Regulatory and Institutional Challenges

Lending operations are intertemporal in nature and uncertain, based on a promise to pay in the future. Everything else being equal, the more certain lenders can be of repayment, then the greater will be the supply of loanable funds. The degree of certainty in turn depends on the institutional and legal environment, for example, on how rapidly and cheaply contractual agreements can be enforced. It also depends on the lending technologies utilized. The supply of funds also depends in part on the profitability of lending, and of financial intermediation. While profits are influenced by an institution's own efficiency as an intermediary, they also are determined by aspects of the existing regulatory framework, such as laws and regulations concerning levels of interest rates.

One of the most important strategies for promoting the development of rural finance is strengthening the regulatory framework, in order to give both lenders and depositors greater security and incentives. Conversely, an inappropriate set of laws and regulations can greatly inhibit the expansion of both rural deposit facilities and rural loans.

The sustainability requirements of sound governance and capable management for a microfinance institution are mirrored in the risks presented by such institutions, to their clients, to regulatory agencies and to themselves. Managing those risks successfully is the challenge faced by regulatory and supervisory authorities. Shari Berenbach and Craig Churchill have described those risks clearly and have differentiated them from those that characterize commercial bank operations, in words that reveal the diversity and complexity of the management challenges for microfinance:

Microfinance institutions hold many risk features in common with other financial institutions. For example, MFIs and commercial banks are both vulnerable to liquidity problems brought on by a mismatch of maturities, term structure and/or currencies.

On the other hand, many risk features of commercial banks are not directly applicable to microfinance. For example, commercial banks are vulnerable to concentration of risk when a large loan to a single borrower can put at risk the total bank's capital or when multiple loans are exposed to the risk of a related enterprise group. Insider lending is another area of concern for commercial banks when managers or owners can use their influence to extract unsound loans of significant size. Yet, because of the volume of transactions and their very small size, such issues do not present significant risks to microfinance institutions.

There are four principal areas of risk that are specific to microfinance institutions: ownership and governance, management, portfolio, and new industry.

Ownership and Governance Risk. . . . Ownership and governance risk occur if the owners and directors of the MFI do not have the capacity to provide adequate management oversight. This is an issue because of the nature of institutions and individuals who typically own an MFI, or who are on its board. .. . the directors of a non-profit organization may not have the skills and experience to govern a formal financial institution. . .. Ownership and organizational structure: In some regulated microfinance institutions, there are unclear ownership and organizational arrangements involving the nongovernmental organization or public institutions that played a role establishing the newly formed regulated MFI. High risk scenarios can develop. If an NGO, which is funded with public resources and does not have owners, oversees the management and determines the policies of the regulated financial intermediary, the social mission may take priority over financial objectives. .. . While MFIs may be capable of raising the initial capital requirements from their funding shareholders, these owners may lack financial depth or flexibility to respond to additional calls for capital as may be needed.

Management Risks. The management risks that apply to microfinance portfolios are generated by the specific service delivery methods required to serve this market. . . Decentralized operational systems:... a decentralized organizational structure... is central to microfinance service methodologies. Such decentralized operating methods present management challenges in any industry. Poor telecommunications and transportation infrastructure can compound this challenge. Furthermore, decentralized operating methods generate an environment that can be subject to fraudulent practices if internal controls are not sufficient. Management efficiency: Microfinance institutions offer a high volume, repetitive service that operates on low returns per loan. If a branch or unit falls short in the project loan volumes, profits can quickly turn to losses. .. . The quality of management to ensure brisk and timely services is essential to the financial success of microfinance portfolios. Management information: The backbone of an MFI's management is its management information system. While this is true of all financial institutions, the decentralized operating methods, the high volume of short-term loans, the rapid portfolio turnover, and the requirement for efficiency service delivery make accurate and current portfolio information essential for effective MFI management. ... A weak management information system might delay the follow-up on delinquent loans and could quickly undermine the quality of a microfinance portfolio.

Portfolio Risk. The basic features of the products and services that are appropriate for the microfinance market contribute to a different set of portfolio risks than are usually encountered by commercial lending institutions. Unsecured lending: Most microlending is unsecured in traditional terms. . .. The non-traditional approaches employed in microfinance are usually as effective as traditional collateral, but economic shocks could expose the institution if these approaches break down in a crisis. Delinquency management: Some

MFIs have undergone significant swings in the on-time repayment of their portfolio. Although the MFI may hold delinquency levels low for extended periods, precipitous changes in delinquency rates may arise. .. . Since operating costs are so high relative to the size of the portfolio, temporary delinquency problems become serious more quickly than in traditional banking. .. . Sector or geographic concentration risk: Unlike the risk concentration typically borne by commercial banks, where an individual large loan or loans to a related enterprise group may put the bank at risk, MFIs may be subject to risk if many clients come from a single geographic area or market segment that is vulnerable to economic dislocations It is important to point out, however, that this risk is largely theoretical. There are very few examples to date of sector or geographic concentration risk affecting microfinance portfolios.61

New Industry Risk. A number of the risks that face the microfinance industry stem from the fact that its techniques are relatively new and untested. Adequate professional experience: There are few professionals with prior banking experience that are also directly familiar with microfinance methods. .. . Because .. . many MFIs are unable to offer attractive compensation packages, MFIs may have difficulty attracting capable management talent. Growth management: MFIs .. . can experience dramatic growth in their initial years of operation. . .. Sustaining such growth rates presents management with the challenges of developing a trained cadre of employees, implementing standard policies and procedures, and maintaining portfolio quality. New products, services and methodologies: While this industry has made considerable advances in the design of appropriate microfinance products and services, the field remains young and relatively untested. It is difficult to assess whether a new product, service or methodology is an ill con

61. Author's note: The depression in Nicaragua's agricultural sector in 2001, led by a collapse in coffee prices, caused many MFIs affiliated with the federation ASOMIF to suffer losses and consequently they largely withdrew from lending to agriculture.

ceived deviation from an existing methodology or is a breakthrough in new services for the market. .. . Young institutions: there remains much to learn about how these institutions behave in a crisis. What is the institutional learning curve?62

The following sections of this chapter deal with a number of issues that are related to meeting these challenges successfully.

7.4.2 Collateral

The security of a lender's position can be pursued with and without tangible collateral, i.e. as secured or unsecured lending. The latter requires more knowledge of the borrower, or the ability to penalize borrowers in arrears. Since it usually is less costly to assess tangible collateral than to acquire all of the necessary information about an unsecured borrower, lenders can provide larger and cheaper loans on the basis of tangible guarantees.63 The success of unsecured lending also depends in good measure on the development of social collateral. A kind of social collateral has been created by microfinance institutions that have fostered the formation of groups of borrowers in which a member guarantees the loans of all of the others. As pointed out by Khandker (citing Besley and Coate, 1995)64:

.. . group-based lending is a necessary but not sufficient condition for better repayment or better functioning of a group. For effective functioning of groups, the group method has to create social collateral that imposes certain disciplinary actions on group members. A group-based method may fail to enforce eligibility criteria, for example, if the entire group colludes in doing so. To prevent this problem, all microcredit programs use a larger community-based organization to ensure that the group meets the eligibility criteria.65

Appropriate government policies can facilitate both secured and unsecured lending. One of the greatest hurdles to the expansion of secured lending in rural areas of developing countries is the lack of formal title to land which could be used as collateral, as discussed in Chapter 5. From the viewpoint of financial transactions, there are two aspects of a land title which are crucial: confirming the ownership of the property, and registering all liens against it. The latter is essential so that lenders may perfect their claims, or establish publicly the priority of them. For this reason, it is important both to title agricultural lands and to develop effective systems of land registry.

Land titles are of little value for financial purposes unless the judicial system permits a rapid settlement of claims in cases of default. Lengthy, costly or uncertain judicial procedures diminish very considerably the value of collateral and therefore reduce incentives to lend. By the same token, procedures for settling claims that are swift and decisive act as incentives for borrowers to repay loans, thus reducing the probabilities of default.

For the most part, these considerations are relevant for medium- and large-scale farms. In many, though not all, countries, it is difficult for lenders to foreclose on smallholders' property, even when titles are registered.66 Sometimes, there are legal restrictions against doing so for properties below a certain threshold size. Often, the court system is hesitant to foreclose on low-income farmers, and lenders themselves may share that reluctance. Advocates of financial development point out that the legal ability to

62. Shari Berenbach and Craig Churchill, Regulation and Supervision of Microfinance Institutions, The Microfinance Network, Occasional Paper No. 1, Washington, DC, 1997, pp. 19-24 [emphasis added].

63. J. Yaron, M. P. Benjamin and G. L. Piprek, 1997, p. 54.

64. T. Besley and S. Coate, 'Group lending, repayment incentives and social collateral', Journal of Development Economics, 46(1), 1995, pp. 1-18.

66. 'It is not cost effective for the Grameen Bank to exercise foreclosure' (J. Yaron, M. P. Benjamin and G. L. Piprek, 1997, p. 125).

foreclose is rarely exercised but maintain that its presence still enhances smallholders' access to credit. It is likely that the reluctance to allow foreclosure will continue to prevail in many countries, out of understandable social concerns in addition to the cost of foreclosure in relation to the value of the asset.

Under these circumstances, an alternative method of providing land as security for a loan, to date relatively underexploited, is antichresis. Under antichresis, the borrower agrees to cede control of his or her land, in the event of default, until the loan is repaid out of its harvests or a specified period of time has lapsed. To ease the burden on the smallholder family, the creditor may agree to hire the borrower's family to work the land during this period. In many developing countries, this specification would be more acceptable than one under which a smallholder family risked losing its land. Examples of this approach are found in Bangladesh.67 See Chapter 5, Section 5.9, for a further discussion of this. For antichresis to become operational, enabling legislation must be enacted, and in most developing countries it does not yet exist.

In addition to use of land as collateral, options for lenders include the use of other forms of collateral as well as undertaking unsecured lending. Among the other forms of agricultural collateral, crops and livestock figure prominently. Liens against future harvests are common instruments although, because of yield risk, they obviously do not confer the same degree of potential security that land liens do. It is relatively common for agro-processors and exporters to lend to farmers against a pledge of the future harvest. In the case of livestock, the risks include not only the possibility of decimation of a herd through disease but also the possibility that the borrower could sell the crop or animals without advising the buyer that a lien exists. (In Colombia a major hindrance to greater participation by small farmers in long-term marketing contracts with agro-processors and modern marketing channels is their tendency to break the agreement if a better price is offered in the short term.) Hence, crops and livestock are imperfect forms of collateral, but when complemented by knowledge of the borrower a lending institution may choose to utilize them. Again, enabling legislation is required. In some countries, under existing legislation neither commodities nor other movable property can serve as collateral.68 Another form of collateral is crops in storage. Obviously, this instrument is applicable only to non-perishable crops, primarily grains but also others such as cotton and coffee. When crops are deposited in a registered place of storage, their owners can receive documents known as certificates of grain deposit or warehouse receipts. A certificate of deposit can then be used as collateral for a bank loan. One of the most important uses of such loans is to permit a farmer to wait until prices experience a seasonal upturn before selling the crop, since prices always reach their cyclical low point at harvest. A system of certificates of grain deposit also requires specific legislation. The requirements for bonded warehouses have to be established, along with grading standards for the crops to be stored and rules that permit banks to accept this form of collateral.69 The enabling legislation should be broad enough to cover rotating inventories and changes in form of the

67. See K. A. S. Murshid, 'Informal Credit Markets in Bangladesh Agriculture: Bane or Boon?', in G. H. Peters and B. F. Stanton (Eds), Sustainable Agricultural Development: The Role of International Cooperation, Proceedings of the XXI International Conference of Agricultural Economists, Dartmouth Publishing Company, Aldershot, UK, 1992, p. 660.

68. (a) J. Yaron, M. P. Benjamin and G. L. Piprek, 1997, p. 55; (b) Heywood Fleisig, 'The Right to Borrow: Legal and Regulatory Barriers That Limit Access to Credit by Small Farms and Businesses', Viewpoint, Note No. 44, The World Bank, Washington, DC, USA, April 1995, p. 3.

69. Patience and persistence are sometimes required to implement new regulations. This author participated in a team that developed and implemented, among other policy reforms, a system of certificates of deposit for grains in Honduras. After the detailed proposal was approved by the Minister of Natural Resources (Agriculture) and the decree drafted, it took two and a half years to obtain the necessary additional approvals from government agencies in order to make the decree effective!

commodity as it is processed, as indicated in the adjacent box.

Another potentially viable form of collateral is accounts receivable and loans. Agricultural input suppliers and rural retailers frequently are sources of lending to farmers, but their capacity to lend may be constrained by their ability to borrow against their accounts receivables. Similarly, a village moneylender could expand operations if it were possible to use his/her portfolio of loans as collateral - if a secondary market existed in such paper.

As pointed out by Yaron et al.:

Compared to the bank, the store owner knows more about the customers and can more safely select good risks. However, in most developing countries problems in the framework for secured transactions prevent banks from creating, perfecting, and enforcing security interests in accounts receivable. These problems limit the access to credit of store owners and choke off a potentially promising source of rural credit. The same story, with small variations, can be told for all rural credit sellers and non-bank lenders (1997, p. 59).

Heywood Fleisig adds:

When dealers and nonbank lenders can refinance the credit they offer, the supply of such credit expands and its cost falls. But expanding such financing requires a secured transactions law that permits easy, inexpensive public registration of security interests in accounts receivable or in chattel paper, and inexpensive transfer of these accounts if the borrower (the dealer or nonbank lender) defaults. Otherwise, these dealers and nonbank lenders will find it impossible to raise enough money to fund the loans they otherwise could profitably make.70

In most developing countries, rules governing collateral need to be broadened in order to

Legal obstacles against use of movable collateral can represent a formidable hurdle for the expansion of agricultural finance. For example:

Few countries have [legal] provisions for continuation in proceeds that would permit the security interest to be maintained as the collateral is transformed. A lender with a security interest in wool in a warehouse will lose [it] when the wool is sold. Sometimes high costs prohibit certain transactions. In Uruguay it costs 6 percent of the amount of the instrument to register a pledge; in Russia it costs 3 percent. Such registration fees alone, calculated at an annual rate, will exceed the interest rate on short-term loans for storing farm inventory. . . . In Argentina and Bolivia, something that does not yet exist cannot be the object of a loan. Consequently, farmers cannot get credit against the eggs from their poultry, the milk from their cattle, or the wine from their grapes. In Peru a rotating inventory requires redefinition of the loan, so fruit extract in warehouses cannot serve as collateral but fish meal, stored in containers of fixed sizes, can. For similar reasons, wheat in an Argentine silo cannot secure a loan but sugar in a warehouse can. These problems are fatal to lending because the lender knows that in the event of default the borrower can claim that the underlying contract has no legal foundation. These legal problems have no valid basis in policy ( from J. Yaron, M. P. Benjamin and G. L. Piprek, 1997, pp. 55 and 57).

encourage increases in the supply of agricultural credit from private sources. However, formulating new legislation in this area is a delicate task that must be approached with care because difficult issues can arise concerning lenders' rights versus borrowers' rights. When movable assets are used as collateral, obviously liens can be placed on them in the event of defaults. However, precisely because the assets are movable, legislation to facilitate their collateralization tends to allow

creditors to act quickly in seizing the assets. It can be argued that such a provision is necessary in order to protect creditors' interests and that without it loans will not be made against movable assets. However, the other side of the coin is that, in the event of delinquency, possibly temporary, farmers stand to lose assets which are vital to earning their livelihood or their family's welfare, such as livestock, stored grain, farm tools and tractors. The issue is complicated by the fact that poor farmers in remote areas may not fully understand the implications of a credit agreement based on movable assets as collateral, and those farmers are unlikely to be able to use the court system for redress.

One possible solution would be to create special rural tribunals that could promptly rule on financial disputes, at a minimal or zero cost to low-income litigants. Whatever the approach adopted to this issue, legislation that legalizes movable collateral can be an important tool for promoting the growth of agricultural finance.

Subsidized crop insurance has proven disappointing and financially unsustainable wherever it has been tried throughout the developing world. Luz MarĂ­a Bassoco, Celso Cartas and this present author carried out a quantitative assessment of the effects of the crop insurance program in Mexico and arrived at the following conclusions:

it is clear that there is a sizeable net social loss as a result of the subsidized insurance. ... If the crop insurance program were not subsidized, there would still be a loss in net social welfare compared to the no-insurance situation. This loss arises because the insurance is compulsory, and in aggregate the administration costs exceed the value of the risk-reduction benefits conferred by the program.71

Other concerns with crop insurance are the potential for moral hazard - that a farmer may not take enough measures to prevent crop loss because the harvest is insured - and the difficulty of establishing an objective basis for measuring the degree of crop loss.

Private, unsubsidized crop insurance has been launched in a few developing countries such as Mexico and Honduras. To date, it has been profitable for the insurance companies involved, a sign of sustainability. However, it is limited to catastrophic losses resulting from drought, hurricanes, torrential rains, very low temperatures, hailstorms, and other extreme natural phenomena. A farmer that lost, say, 30% of the crop from insufficient or irregular rains would not be able to receive compensation from this kind of insurance. The possibility of developing more refined kinds of insurance is inhibited by an asymmetric information problem, in that farmers know their own history of yields better than an insurance company does.

Government guarantees of loans have, if anything, fared worse than subsidized crop insurance. They are characterized by two principal problems: moral hazard (inducing lenders to make loans they would otherwise have considered too risky) and operational shortcomings. In Honduras, for example, it was found that the loan guarantees advanced by the National Agrarian Institute, for loans made to beneficiaries of the Agrarian Reform by the National Agricultural Development Bank, were in fact never paid to that bank for the many defaults that occurred.72 This problem contributed significantly to the bank's decapitalization. Consequently, one of the provisions of the Honduran Agricultural Modernization Law of 1992 prohibited such guarantees.

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