Microfinance Institutions and Public Policy

This paper addresses public policy issues connected with the growth of the microfinance sector. It observes that the multiplication and growth of microfinance institutions (MFIs) has prompted many countries to reconsider public policy issues:

• Regulation of microfinance - principles for the prudential and non-prudential regulation and supervision of MFIs;
• Relationship between the microfinance sector and the rest of the financial system - commercial banking in particular;
• Potential assistance for MFIs from official or nonofficial sources - means of efficient deployment;

Further, the paper models asymmetric information, transaction fees, and support for MFIs and looks at case studies from Chile, Ethiopia, Indonesia, Peru and Zambia.

It finds and concludes that:

• There are good reasons to provide support for MFIs:
  • They have an informational advantage,
  • Can be more efficient than other financial institutions or direct government transfers in bringing benefits to the poor parts of the society,
  • Overcome high administrative costs and an intrinsically risky environment in their start-up period.
• On-going support is likely to increase moral hazard and result in poor management and should be accompanied by mechanisms designed to limit aid-dependence and promote competition between MFIs;
• Only one-time support should be offered to cover the start-up costs of MFIs or the initial costs of banks entering in the microfinance business;
• Regulation and supervision of MFIs needs to recognize their heterogeneity, and accommodate the flexibility and scope for development;
• MFIs that do not take deposits and only lend out donor funds need internal control but not prudential regulation;
• MFIs that act as full-fledged commercial banks should be subject to the same prudential regulatory regime as applied to the commercial banks;
• Any regulatory framework for MFIs would have to balance depositors' protection with potential stifling of financial innovation and competition;
• Regulations also need to be carefully gradated to allow for the development of MFIs from very small, local, and specialised institutions to full-service providers of financial services.