Policy Analysis Paper on Draft Proposals for Regulating MFI in Sri Lanka

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1 Policy Analysis Paper on Draft Proposals for Regulating MFI in Sri Lanka S.P.Premaratne Submitted to Pathfinder Foundation Colombo May 2007 i

2 1. Introduction Micro Finance (MF) Sector and Economic Development Paradigms of MF Relationship between MF and Economic Development Typology of Micro Finance Institutions (MFIs) Risk in MF Sector) Regulatory and Supervisory Aspects of MFIs 3.1 Rationale behind Regulation and Supervision of MFIs Modes of Regulation and Supervision Special Aspects of Regulating MFIs. 3.4 Principles and Practices for Regulating MF Industry 3.5 Cost-Benefit Analysis of Regulation and Supervision Role of Regulation in MF Development.. 4. MF in Sri Lanka: A Way Forward? Current State of MF Sector and its Development in Sri Lanka 4.2 Draft Micro Finance Institutional Act (Bill): Key Provisions Reasons for Introducing the Proposed Bill Why should the Central Bank Care about the MF Industry? 5. Analysis of the Proposed Regulations. 5.1 Achievements of Objectives. 5.2 Costs and Benefits 5.3 Flexibility and Simplicity. 5.4 Impact on Poor Clients and thereby Poverty Reduction Promoting the Growth of the MF Sector through Regulations Conclusion and Recommendations. 23 Appendix 1: Distinguishing Characteristics of Types of MFIs. Appendix 2: Four Criteria for MFIs Regulation Reference Table 1: characteristics of different types of MFIs 4 Table 2: Four Criteria for MFIs Regulation 8 Table 3: Trend in Outreach 12 Table 4: Deposits and Outstanding Loans 13 Table 5: Different Features of MF 19 Figure 1: Costs and Benefits of the Supervision of MFIs 07 Figure 2: Share of Government Loans and Deposits 12 Figure 3: Proportionate Amount of Loans and Deposits 13 Figure 4: Liquidity by Institutional Types 14 ii

3 Policy Analysis Paper on the Draft Proposals for Regulating MFI in Sri Lanka 1. Introduction The objective of this article is to evaluate the proposed Micro Finance Institution legislation drafted by the Central Bank of Sri Lanka (CBSL) recently. The article identifies key issues and potential outcomes of the draft proposal for legislation for micro finance institutions (MFIs) focusing on how the proposed regulatory framework affects MFIs and their clients. This paper focuses on the possible guidelines that could animate a debate about the opportunity to regulate MF as well as how to perform such regulation, in order to foster the expansion and the sustainability of the MF approach to poverty. Information for this study was gathered from published documents and papers, and discussions with practitioners and expertise in the field of MF and micro and small enterprise (MSE) sectors. There is no universally agreed definition for MF. It can vary from one country to another, within the same country, and from one institution to another. The Asian Development Bank (ADB) defines MF as the provision of broad range of financial services such as deposits, loans, payment services, money transfers, and insurance to poor and low income households, and their micro enterprises. It covers not only credit but also savings and other financial services such as insurance. For the purpose of this study, one of the common definitions is used. That is, MF is the provision of financial services to the poor and low-income people including micro and small entrepreneurs who usually do not have access to capital markets and financial services. Financial services include one or any combination of the following: lending, savings, insurance, pension/retirement and payment services. Different types of players are engaged in MF activities. Some of them are informal individual players such as relatives, friends, and moneylenders, while some are informal institutions or organizations such as savings and credit clubs, rotating savings and credit associations (ROSCA), self-help groups. In addition, some formal and semi-formal institutions are also engaged in MF activities such as village banks, MF banks, savings and credit associations etc. Most of the MFIs had started as community organizations and NGOs. In Sri Lanka, the formal MF sector consists of commercial banks including private and public banks, Regional Development Banks, the SME Bank, and SANASA Development Bank. The semi-formal MFIs include Cooperative Rural Banks, Samurdhi Bank Societies, and NGO-MFIs. In addition there are numerous informal or non-institutional MF service providers that include ROSCAs, Savings Associations, Credit Associations/ Clubs, Funeral assistant societies,. It is noted that none of the MF service providers in Sri Lanka, except commercial banks, take deposits from non-members or grant credit facilities to non-members. Nevertheless, some MFIs are willing to accept non-member deposits and be financially sustainable in the medium and long-term. Many countries increasingly promote MF as part of their strategies to reduce poverty. As the MF industry grows, MFIs begin mobilizing substantial savings, and the sustainability of MF programs receives great deal of attention. As a consequence, the complexity in managing MFIs has increased too. The typology of institutions that offer MF services became also wider, including NGOs, but also commercial banks and specialized MF banks. Since at present MFIs begin to offer more complex set of services, and sustainability becomes an important variable for the donors too, need for some kind of regulation of MFIs is arising. 1

4 Regulation of MFIs may take place in three main forms: simple regulations; self-regulations; and prudential regulations. The Central Bank of Sri Lanka has drafted proposals for regulating Micro Finance with the purpose to provide for the licensing, regulation, and supervision of institutions that carry on MF business and connected matters. It will be presented to the Parliament of Sri Lanka shortly. According to the draft proposals, only institutions licensed by the CBSL will be permitted to carry on MF businesses. These proposals will directly affect positively and/ or negatively on MFIs, on MSEs, and on the grassroots community particularly the poor. Hence, the main aim of this policy brief is to critically evaluate the proposed Micro Finance legislation. Some of the research questions the policy paper should attempt to answer are: 1. Is it necessary to regulate the MFIs? If so, why? If not, why not? 2. What are the basic elements of the proposed bill? 3. Does the bill address the justification for regulation of MFIs? 4. Are the elements of the proposed bill the best way to regulate the MFIs? 5. What alternative ways of regulation would serve the interest of the poor better than that are contained in the proposed bill? The policy paper is organized as follows. Next section, which consists of four sub-sections, reviews basic literature on MF. It includes (2.1) paradigms of MF, (2.2)relationships between MF and economic development, (2.3) typology of MFIs, and (2.4) risk in the MF sector. Section 3 discusses regulatory aspects of MFIs. It also comprises six sub sections. They are (3.1) rationale behind regulation and supervision, (3.2) modes of regulation and supervision, (3.3) special aspects of regulating MFIs, (3.4) principles and practices for regulating the MF industry, (3.5) cost-benefit analysis of supervision, and (3.6) role of regulation in MF development. Section 4 deals with the current environment of the MF sector in Sri Lanka. It includes (4.1) current state of the MF sector and its development in Sri Lanka, (4.2) key provisions of the draft Micro Finance Institutions Bill (Sri Lanka), (4.3) reasons for introducing the proposed Bill, and (4.3) reasons for the Central Bank involvement in the MF sector. Section 5 analyzes the proposed Bill. It includes (5.1) achievements of objectives, (5.2) costs and benefits, (5.3) flexibility and simplicity, (5.4) impact on poor clients and poverty reduction, and (5.5) promoting the growth of the MF sector through regulation. Section 6 presents conclusions and recommendations. 2. MICRO-FINANCE SECTOR AND ECONOMIC DEVELOPMENT 2.1 Paradigms of MF The literature suggests that MFIs are generally guided and broadly defined by two competing paradigms; namely, financial self-sustainability paradigm, and poverty alleviation paradigm The financial self-sustainability paradigm or also known as profit or institutional approach, views the overall goal of the MF as the provision of financial services to low-income people, but not to the poorest among them (Gulli 1998). Its definition of empowerment is essentially individualist with the ultimate aim being the expansion of individual choice or capacity for self-reliance. The paradigm assumes that increasing access to MF services will in itself lead to individual economic empowerment. It is then assumed that increased economic empowerment will lead to increased well-being of the poor and low-income people, and also to social and political empowerment. 2

5 The main target group, despite claims to reach the poorest, is the bankable poor'; small entrepreneurs and farmers. Financial self-sustainability is achieved when the program is fully financed from the savings of clients and capital is raised at commercial rates from formal financial institutions. The ultimate aim of this paradigm is to build institutions that are profitable and fully self-supporting in competition with other private sector banking institutions, and able to raise funds from international financial markets rather than relying on funds from development agencies. Generally, those who deliver MF services as regulated financial institutions fall under this approach. Financial self-sustainability is seen as a necessary precondition for achieving exponential growth for MFIs (Christen 2000). Policy discussions have focused particularly on setting of interest rates to cover costs, separation of MF from other interventions to enable separate accounting and program expansion to increase outreach and economies of scale, reduction of transaction costs and ways of using groups to decrease costs of delivery. The poverty alleviation paradigm, also known as welfarist approach, differs in many of its interpretations and understandings of empowerment in MF. This approach claims that the overall goals of MF should be poverty reduction and empowerment. The main focus of such programs as a whole is on developing sustainable livelihoods, community development and social service provisions like literacy, healthcare and infrastructure development. There is not only a concern with reaching the poor, but also the poorest. There is a significant debate about the trade-off between these two paradigms. The MF community is divided between those who argue poverty alleviation is the primary goal for MFIs and those who argue the priority is to achieve financial self-sustainability. Recently a new paradigm has emerged. This promotes a middle ground between the poverty alleviation and financial self-sustainability approaches. Accordingly, if institutions develop service delivery methods that meet client needs at an affordable rate, then financial viability as well as poverty outreach could be achieved. In addition, another group of authors believes in another approach of MF, which is known as the feminist empowerment paradigm. The feminist empowerment paradigm is firmly rooted in the development of some of the earliest MF programs in the South, including the Self- Employed Women s Association (SEWA) in India. Its underlying concerns are gender equality and women s human rights. MF is promoted as an entry point in the context of a wider strategy for women s economic and socio-political empowerment that focuses on gender awareness and feminist organization. Under this paradigm, MF must be part of a sectoral strategy for change that identifies opportunities, constraints and bottlenecks within industries, which, if addressed, can raise returns, and prospects for large numbers of women. Possible strategies include linking women to existing services and infrastructure, developing new technology such as labor-saving, food processing, building information networks, shifting to new markets, and policy level changes to overcome legislative barriers and unionization. 2.2 Relationships between MF and Economic Development At a broader level, MF and development intersect in three ways: relationship with the poor, reliance on permanent institutions, and integration with the financial system of the country Senanayake and Premaratne 2006). 3

6 The first relationship concerns MF as an objective to alleviate poverty. This is the client level relationship. Clients of MFIs are poor and low-income people, often living in awful overcrowded settings, lacking access to basic services such as education, water, electricity etc. They lack access to convenient, affordable and appropriate financial services. MF creates access to productive financial capital, which together with two other forms of capital, i.e., human capital and social capital, enable people to move out of poverty. MFIs address the issues of human capital through education and vocational training, while it builds social capital through community organization building, promoting democratic systems, and strengthening human rights. The second type of relationships between MF and development occurs at the institutional level. MF seeks to create private institutions that deliver financial services to the poor. Institutional sustainability is very crucial to delivering MF services effectively and efficiently. The third connection between MF and development occurs at the intersection between MFIs and the financial system in a country, accomplished when MFIs become a regulated institution that is part of the financial system. The third connection with development is made possible only after attaining the creation of financially viable institutions. MF operates at its best when it intersects with development in these three dimensions. Nevertheless, the reality is that many MFIs, either because they have not become sustainable, or because they operate in an unfriendly regulatory environment, are not able to satisfactorily address these three types of connections. 2.3 Typology of MFIs As noted above, different types of players are engaged in MF activities. Traditional sources of finance for low income people and MSEs are family and friends and the informal sources such as ROSCAs), various club systems pooling members savings for loans, village banks, and moneylenders. Then there are some semi-formal MFIs such as non-profit NGOs, larger village banks, and pawnbrokers. Formal MFIs consist of saving and credit cooperatives, credit unions, NGO-MFIs, finance companies, and specialized and regulated banks. Table 1 summarizes the characteristics of different types of MFIs. Table 1 (characteristics of different types of MFIs) inserts here Broadly, all MFIs can be classified into three categories basically based on their main sources of funding. Category A comprises all MFIs which depend on other people s money to finance their lending activities. This category consists of again three types of MFIs; namely (a) nonprofit NGOs using grants and donations to provide micro-loans (type 1), (b) non-profit NGOs that accept grants and donations with members savings and limited borrowings from commercial banks (type 2), and (c) non-profit NGOs that have changed their organizational format into incorporated bodies and mobilize wholesale funds through wholesale deposits, commercial paper issues, or bank credit lines (type 3). Category B comprises formal MFIs which use members money to grant loans exclusively to members. Classic examples of these MFIs are ROSCAs, savings and credit cooperatives and credit unions (Type 4). Category C, the general public s money is used to finance their lending business. The MFIs consist of (a) corporate entities authorized to operate as specialized banks or finance companies (Type 5), (b) licensed regular banks whose share capital is mutually owned by 4

7 members (Type 6), and (c) licensed regular banks with equity capital owned by individual investors (Type 7). A major characteristic of MFIs is their large number of clients and their share in the national financial system is relatively small compared with traditional financial institutions. Overall, because of its small role and its possible contribution to financial systems development, regulation and supervision in MF are less important. 2.4 Risk in MF Sector MFIs are exposed to several risks. Examining the risk profile of MFIs can help to identify necessary adjustments to regulatory guidelines and supervisory methods. Some of the most important risks faced by MFIs are: namely (i) credit risk, (ii) liquidity risk, (iii) interest rate risk, (iv) operation risk, (v) new industry risk, and (vi) subsidy dependence risk. The risks may not be certainly systemic in their possible political ramifications. Therefore, supervisors need to take a closer look at how to address the issues of MFIs. 3. REGULATORY AND SUPERVISORY ASPECTS OF MFIs 3.1 Rationale Behind Regulation and Supervision of MFIs Whether MFIs should be regulated has long been a matter of controversy. Economists generally agree that an unregulated system of enterprise tends to achieve an optimal allocation of resources, given four important assumptions: a given endowment of wealth among individuals; a competitive market; government regulation cannot improve administrative efficiency; and there are no externalities that could justify government interferences. Economists agree on two negative externalities from MFIs runs: economic distress or collapse due to bank failure; and increases in the cost of government-provided deposit insurance. The failure of an MFI or even many MFIs at about the same time would not result in a general economic collapse, even a financial sector collapse, because the formal MFIs in Sri Lanka play only a small role in the financial sector in the economy. Their role is not of significance in the development of the financial sector, though they play a reasonably crucial role in poverty reduction in the country. A major problem is that MFIs should insure in deposit insurance agencies. These costs must be borne either by prudently run MFIs or by taxpayers or finally by poor clients. In the absence of government-provided deposit insurance, MFIs should not be regulated for purposes of achieving objectives such as efficiency, safety, and monetary control. Why, then, have they been subject to regulation in some countries? Broadly speaking, there are two related reasons: (i) to limit competition; and (ii) to provide revenue and power for government officials. It is generally accepted that financial institutions should be subject to prudential regulation and supervision for two main reasons: namely (1) to protect depositors, and (2) to ensure that the financial system as a whole does not become unstable through a loss of confidence as a result of major financial institutions becoming insolvent. 5

8 3.2 Modes of Regulation and Supervision Broadly, there are five different forms of regulation and supervision in the financial sector. The five forms of regulation and supervision are (i) regulation within the existing formal bank regulatory framework, (ii) specific regulation for MFIs, (iii) self-regulation, (iv) delegated supervision, and (v) combination of self-regulation and delegated supervision. Beyond the five basic options, new regulatory models are also being proposed in the literature, for example, a saving guarantee foundation, market-driven deposit insurance, a credit union rationing agency etc. 3.3 Special Aspect of Regulating MFIs The creation of a new type of financial institution to do MF requires consideration of a whole new set of regulatory issues which includes legal form and purpose, ownership structure, management, minimum capital, internal control, capital adequacy, permitted operation, distribution of dividends, geographic scope and hours of operation, non-commercial credit, and investment in fixed assets and other companies. The operation hours should also be flexible since these clients, in particular MSE clients, work long hours and without a fixed time table. The regulatory framework should be free not only from geographic restrictions and hours of working on their operations, but also from any other mechanism designed to provide exclusive markets and limit competition.3.4 Principles and Practices for Regulating MF Industry 3.4 Principles and Practices for Regulating MF Industry MF regulations should take account of special characteristics and risk profile of MF. Any regulatory framework for MF should be based on simple rules and principles. These basic principles for regulating MF sector- flexibility and simplicity- are necessary to foster a continued and balanced growth of MF. It requires flexibility in terms of interest rates, collateral and internal lending processes. It requires simplicity in terms of client documentation, loan procedures, portfolio classification, loan loss provisioning and loan write-offs. These basic principles allow room for innovation, and reduce the regulatory costs of compliance. All regulatory guidelines and supervisory methods must be subject to a cost-benefit analysis. Theoretically, costs of supervision of MFIs would be extremely high since there are a huge number of small MFIs in the financial system. 3.5 Cost-Benefit Analysis of Supervision Promoters of any regulatory framework for MFIs are rightly enthusiastic about the possibility of providing financial services to the poor and low-income people. A regulatory framework should also consider the cost side of the supervision. A good MF regulation framework needs to balance both costs and benefits of regulation and supervision. The cost of supervision depends on several factors. For example, on-site inspections will cost more than off-site inspections. Although it is widely discussed, as regards the supervision of MFIs, there is little evidence of its cost-benefit structure. The best way is to compare the cost of supervising MFIs to the cost of supervising the commercial bank sector. Past experiences 6

9 in some countries indicate that the cost of supervising MFIs is about 30 times as expensive as the cost of supervising of commercial banks Figure 1 illustrates the cost-benefit analysis of supervising financial institutions. It compares costs and benefits of supervising the commercial bank sector and MFIs. The benefit of supervising, which is measured in supervision fees and indirectly the volume of savings and public resources protected, is expressed as a straight line OU. The cost of supervising the MFIs is represented by the line NV, while the cost of supervising the commercial bank sector is represented by the line NW. The distance ON is the fixed cost of supervision, which is high due to costs of authorization, information systems and other parts of its operating capacity. The slope of the cost line of supervising MFIs is steeper since the high marginal cost of MFI assets. Figure 1: Costs and Benefits of the Supervision of MFIs Cost Benefit U V P Q W N R S O A B Supervised Assets The break-even point of supervising MFIs is at Q, while the supervision cost of the commercial bank sector is at R. If MFIs had only a level of OA in assets, the supervision of MFIs would produce a deficit to the extent of PS. The main problem in the segment of MF is that the majority of specialized MFIs do not have the minimally required level of equity. Therefore, the volume of assets subject to supervision is not the break-even level, OB, but OA, which is usually less than half of it. As a result, the supervision of MFIs would produce a higher deficit, to the extent of PS, since the level of fixed costs of supervision is invariable. This graph describes the normal situation of supervision. When it comes to bankruptcy situation, the public cost is mush higher. Transferring the costs of supervision to supervised MFIs could easily cause a dramatic increase in costs of credit. It would finally be charged to the borrowers. This would hardly be appreciated in a country where MF services are used as poverty alleviation strategy. 3.6 Role of Regulation in MF Development Although those who are in favor of self-sustainable approach argue that the collection of deposits represents a frontier for the sustainability of MFIs and it is a further useful investment for the poor and low-income people that are the beneficiaries of the MF initiatives, it is opportune to highlight that offering both deposits and credits increases the complexity of managing MFIs, and exposes the financial system to higher risks. 7

10 Therefore, the regulators interest in financial intermediation is not only limited to depositor protection, but should also consider the institutional sustainability and the overall risk of the system. On the other hand, while an effective regulation has to maintain a valuable service quality, it has to ensure the implementation of internal mechanisms for an efficient risk management of MFIs. Another role of regulation is to ensure the soundness of MFIs and the quality of the services that they provide. But economists who believe in free-market discourage regulation. They believe that deregulation increases efficiency in capital allocation. Four Criteria for MFIs Regulation (insert Table 2 here) The role of the regulator in MF development is an open issue. In some countries, the role of the regulator is to integrate MF into the overall financial structure. In these countries, the regulator gives some promotional support in the early stage of the industry s development; and gradually introduces prudential regulation. A strict regulatory framework would contribute to make the MF safer, but at the same time, it would make it too complex for small MFIs to operate in accordance with regulation. Obviously, the next and final effect could be a reduction in MF supply. It could have a negative impact on poverty alleviation since MF is usually used as poverty alleviation strategy. Further, a strict regulatory framework usually limits the capability to innovate. 4. MF IN SRI LANKA: A WAY FORWARD? 4.1 Current State of MF Sector and its Development in Sri Lanka In Sri Lanka, provision of financial services to low income households has a long history dating back to the early years of the 20 th century. The history begins with the enactment of the Cooperative Credit Ordinance in The pioneers in providing financial facilities to the poor were Thrift and Credit Cooperative Societies (TCCSs), which were established as a result of the Ordinance. By about the 1950s, the need to provide credit facilities to the rural poor had emerged as an important issue and in that context, the establishment of Cooperative Rural Banks as banking windows of the Multi-Purpose Cooperative Societies (MPCSs) in 1963 was considered to be an important government initiative. During 1980s, with the enactment of Government s Janasaviya Programme, MF, in its strict sense, began to be widely recognized in Sri Lanka as a central tool for alleviating poverty and empowering the poor. The expansion of MF activity in the 1990s has embraced all sectors namely governmental, non-governmental and cooperative sectors. Establishment of the National Development Trust Fund (NDTF) in 1991 as an apex lending institution was also another turning point in the MF sector in Sri Lanka. Currently, there is wide range of institutions that are involved in providing MF services to low income groups. The formal MF sector in Sri Lanka comprises commercial banks, the National Savings Bank, Regional Development Banks and SANASA Development Bank, which together have almost 900 branches. The semi-formal MFIs are the over 300 Cooperative Rural Banks (CRBs) with 1,196 outlets; approximately 8,500 thrift and credit cooperative societies (TCCS, or Sanasa); 970 Samurdhi Banking Societies; approximately 200 local or international NGO-MFIs; numerous government rural credit programs; pawnshops; and over 4,000 post-offices that collect savings (Wiedmaier-Pfister, and Wohiner, 2004). Informal, or non-institutional service suppliers are also numerous. Some of 8

11 the most important ones include: savings associations, ROSCAs, funeral or death-benefit societies, traders, moneylenders, input suppliers, friends and relatives. Moreover, the CBSL is another key player, which functions as the executing agency for a number of rural credit programs funded by various donor agencies and the Government of Sri Lanka. The National Development Trust Fund, which was formerly known as the Janasaviya Trust Fund (JTF) serves as an apex lending organization institution with the funds of World Bank/IDA funds. Recent development of the sector is the establishment of the Lankaputhra bank. As already mentioned, a wide range of institutions and programs including banks, NGOs, CBOs and Cooperative Societies have entered the field of MF during the last couple of decades. These institutions vary largely in terms of their sources of funding, clientele, coverage, legal, organizational structure, main activities and financial services provided to individuals/households. When factors like savings mobilized and loans granted are taken into account, CRBs have mobilized the largest volumes of micro-savings, approximately 21 percent of the total microsavings (IPS 2005). The bulk of savings of CRBs are deposited in commercial banks and other financial institutions, implying a resource transfer from rural to urban sector. Regional Development Banks (RDBs) and TCCSs have mobilized a large sum of savings in recent years. In contrast to the CRBs, RDBs and SANASA, Sarvodaya (SEEDS) and Janashakthi Banking Societies have a relatively lower amount of savings compared to their loan disbursements. Legal constraints on NGOs such as prohibition of savings mobilization and lack of regulation and supervision may have contributed to lower savings by NGOs. In Sri Lanka, Microcredit loans are granted for diverse activities including agriculture, animal husbandry, housing, trade, etc. Out of the total disbursed loan amount of these institutes, a relatively higher proportion have accounted for agricultural activities. Moreover, a significant amount of loans are granted for small industries, commerce and building construction. Having briefly provided an overview of the state of MF in Sri Lanka, it is now appropriate to analyze the stakeholders within the MF sector in the country. The key stakeholders broadly fall into three categories, namely, policy makers and supervisors, financial service providers, and the wholesale facilitators. The licensed commercial banks and the licensed specialized banks, both of which provide MF services fall under the direct supervision of the Central Bank of Sri Lanka. Other supervisory bodies include the Ministry of Samurdhi that supervises Samurdhi Bank Societies and the Ministry of Cooperatives that supervises all the Cooperative Rural Banks. Recent plans have been made in order to harmonize at least to some extent the supervisory activities in relation to MF under a new agency named the Rural Finance Sector Development Agency. The MFIs which operate with a fund base of over 2 million LKR will have to apply for and obtain their license from this agency which will be responsible for the supervision of such MFIs. Other set of stakeholders is the financial service providers. In Sri Lanka, as in many other developing countries, providers of MF range from highly sophisticated, well- regulated banks to absolutely informal systems. At the top layer of the hierarchy of the financial system in Sri Lanka stand commercial banks. However in terms of the supply of MF, less than six of the total of 22 commercial banks, which fall under the supervision of the CBSL, extend services to the low income strata of society. The story is more or less the same with licensed specialized banks (LSB). Currently 14 specialized banks are supervised by the CBSL, 6 of which are state owned regional development banks. Other LSBs include National Savings 9

12 Bank, NDB Hosing Bank Ltd, SME Bank Ltd, etc. all of which are state owned, and other private banks such as DFCC bank, Ceylinco Savings Bank etc. The LSBs mostly cater only very modestly to the financial requirements of the poor income segments. Another stakeholder in MF and a rapidly developing sub-section of the local financial system is the finance companies. Currently there are 28 finance companies, which have been registered under and are supervised by the CBSL. Out of them, Lanka Orix Finance Co, Ltd provides some financial services to the low-income segment in the country. On the other hand, government acts as a major stakeholder in MF, providing credit and savings services to the low- income and poor population directly through Samurdhi Banks and Gamidiriya, both of which are administered under the Samurdhi Authority. Cooperatives are more actively involved in MF in comparison to LCBs and LSBs. This sector envelops 1,539 CRB branches, more than 7,400 TCCSs set up by the SANASA group, and numerous other cooperatives that provide savings and credit facilities to the public. The regulatory body for these cooperatives is the Ministry of Cooperatives. Unregulated providers are the MF providing institutions that are neither licensed nor regulated by the CBSL or the Ministry of Cooperatives and are generally registered as either NGOs, or societies or companies. These make up a good portion of MF sector in Sri Lanka. While there are about 3,400 unregulated cooperatives operating in Sri Lanka, around 250 of them provide financial services. Apart from these institutions, as in many other countries, there are also moneylenders who provide credit at usury rates and pawnshops are also available for the poor to pawn their valuables and obtain the financial requirements. The final set of stakeholders in MF is the wholesale facilities of MF. There are three main wholesale facilities in Sri Lanka all of which are governed by the government. The funding for these wholesale facilities comes through the following donor bodies: NDTF, Susahana and the Isuru Fund. The NDTF gives funding to over 300 MFIs including CRBs, TCCSs, RDBs, other banks and NGOs. Susahana wholesale facility has been created in the aftermath of the Tsunami disaster, and is managed by the CBSL. The main source of its funds come from UNDP and the government, and owns a fund base of US $ 81 million. The Isuru Poverty Alleviation MF Project operates with a fund base of US $ 12 million, supported by Japan Bank for International Cooperation (JBIC) through CBSL. Having thus conducted a stakeholder analysis in the MF sector in Sri Lanka, it is now apt to analyze the donors of MF in Sri Lanka. A distinct feature in the local MF sector is that a large number of funding agencies support this sector. There are over 40 organizations varying from international donors, public organizations, national and international NGOs to private investors, which are actively involved in MF. Broadly categorized, these funding agencies fall into two segments-domestic and international. Domestic donors include six ministries and at least two private investors while international funders include more than 15 NGOs, 4 multilateral agencies, eight bilateral agencies and six international investors. Out of international donors the largest five are the ADB, JBIC, the World Bank, USAID and BMZ. Provided below is a tabular arrangement of the MF donors in Sri Lanka. 10

13 Organizations that fund Micro Finance in Sri Lanka International NGOs CARE CCA CCF Concern FORUT Grameen Foundation Mercy Crops OXFAM NOVIB Multilateral Agencies ADB EC Bilateral Agencies BMZ (KfW & GTZ) CIDA DANIDA JBIC International Private Investors PLAN Planet Finance Relief International Save the Children Stromme Foundation Trickle up WOCCU WWB World Vision UNDP WB NORAD SIDA USAID German Savings Bank Foundation Gates Foundation Rabobank Local Private Investors Government Ceylinco Group Ceylon Chamber of Commerce ETIMOS HSBC Citigroup CBSL NDTF Line Ministries (e.g., Samurdhi, Gemidiriya Foundation, Mahaweli and River Basin Management, SME Development, Lankaputhtra Bank, Agriculture, Irrigation and Livestock) Source: Duflos et al Having discussed the stakeholders and funders of MF in Sri Lanka, the paper moves on to recent trends observed in the local MF sector. A major trend observed in the recent years is the improvement in outreach that has been achieved by Sri Lanka in providing MF. According to the survey conducted by the Consultative Body to Assist the Poor (CGAP), the deposit accounts grew from about 10 million in 2000 to over 15 million in 2004, which marks a 51 per cent growth, a commendable increase in the lapse of just four years. Moreover, by the end of 2004, the volume of deposits stood at about LKR 50 million as opposed to the 11

14 volume of deposits of LKR 23 million reported in This indicates a growth of over 100 per cent and highlights the fact that the volume of deposits has risen faster than the number of accounts during The number of loans and the portfolio of loans outstanding have also experienced significant growth of 37 per cent and 87 per cent respectively. Table 3 shows the trend in outreach in the local MF sector in Sri Lanka. Table 3: Trend in Outreach Year No of Deposits Volume of Deposits (LKR) No. of Loans Loan Portfolio Outstanding ('000, LKR) ,983 23,250,725 1,626 16,468, ,984 26,337,688 1,878 14,777, ,408 33,710,950 1,846 16,524, ,587 39,687,554 2,042 21,556, ,102 48,672,310 2,234 29,876,496 Source: Duflos et al 2006 (based on CGAP Survey, 2005) In Sri Lanka, there are MF service providers in almost every district that signifies a high geographic coverage. Almost all rural areas are marked by the presence of MF facilities. On average, in the island, there is one point of financial service per 1,300 inhabitants (Duflos et al., 2006). This coverage is way ahead of the level of outreach in other developing countries. In Mexico, for instance, there is a point of financial services per every 10,000 inhabitants only. (Duflos et al., 2006) Highest areas of coverage include Vavunia, Jaffna, Matale, Hambantota, Moneragala and Ampara. These include some of the most underdeveloped districts in the country. On the other hand the lowest coverage areas with more than 2000 people per point of service include Batticoloa, Colombo, Gampaha, and Nuwara-Eliya. Incidentally, included here are some of the relatively developed districts in the country. One reason for these areas to have lower coverage is that they are highly populated. For example, Moneragala is a sparsely populated district and falls under the highest coverage areas while Colombo and Gampaha are more thickly populated and falls under the lower coverage areas. Figure 2: Share of Government Loans and Deposits Share of Government Loans and Deposits Percentage Year No of Deposit Accounts (%) Amount of Deposits (%) No of Loan Accounts (%) Loans O/S (%) Source: Duflos et al 2006 (Based on CGAP Survey, 2005). Another important trend observed is the higher presence of the government in MF in terms of the market share. The government s share of loans and deposits has risen during the period 12

15 In 2004, nearly half of the loan and deposit accounts in the MF sector has been owned by Samurdhi Banks and RDBs. The amount of deposits has risen from about 30 per cent to 45 per cent from 2000 to Also, the share of the amount of loans of the government sector has risen by about 10 per cent from 2000 to Figure 2 presents a graphical representation of the share of government loans and deposits in the MF sector. According to the CGAP survey the proportionate amount of loans and deposits have not undergone significant changes from 2000 to The only exception to this trend is the CRBs, which have reduced their market share in both the number and volume of deposits and loans. Mainly the Samurdhi Program and the RDBs have absorbed this fall in market share. In 2004, RDBs and CRBs accounted for the most number of loans followed by Samurdhi Program and NGOs respectively. In terms of the number of deposits, in 2004, the highest market presence was exhibited by the RDBs closely followed by the Samurdhi Program. NGOs showed only a low market share of 8 per cent in this segment. RDBs show a high market presence in the number of loans provided and in the outstanding loan portfolio. However, CRBs and Samurdhi dominate the number and volume of deposits. On the other hand, Samurdhi program has a reasonable presence in both the number and volume of loans and deposits. Figure 3: Proportionate Amount of Loans and Deposits Number of Loans in 2004 (%) No of Deposits (by institutional type) in 2004 Accounts (%) RDBs CRBs NGOs Samurdhi RDBs CRBs NGOs Samurdhi Source: Duflos et al 2006 (Based on CGAP Survey, 2005). One distinct feature of the overall MF system is that there is excess liquidity in the MF sector with deposits almost double the amount of loans granted. Analyzing the CGAP survey data, it is rather obvious that excess liquidity is highest among CRBs with deposits being approximately thrice the size of loans. Samurdhi also has a markedly high level of liquidity. Such high levels of liquidity represent inefficiency in fund utilization as well as the interest income lost which could have been earned had the excess funds been lent out. Table 4: Deposits and Outstanding Loans MFIs Amount of Deposits ('000 LKR) Loans O/S ('000 LKR) RDBs SDB CRBs NGOs Samurdhi Source: Duflos et al 2006 (Based on CGAP Survey, 2005) 13

16 On the other hand, RDBs are short of liquidity, while Sanasa Development Bank and NGOs are at a flat position with the amount of deposits roughly equaling the amount of outstanding loans (see Table 4). Figure 4: Liquidity by Institutional Types Liquidity by Institutional Type LKR ('000) Amount of Deposits('0 00 LKR) Loans O/S ('000 LKR) RDBs SDB CRBs NGOs Samurdhi Institutional Type Source: Duflos et al 2006 (Based on CGAP Survey, 2005). Another important feature of the local MF sector is its poor quality in its portfolio of assets and liabilities. RDBs report an average portfolio at risk (PAR) greater than 30 days ranging from 6 percent to 9 percent, while the NGOS report PAR greater than 30 days ranging from 5 percent to 25 percent, with most closer to 25 percent (Duflos et al 2006, based on CGAP Survey, 2005). According to this survey, most of the MFIs have appeared to be either unfamiliar with this concept or unable to calculate PAR within their systems which in most cases are manual. In terms of loan size, banks tend to provide larger loans than NGOs or Samurdhi. Amongst commercial banks HNB reports an average disbursed loan size of LKR 80,000. On the other hand, RDBs have a disbursed loan size amounting to LKR 20,000-30,000. NGOs/ companies generally report an average loan size of LKR 5,000-10,000. However, two NGOs have a loan size that is around LKR 25,000. Samurdhi and the cooperatives have loan sizes that range between LKR 10,000-14,000. Over the period NGOs and Samurdhi have catered to the financial requirements of the low-income groups than the RDBs. An important development in relation to the MF sector is the increasing awareness of good practice among donor systems. In fact, some donors of funds and international NGOs have started to take the financial systems approach where MF is treated as an integral part of the overall financial system. This trend is explicit in the recent project documents of the ADB Rural Finance Sector Development Program (Duflos et al., 2006). Another significant development is the funders effort to better share information in matters related to MF. This in part has been a result of the Tsunami disaster. One example in this direction includes the joint sponsorship of the Rural Banking Innovations Project by the People s Bank of Sri Lanka and GTZ. Attempt for information dissemination has materialized with the creation of the website Establishment of the lankamicrofinance network is another significant development in Sri Lanka. 14

17 On the other hand, International NGOs like PLAN International hope to adapt its successful programs in the Philippines to the Sri Lankan context (Duflos et al, 2006). However, several weaknesses in the local MF sector surfaced in terms of the lack of expertise in MF relative to the significant amount of donor funding coming in to the MF sector, the inflexibility of the funding instruments in the MF sector, lack of monitoring and evaluation systems for MF, lack of coordination among donors, international NGOs and government, the lack of regulatory harmonization among various types of MFIs operating in the country. 4.2 Draft Micro Finance Institutions Act (Sri Lanka): Key Provisions The Central Bank of Sri Lanka has drafted the Micro Finance Institution Act. Some of the key and debatable provisions of the draft Act (Bill) are as follows: Licensing of MFIs Only institutions or person licensed by the CBSL will be permitted to carry on MF business. The following categories of are carrying on MF business will be eligible for licensing: Public companies limited by shares registered under the Companies Act, No. 17 of 1982 (4.1.a) Companies registered under the Companies Act, No. 17 of 1982 as companies limited by guarantee (4.1.b) Non-governmental organizations registered under the Companies Act, No. 17 of 1982 and Voluntary Social Service Organizations (Registration and Supervision) Act, No. 31 of 1980 (4.1.c) Bodies corporate formed, established or incorporated by special statute to provide financial services and other support services to low income persons (4.1.d) Societies registered under the Societies Ordinance, No. 55 of 1945 that meet the requirements of the Monetary Board that may be specified from time to time (4.1.e) At the same time, the following institutions will be exempted from the licensing requirement: Licensed commercial banks and licensed specialized banks under the Banking Act, No. 30 of 1988 (3.1) Finance companies registered under the Finance Companies Act, No 78 of 1988 (3.1) Building companies incorporated under the National Housing Act, No. 37 of 1954 (3.3) Co-operative societies registered under the Co-operative Societies Law, No. 5 of However, co-operative societies are required to comply with certain provisions of the Micro Finance Institutions Act (3.4) Organizations established or registered under any written law, not being an organization established primarily for the purpose of making profit, which accept deposits only from their registered members under written permission from the Monetary Board (3.5) Minimum Capital Requirements The draft Micro Finance Institutions Act states minimum capital requirements for institutions carrying on MF business. They are as follows: For institutions at national level, the minimum capital requirement is Rs 50 million. 15

18 For carrying on MF business within a Province or in the Administrative District where the head office of the institution is located and in one or two other Administrative Districts, a core capital or a minimum capital requirement is Rs 10 million. For institutions carrying on MF business within an Administrative District, a minimum capital requirement is Rs 5 million. For institutions carrying on MF business within a Divisional Secretary s Division, a minimum capital requirement is Rs 1 million. Functions and Powers Given to and Restrictions Imposed on Licensed MFIs No person other than a licensed MFI shall use its name, the words micro finance, micro finance institution, micro credit, micro credit institution, or any of its derivatives or its transliterations or their equivalent in any other language whether alone or in combination with any other word (12) MFIs are restricted to operate outside the operative area (13.1) The location of the principal office of a licensed MFI shall not be changed without prior written approval of the CBSL (14.1) No licensed MFI shall establish, relocate or close down any branch office or service outlet (15) Relevant Authority for Supervision The Board may appoint, subject to such terms and conditions as the Board may deem necessary, a person or persons for the supervision of licensed micro finance institutions carrying on micro finance business at the National Level or within an Administrative District or within a Divisional Secretary s Division (16.2) Every person appointed under subsection (16.2) shall be referred to as the Agent of the Director (16.3) Unless the Board has appointed some other person, the Divisional Secretary of each Divisional Secretary s Division or any other authority to be appointed under any law in the future to take over the functions assigned to the Divisional Secretary shall be the Agent of the Director for the supervision of (a) licensed micro finance institutions carrying on micro finance business within his Division; and (b) licensed micro finance institutions having the head office in his Division and carrying on micro finance on micro finance business within the Administrative District in which his Division locates (16.4) Supervisory Functions The supervisory functions will be the responsibility of the Director of the department of the Central Bank of Sri Lanka to which the subject of micro finance is assigned by the Monetary Board. However, the draft Act also provides for delegation of the supervisory function to an external body which will serve as the agent of the Director. Power to Issue Directions: Some of the areas of the power are: 16