions
prudentially licensed by the financial authorities should also be
insured, absent compelling reasons to the contrary.
IV FACING THE SUPERVISORY CHALLENGE
Decades of experience around the world with many forms of
“alternative” financial institutions—including various forms of
financial cooperatives, mutual societies, rural banks, village
banks, and now MFIs—demonstrate that there is a strong and
nearly universal temptation to underestimate the challenge
of supervising such institutions in a way that will keep them
reasonably safe and stable. When the various stakeholders start

Regulation and Supervision 25
discussing legal frameworks for microfinance in a country, it is
relatively easy and interesting to craft regulations, but harder and
less attractive to do concrete practical planning for effective
supervision. The result is that supervision sometimes gets little
attention in the process of regulatory reform, often on the
assumption that whatever supervisory challenges are created by
the new regulation can be addressed later, by pumping extra
money and technical assistance into the supervisory agency for a
while. This assumption can be wrong in many cases. The result
may be regulation that is not enforced, which can be worse than
no regulation at all.
Microfinance as an industry can never reach its full potential
until it is able to move into the sphere of prudentially regulated
institutions, where it will have to be prudentially supervised.16
While prudential regulation and supervision is inevitable for
microfinance, there are choices to be made and balances to be
drawn in deciding when, and how, this development takes place.
Those balances are likely to be drawn in the right place only
if supervisory capability, costs, and consequences are exam-
ined earlier and more carefully than is sometimes the case in
present regulatory discussions.
The crucial importance of early and realistic attention to
supervision issues stems from the fiduciary responsibility the gov-
ernment assumes when it grants financial licenses. Citizens should
be able to assume, and usually do assume, that the issuance of a
prudential license to a financial intermediary means that the gov-
ernment will effectively supervise the intermediary to protect
their deposits. Thus, licenses are promises. Before deciding to
issue them, a government needs to be clear about the nature
of the promises and about its ability to fulfill them.
Supervisory Tools and Their Limitations
Portfolio supervision tools. Some standard tools for examining
banks’ portfolios are ineffective for microcredit. As noted earlier,
loan-file documentation is a weak indicator of microcredit risk.
Likewise, sending out confirmation letters to verify account bal-
ances is usually impractical, especially where client literacy is low.
Instead, the examiner must rely more on an analysis of the insti-
tution’s lending systems and their historical performance.
Analysis of these systems requires knowledge of microfinance
methods and operations, and drawing practical conclusions from
such analysis calls for experienced interpretation and judgment.
Supervisory staff are unlikely to monitor MFIs effectively
unless they are trained and to some extent specialized.
Capital calls. When an MFI gets in trouble and the supervisor
issues a capital call, many MFI owners are not well-positioned to
respond to it. NGO owners may not have enough liquid capital
available. Donors and development-oriented investors usually

26 Microfinance Consensus Guidelines
have plenty of money, but their internal procedures for disburs-
ing it often take so long that a timely response to a capital call is
impractical. Thus, when a problem surfaces in a supervised MFI,
the supervisor may not be able to get it solved by the injection
of new capital.
Stop-lending orders. Another common tool that supervisors use
to deal with a bank in trouble is the stop-lending order, which
prevents the bank from taking on further credit risk until its
problems have been sorted out. A commercial bank’s loans are
usually collateralized, and most of the bank’s customers do not
necessarily expect an automatic follow-on loan when they pay off
their existing loan. Therefore, a commercial bank may be able to
stop new lending for a period without destroying its ability to
collect its existing loans. The same is not true of most MFIs.
Immediate follow-on loans are the norm for most microcredit. If
an MFI stops issuing repeat loans for very long, customers lose
their primary incentive to repay, which is their confidence that
they will have timely access to future loans when they need them.
When an MFI stops new lending, many of its existing borrowers
will usually stop repaying. This makes the stop-lending order a
weapon too powerful to use, at least if there is any hope of sal-
vaging the MFI’s portfolio.
Asset sales or mergers. A typical MFI’s close relationship with its
clients may mean that loan assets have little value in the hands of
a different management team. Therefore, a supervisor’s option
of encouraging the transfer of loan assets to a stronger institution
may not be as effective as in the case of collateralized commer-
cial bank loans.
The fact that some key supervisory tools do not work very
well for microfinance certainly does not mean that MFIs cannot
be supervised. However, regulators should weigh this fact care-
fully when they decide how many new licenses to issue, and how
conservative to be in setting capital-adequacy standards or
required levels of past performance for transforming MFIs.
Costs of Supervision
Promoters of new regulatory windows for MFIs are rightly
enthusiastic about the possibility of bringing financial services to
people who have never had access to them before. Supervisors,
on the other hand, tend to concentrate more on the costs of
supervising new, small entities. Good microfinance regulation
needs to balance both factors.
In relation to the assets being supervised, specialized MFIs
are much more expensive to supervise than full-service banks.
One supervisory agency with several years of experience found
that supervising MFIs cost it 2 percent per year of the assets of
those institutions—about 30 times as expensive as its supervision

Regulation and Supervision 27
of commercial bank assets. Donors who promote the develop-
ment of depository microfinance should also consider pro-
viding transitional subsidy for supervising the resulting
institutions—particularly in the early stages when the supervi-
sory staff is learning about microfinance and there are a small
number of institutions to share the costs of supervision.
However, in the long term, the government must decide
whether it will subsidize these costs or make MFIs pass them on
to their customers.
Even if a donor pays the additional cash costs of MFI supervi-
sion, there is a further cost in terms of the time and attention of
the managers of the supervisory agency. In some developing and
transitional economies, the national economy is at serious risk
because of systemic problems with the country’s commercial
banks. In such settings, serious consideration should be given to
the cost of diverting too much of agency management’s attention
away from their primary task, by requiring them to spend time on
small MFIs that pose no threat to the country’s financial systems.
The administrative costs within the supervised MFI are also
substantial. It would not be unusual for compliance to cost an
MFI 5 percent of assets in the first year or two and 1 percent or
more thereafter.
Where to Locate Microfinance Supervision?
Given the problem of budgeting scarce supervisory resources,
alternatives to the conventional supervisory mechanisms used for
commercial banks are frequently proposed for depository MFIs.
Within the Existing Supervisory Authority?
The most appropriate supervisory body for depository microfi-
nance is usually (though not always) the supervisory authority
responsible for commercial banks. Using this agency to supervise
microfinance takes advantage of existing skills and lowers the
incentive for regulatory arbitrage. The next question is whether
to create a separate department of that agency. The answer will
vary from country to country, but at a minimum, specially
trained supervisory staff is needed, given the differing risk char-
acteristics and supervisory techniques in the case of MFIs and
microfinance portfolios.
The question whether to house microfinance regulation
within the existing supervisory authority becomes more compli-
cated when both non-depository microlending institutions and
depository MFIs are to be addressed within a single, compre-
hensive regulatory scheme. The tasks involved in issuing permits
to non-depository microlending institutions have relatively little
to do with the prudential regulation and supervision of deposi-
tory institutions. In some contexts, lodging both of these dis-
parate functions within the same regulatory body might be jus-

28 Microfinance Consensus Guidelines
tified on pragmatic grounds—such as the absence of any other
appropriate body, or the likelihood that the permit-issuing func-
tion would be more susceptible to political manipulation and
abuse if carried out by another body. In other cases, non-depos-
itory MFIs are required to report to the banking supervisor in
order to make it easier for them to move eventually into more
services and more demanding prudential regulation. Often,
however, the risks of consolidating prudential and non-pruden-
tial regulation of microfinance within the supervisory body
responsible for banks will outweigh the benefits. These risks
include the possibility of confusion on the part of supervisors as
to the appropriate treatment of non-depository institutions, and
the possibility that the public will see the supervisory authority
as vouching for the financial health of the non-depository insti-
tutions, even though it is not (and should not be) monitoring
the health of these institutions closely.
“Self-Regulation” and Supervision
Sometimes regulators decide that it is not cost-effective for the
government financial supervisor to provide direct oversight of
large numbers of MFIs. Self-regulation is sometimes suggested
as an alternative. Discussion of self-regulation tends to be con-
fused because people use the term to mean different things. In
this paper, “self-regulation” means regulation (and/or supervi-
sion) by any body that is effectively controlled by the regulated
entities, and thus not effectively controlled by the government
supervisor.
This is one point on which historical evidence seems clear.
Self-regulation of financial intermediaries in developing
countries has been tried many times, and has virtually never
been effective in protecting the soundness of the regulated
organizations. One cannot assert that effective self-regulation in
these settings is impossible in principle, but it can be asserted
that such self-regulation is almost always an unwise gamble,
against very long odds, at least if it is important that the regula-
tion and supervision actually enforce financial discipline and con-
servative risk management.
Sometimes regulators have required certain small intermedi-
aries to be self-regulated, not because they expect the regulation
and supervision to be effective, but because this is politically
more palatable than saying that these depositor-takers will be
unsupervised. This can be a sensible accommodation in some
settings. While self-regulation probably will not keep financial
intermediaries healthy, it may have some benefits in getting insti-
tutions to begin a reporting process or in articulating basic stan-
dards of good practice.

Regulation and Supervision 29
Delegated Supervision
“Delegated supervision” refers to an arrangement where the gov-
ernment financial supervisor delegates direct supervision to an
outside body, while monitoring and controlling that body’s work.
This seems to have worked, for a time at least, in some cases
where the government financial supervisor closely monitored the
quality of the delegated supervisor’s work, although it is not clear
that this model reduces total supervision costs. Where this model
is being considered, it is important to have clear answers to three
questions. (1) Who will pay the substantial costs of the delegated
supervision and the government supervisor’s oversight of it? (2)
If the delegated supervisor proves unreliable and its delegated
authority must be withdrawn, is there a realistic fallback option
available to the government supervisor? (3) When a supervised
institution fails, which body will have the authority and ability to
clean up the situation by intervention, liquidation, or merger?
Because many MFIs are relatively small, there is a temptation
to think that their supervision can be safely delegated to external
audit firms. Unfortunately, experience has been that external
audits of MFIs, even by internationally-affiliated audit firms, very
seldom include testing that is adequate to provide a reasonable
assurance as to the soundness of the MFI’s loan assets, which is
by far the largest risk area for microlenders. If reliance is to be
placed on auditors, the supervisor must require microfi-
nance-specific audit protocols that are more effective, and
more expensive, than the ones now in general use, and must reg-
ularly test the auditors’ work.
V KEY POLICY RECOMMENDATIONS
Discussion of microfinance regulation and supervision is neces-
sarily complex and filled with qualifications and caveats. For the
sake of clarity and emphasis, this paper concludes with a brief
reiteration of some of its more important recommendations.
➨ Powerful new “microfinance” techniques are being developed
that allow formal financial services to be delivered to low-
income clients who have previously not had access to such
services. In order to reach its full potential, the microfinance
industry must eventually be able to enter the arena of licensed,
prudentially supervised financial intermediation, and regula-
tions must eventually be crafted that allow this development.
➨ Problems that do not require the government to oversee and
attest to the financial soundness of regulated institutions
should not be dealt with through prudential regulation.
Relevant forms of non-prudential regulation, including regu-
lation under the commercial or criminal codes, tend to be eas-
ier to enforce and less costly than prudential regulation.

30 Microfinance Consensus Guidelines
➨ Proponents of microfinance regulation need to be careful about
steps that might bring the topic of microcredit interest rates
into public and political discussion. Microcredit needs high
interest rates. In many countries, it may be impossible to get
explicit political acceptance of a rate that is high enough to
allow viable microfinance. In other contexts, concerted edu-
cation of relevant policymakers may succeed in establishing
the necessary political acceptance.
➨ Credit-reference services can lower lenders’ costs and expand
the supply of credit for lower-income borrowers. However,
they are not technically feasible in all countries.
➨ A microlending institution should not receive a license to take
deposits until it has demonstrated that it can manage its lend-
ing profitably enough so that it can cover all its costs, includ-
ing the additional financial and administrative costs of mobi-
lizing the deposits it proposes to capture.
➨ Before regulators decide on the timing and design of pruden-
tial regulation, they should obtain a competent financial and
institutional analysis of the leading MFIs, at least if existing
MFIs are the main candidates for a new licensing window
being considered.
➨ Prudential regulation should not be imposed on “credit-
only” MFIs that merely lend out their own capital, or whose
only borrowing is from foreign commercial or non-commer-
cial sources or from prudentially regulated local commercial
banks.
➨ Depending on practical costs and benefits, prudential regula-
tion may not be necessary for MFIs taking cash collateral
(compulsory savings) only, especially if the MFI is not lending
out these funds.
➨ As much as possible, prudential regulation should be focused
on the type of transaction being conducted rather than the
type of institution conducting it.
➨ Where possible, regulatory reform should include adjusting
any regulations that would preclude existing financial institu-
tions (banks, finance companies, etc.) from offering microfi-
nance services, or that would make it unreasonably difficult
for such institutions to lend to MFIs.
➨ Where cost-effective prudential supervision is impractical,
consideration should be given to allowing very small commu-
nity-based intermediaries to continue taking deposits from
members without being prudentially supervised, especially in
cases where most members do not have access to safer deposit
vehicles.

Regulation and Supervision 31
➨ Minimum capital needs to be set high enough so that the
supervisory authority is not overwhelmed by more new insti-
tutions than it can supervise effectively.
➨ Most microlending is for all practical purposes unsecured.
Limits on unsecured lending, or high provisioning of unse-
cured portfolio that has not fallen delinquent, are not practi-
cal for MFIs. Instead, risk control needs to be based on the
MFI’s historical collection performance, and analysis of its
lending systems and practices.
➨ Loan documentation and reporting requirements need to be
simpler for microfinance institutions and operations than for
normal commercial bank operations.
➨ Limitations on foreign ownership or maximum shareholder
percentages may be inappropriate, or need flexible applica-
tion, if local microfinance is at a stage where much of the
investment will have to come from transforming NGOs and
other socially-motivated investors.
➨ Designers of new regulation for microfinance need to pay
much more attention to issues of likely effectiveness and cost
of supervision than is usually done. Financial intermediation
licenses are promises. Before issuing them, a government
needs to be clear about the nature of the promises and its
practical ability to honor them.
➨ Design of microfinance regulation should not proceed very
far without estimating supervision costs realistically and iden-
tifying a sustainable mechanism to pay for them. Donors who
encourage governments to take on supervision of new types
of institution should be willing to help finance the start-up
costs of such supervision.
➨ Supervision of microfinance—especially portfolio testing—
requires some techniques and skills that are different from
those used to supervise commercial banks. Supervisory staff
will need to be trained and to some extent specialized in order
to deal effectively with MFIs.
➨ Financial cooperatives—at least large ones—should be pru-
dentially supervised by a specialized financial authority, rather
than by an agency that is responsible for all cooperatives.
➨ In developing countries, “self-supervision” by an entity under
the control of those supervised is extremely unlikely to be
effective in protecting the soundness of the supervised finan-
cial institutions.
➨ External auditors cannot reliably appraise the financial condi-
tion of MFIs unless they test portfolio with microfinance-
specific procedures that go well beyond normal present
practice.

32 Microfinance Consensus Guidelines
NOTES
1. CGAP, the Consultative Group to Assist the Poor, is made up of
29 international donor agencies that support microfinance. A ver-
sion of this document was approved and adopted by the
Consultative Group members in September 2002.
2. Average microcredit loan balances tend to be below per-capita nation-
al income.
3. This paper does not embrace insurance and leasing, even though
these financial services have important potential for lower-income
people. For these services, there is almost no experience yet with
specialized regulation focused on the needs of poorer clients.
4. The term “non-prudential regulation” poses some problems. The
distinction between prudential and non-prudential regulation is
not always crisp—sometimes a rule serves both prudential and non-
prudential objectives. For example, regulation aimed at prevention
of financial crimes (see the discussion on fraud and financial crimes,
on page 8), also contributes to prudential objectives. Moreover,
defining non-prudential regulation simply by reference to what it is
not leaves open the question of the scope of the concept. The term
“conduct of business” regulation is sometimes used to denote the
non-prudential rules applicable to financial institutions. However,
this term is also problematic since prudential regulation also affects
the conduct of a financial institution’s business.
5. This is not to say, of course, that the failure of a lending-only MFI
has no adverse consequences. If customers lose access to loans from
an MFI, it may become a severe problem particularly if the failing
microlender is the only available source of much-needed capital.
However, the same is true of any other important supplier. The fact
that a good or service is important to customers has not been held
to justify prudential regulation of the supplier’s business.
6. The point here is not that cost of funds and loan losses is always the
same for MFIs and commercial banks, but rather that both types of
lenders face higher administrative costs per dollar lent when they
engage in microlending.
7. Sometimes, of course, high interest rates do reflect inefficiency
(excessive administrative costs) on the part of MFIs. However,
competition has proved to solve this problem better than interest-
rate caps.
8. In the case of prudentially regulated financial institutions, these
types of restrictions are sometimes exacerbated by other, pruden-
tially motivated, limitations on ownership. (See the discussion of
ownership suitability and diversification requirements on page 22.)
9. The discussion of MFI transformation in this section has dealt with
non-prudential issues only. Such transfers are also affected by pru-
dential rules, especially the rules about suitability and diversifica-
tion of owners, discussed on page 22.
10. A useful analysis of microfinance regulation along these lines can be
found in Hennie van Greuning, Joselito Gallardo, and Bikki
Randhawa, “A Framework for Regulating Microfinance
Institutions,” Policy Research Working Paper 206 (Washington,
D.C.: World Bank, 1999).
11. In some countries, banks have to provision 100% of unsecured

Regulation and Supervision 33
loans, except for loans to other licensed intermediaries. In such a
context, banks may be more willing to lend to MFIs who are them-
selves licensed, and thus licensed MFIs might be able to borrow at
a low interbank rate. These are reasons why an MFI borrowing
from commercial banks might want to be prudentially licensed, but
they do not justify imposition of a licensing requirement.
12. Rationing licenses is not cost-free, because barriers to entry hinder
competition.
13. Regulators sometimes hope that, instead of shutting down, these
small intermediaries will merge to form larger ones that can be
supervised more easily. But the practical economics of branch oper-
ation can often make this impossible.
14. Capital adequacy has to do with maintaining a prudent relationship
between an institution’s risk assets and its “cushion” of owner’s
funds. This relationship is affected, not only by the equity/assets
ratio, but also by the rules for risk-weighting and provisioning.
Capital adequacy in the broad sense is managed using a combina-
tion of these measures.
15. This section discusses prudentially-driven ownership requirements.
These tend to overlap with non-prudential ownership requirements
discussed on page 11.
16. This statement does not imply that prudential regulation will even-
tually embrace all institutions providing microfinance services.

Building financial systems that work for the poor
CGAP MEMBER DONORS
African Development Bank
Argidius Foundation
Asian Development Bank
Australia: Australian International Development Agency
Belgium: Directorate General for Development Cooperation,
Belgian Development Cooperation
Canada: Canadian International Development Agency
Denmark: Royal Danish Ministry of Foreign Affairs
Die Deutsche Gesellschaft für Technische Zusammenarbeit
European Bank for Reconstruction and Development
European Commission
European Investment Bank
Finland: Ministry of Foreign Affairs of Finland
Ford Foundation
France: Agence Française de Développement
France: Ministère des Affaires Etrangères
Germany: Federal Ministry for Economic Cooperation
and Development
Inter-American Development Bank
International Bank for Reconstruction and Development
(The World Bank)
International Finance Corporation
International Fund for Agricultural Development (IFAD)
International Labour Organization
Italy: Ministry of Foreign Affairs, Directorate General
for Development
Japan: Ministry of Foreign Affairs/
Japan Bank for International Cooperation/
Ministry of Finance, Development Institution Division
Kreditanstalt für Wiederaufbau
Luxembourg: Ministry of Foreign Affairs/Ministry of Finance
The Netherlands: Ministry of Foreign Affairs
Norway: Ministry of Foreign Affairs/
Norwegian Agency for Development Cooperation
Spain: Ministerio de Asuntos Exteriores y de Cooperación/
Agencia Española Cooperación Internacional
Sweden: Swedish International Development Cooperation Agency
Switzerland: Swiss Agency for Development and Cooperation
United Kingdom: Department for International Development
United Nations Conference on Trade and Development
United Nations Development Programme/
United Nations Capital Development Fund
United States: U.S. Agency for International Development

GUIDING PRINCIPLES
ON REGULATION
AND SUPERVISION
OF MICROFINANCE
Microfinance
Consensus Guidelines
English Español Français
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