Final study report for publication december 17, 2009

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Final study report for publication december 17, 2009

  1. 1. Microfinance Policy and Regulatory Framework Diagnostic of Nepal: Recommendations Tejhari Ghimire and Tulasi Prasad Uprety Center for Microfinance (CMF) 2009 Bahtbhateni, Kathmandu, Nepal Tel: 977 1 4434041, 4443984 Email: cmf@cmfnepal.org Internet: www.cmfnepal.org
  2. 2. Copy rights2008 Center for Microfinance (CMF), KathmanduAll rights reserved. No part of this publication may be reproduced, stored in a retrieval system, ortransmitted, in any form or by any means, without the prior written permission of the Center forMicrofinance (CMF). CMF does not guarantee the accuracy of the data included in this publicationand accepts no responsibility for any consequences in their use.This publication Microfinance Policy and Regulatory Framework Diagnostic of Nepal:Recommendations was published with the financial support of The Asia Foundation. The study wasconducted by the following team:Tejhari Ghimire, Team LeaderTulasi Prasad Upreti, Microfinance Consultant;Sushila Gautam, Naresh Nepal, Ganesh Bista, Ruchi Bhagat, and Mimu Raghubamshi, FieldResearchersThe views expressed in this publication are those of the authors and do not necessarily reflect theviews of the CMF and The Asia Foundation.Center for Microfinance (CMF)Bahtbhateni, Kathmandu, NepalTel: 977 1 4434041, 4443984Email: cmf@cmfnepal.orgInternet: www.cmfnepal.org i
  3. 3. ABSTRACTSThe objectives of the study were to review the current legal and regulatory frameworks relatedto microfinance institutions in Nepal; to identify stakeholder policy and regulatory frameworkissues; and to suggest measures required for MF sustainability and growth. The study teamreviewed the regulatory frameworks of other countries; held group and individual discussionswith MF industry representatives; and held a national seminar to share the outcome resultsbefore finalizing the study.Many MF practitioners believe that the “Market is the best regulator”. They also realize theneed to have some form of government regulation. The possibility of a stakeholder(investor)panic ‘run’ on an MFI due to lack of information; the public’s concern regarding theopportunistic and risky behavior of agents; the need for consumer protection; and therequirement to ensure stability and protection of wholesale lenders are often put forward asthe reasons for having appropriate regulation and supervision. In addition, the building of an MFdatabase; facilitating the acquisition of a legal identity; ensuring a healthy development of thesector i.e. performance standards; and facilitating the linkages that enable banks to becomeinvolved in direct micro-finance are considered some of the other important areas that help toestablish need.Nepal has experimented with different types of MF models i.e. Grameen replication, Savings &Credit Cooperatives (SACCOs), Financial Intermediary NGOs (FINGOs) as well as project/program based models. These models are apart from any informal MF practices.Many of the MFDBs and FINGOs regulations are acceptable to MFIs but there are areas wherereform is required to ensure the growth and sustainability of the sector. The co-operative MFsector lacks regulation. Unfortunately, the policy and legal framework now under discussion atthe Central Bank lacks the required direction. Consequently, MF industry stakeholders arecommitted to draft an appropriate policy and framework using a participatory approach. Themulti agency regulations for different types of MFIs (current model) are appropriate but anumber of provisions required revision.Rather than applying the Basel Framework of regulations, the Government should use thePEARLS rating system to regulate and supervise MFIs. The Pearls rating system is simpler, morerealistic and comparable to the worldwide MF database. It is also recognized that settingperformance standards, self-regulatory norms and promoting best practices can be enhancedthrough appropriate policy and regulation application.An outcome of this study was the model Microfinance Act of 2009. Its’ adoption byGovernment is expected to set a level playing field for all MFIs, aid the growth of the sector,widen MFI outreach and help to reduce poverty. ii
  4. 4. TABLE OF CONTENTSAbstracts...................................................................................................................................iiAcronyms .................................................................................................................................vList of Tables...........................................................................................................................vii1 Introduction............................................................................................................................1 1.1 Context................................................................................................................................. 1 1.2 Methodology ....................................................................................................................... 3 1.3 Limitations ........................................................................................................................... 32 Microfinance Market Environment ........................................................................................4 2.1.1 Outreach Growth........................................................................................................... 4 2.1.2 Market Penetration........................................................................................................ 53 Policy and regulatory environment.........................................................................................8 3.1 Defining Microfinance.......................................................................................................... 8 3.2 Principles and Characteristics .............................................................................................. 9 3.3 Best Practices ....................................................................................................................... 9 3.4 Why Enabling Regulatory Environment.............................................................................. 10 3.5 Principles of Enabling Environment.................................................................................... 11 3.6 The role of Government and the Central Bank................................................................... 12 3.7 Impact of Micro- finance in Nepal...................................................................................... 12 3.8 Regulations for Microfinance Institutions ........................................................................... 13 3.9 Establishment Criterion...................................................................................................... 13 3.9.1 General......................................................................................................................... 13 3.9.2 Licensing Norms for FINGOs......................................................................................... 15 3.9.3 Registration Norms and SACCOs.................................................................................. 16 3.10 Regulations for Micro Finance Development Bank (MFDB) .............................................. 16 3.11 Regulations to Savings and Credit Co-operative Societies (SACCOs) .................................20 3.12 Regulations for FINGOs..................................................................................................... 224 Micro-Finance Policy, 2065 (2008).........................................................................................225 Survey findings.....................................................................................................................24 5.1 Survey Coverage................................................................................................................. 24 5.2 Policy Issues Awareness...................................................................................................... 24 iii
  5. 5. 5.3 Policy Issues raised by the Actors....................................................................................... 25 5.3.1 Co-operatives.............................................................................................................. 25 5.3.2 FINGOs ........................................................................................................................ 26 5.3.3 MFDBs.......................................................................................................................... 27 5.3.4 Policy Organizations..................................................................................................... 27 5.3.5 Donor Agencies / INGOs............................................................................................... 286 Recommendations................................................................................................................30 6.1 Legal/Regulatory Framework.............................................................................................. 30 6.2 Performance Standards/Indicators..................................................................................... 35 6.3 Model Microfinance Regulation Act 2009.......................................................................... 36 6.4 Other Suggestions .............................................................................................................. 36Annexes..................................................................................................................................37Bibliography............................................................................................................................60 iv
  6. 6. ACRONYMSACCION ACCION International - a Latin American MFI systemADB Asian Development Bank, ManilaADB/N Agriculture Development Banks, NepalASA Association for Social Advancement, BangladeshBASEL Basel Committee for Banking Supervision, Bank for International Settlement, Switzerland, BASELBFI Bank and Financial InstitutionsGBB Grameen Bank BangladeshBRAC Bangladesh Rural Advancement CommitteeCAMELS ‘Capital Adequacy, Asset Quality, Management, Earning, Liquidity and Sensitivity’ to Market RiskCAR Capital Adequacy RatioCMF Center for Micro- Finance, Kathmandu, NepalCBs Commercial BanksCBOs Community Based OrganizationsCEO Chief Executive OfficerCRR Cash Reserve RatioCSD Center for Self Help Development, FINGOCGAP Consultative Group to Assist the PoorestCGISP Community Ground Water Irrigation Sector ProjectDDB Deprosc Development BankDLGSP Decentralized Local Governance Support Program.DSL Deprived Sector LendingFCs Finance CompaniesFD Fixed DepositFGD Focus Group DiscussionFI Financial InstitutionFINGO Financial Intermediary Non-Government OrganizationFSS Financial Self-SufficiencyFWGB Far Western GBGB Grameen BankINAFI International Network of Alternative Financial InstitutionsLLP Loans Loss ProvisionLOI Letter of IntentMCPW Micro-Credit Project for WomenMCR Minimum Capital RequirementMEDEP Micro Enterprise Development ProgramMDGs Millennium Development GoalsMF Micro-financeMFDB Micro Finance Development Bank v
  7. 7. MFI Microfinance InstitutionMGB Madhyamanchal GBMWGB Madhya Paschimanchal GBMIS Management Information SystemNCDB National Co-operative Development BoardNCF National Co-operatives FederationNEFSCUN National Federation of Saving and Credit Co-operativesNGO Non-Government OrganizationNRB Nepal Rastra BankNUBL Nirdhan Utthan Bank LimitedOSS Operational Self-SufficiencyPAF Poverty Alleviation FundPCRW Productive Credit for Rural WomenPEARLS Protection, Effective financial structure, Asset Quality, Rates of return and costs, Liquidity, Sign of growthPGB Paschimanchal GBPuGB Purbanchal GBRFP Rural Finance ProjectRMDC Rural Micro-Finance Development CentreRSRF Rural Self-Reliance FundSACCOS Savings and Credit Co-operative SocietiesSFCL Small Farmer Co- operative LtdSFDP Small Farmer Development ProjectSHGs Self-Help GroupsSKBB Sana Kishan Bikash BankSBB Swabalamban Bikas BankSOL Single Obligor LimitSPOs Sub Project Offices (SFDP)STI Second Tier InstitutionTLDP Third Livestock Development ProgramUN United Nations.VICCU Vijaya SACCOS, NawalparasiWOCCU World Co-operative Union vi
  8. 8. LIST OF TABLESTable 1: MFI Categories and Client baseTable 2: Current Microfinance Market size and penetrationTable 3: Microfinance Market breakdown by regional typeTable 4: Market Concentration in thirteen ( 13) districtsTable 5: Minimum Capital Requirement in Nepalese Rs in MillionsTable 6: MFIs and Organizations Surveyed during policy diagnostic vii
  9. 9. Introduction1 INTRODUCTION1.1 CONTEXTMicrofinance has been one of the few effective tools for poverty reduction. As a result of thecreation of sound microfinance institutions and systems, poor people can safely deposit moneyand accumulate funds for future investments or emergencies as well as access loans forproductive purposes leading to higher incomes. Additionally, microfinance has produced animpact in other areas including good governance, participation in the political process, womenempowerment, social inclusion and conflict transformation.1Currently, more than 1.6 million individuals in the rural population have access to microfinanceservices. This figure represents approximately 7 percent of the population and approximately22.7 percent of the people living below the poverty line. The outreach of sustainable and soundmicrofinance institutions to the rural and urban poor still needs, however, to be increased inorder to further diminish poverty. Despite ongoing development efforts, poverty remainswidespread with approximately 31 percent of the population living below the poverty line. Theincidence of poverty is highest in rural areas, particularly in the remote hill and mountain areas.The Microfinance Summit Nepal held from February 14 to 16, 2008 discussed the major issues inthe microfinance sector. These issues included: • Lack of an enabling microfinance policy based on a broad consensus among policymakers and stakeholders; • Lack of coordination among microfinance stakeholders (including the international donor community) which has lead to market distortions and overlapping interventions; • Lack of appropriate strategies to build a strong and inclusive microfinance sector which responds to the needs of all segments of society, and actively contributes to creating a peaceful and socially equitable society; • Lack of microfinance sector baseline data on key stakeholders and customers which hinders the development of targeted and tailor-made support strategies for different client groups (i.e. how to bring microfinance services to hill areas? How to better access dalit and janajati communities?); • Lack of information sharing on innovations, new technologies and strategies which impedes increased outreach, particularly to the less accessible areas.Delegates (838) of private, government and public microfinance stakeholders together with theinternational donor community attempted to address these issues at the Summit. Microfinance1 Microfinance Summit Nepal 2008 CMF Nepal 60
  10. 10. Introductionstakeholders shared their experiences with microfinance issues and jointly decide on the futuredirection of microfinance in Nepal. The Summit promulgated the ‘21 Point KathmanduDeclaration’ and established goals for Nepal only after recalling national and globalcommitments. • The national development plan; and the United Nations Millennium Development Goals (MDGs) call for reducing international poverty by half by the Year 2015, thereby globally reaching 175 million poor families; • Bearing in mind that the Global Microcredit Summit held in Halifax, Canada declared a goal of ensuring that 100 million of the world’s poorest families move from below USD 1 day earnings to an adjusted purchasing power parity above USD 1 a day; • Recognizing that adopting an inclusive approach for poverty reduction through appropriate financial services contributes to ensuring a peaceful, democratic future for Nepal.The Summit set as its goal: • Reaching 2 million of the ‘poorest of the poor’ with microfinance services for their sustainable income by 2010; • Reaching a total of 3 million of the ‘poorest of the poor’ by 2015The Summit also formulated a two year action plan to meet this goal. The most important stepwas to form a fifteen (15) member Taskforce to lobby for the formulation of a microfinancepolicy and the creation of an enabling regulatory environment. The Summit recognized that anenabling policy and regulatory environment was a necessary pre condition to meeting its goal. Inthe course of this action, a review of new policy, regulations and regulatory provisions was feltto be necessary. This recognition prompted CMF and The Asia Foundation to implement theproject “Advocacy for Enabling Microfinance Policy Environment in Nepal” (May 10, 2008 toJanuary 31, 2009).The partnership conducted primary and secondary research to diagnose the current regulatorygaps and ambiguities in Nepal’s microfinance policy in close coordination with the Summit’sTaskforce. This diagnostic report is the outcome of the primary and secondary research, and thein-depth discussions held with the Microfinance Policy Taskforce formed at the Summit.Rationale:Microfinance in Nepal is emerging and transforming itself from a directed public sectorenvironment to a market led private effort. This does not mean, however, that theGovernment, the Central Bank and donor institutions are not giving it the necessary attention.Their role is recognized as systematizing, regulating, supervising, promoting and facilitating thesystems, methods and institutions.Nepals Central Bank (Nepal Rastra Bank) is considered the prominent regulator. It is always insupport of poverty reduction strategies through the provision of development finance especiallymicrofinance. In this mission it has created not only laws and regulations but also institutions atvarious points in time. In recent years it has concentrated on regulatory reforms in the banking CMF Nepal 2
  11. 11. Introductionand financial system in line with Basel II for creating a safe and sound financial system. This isthe basic requirement of sound macroeconomic stability. Currently, NRB is in the process ofstrengthening microfinance systems, regulations and regulatory frameworks.ObjectivesThis diagnostic study on the policy and regulatory framework for microfinance in Nepal had thefollowing objectives: 1. To review the existing policy, legal and regulatory frameworks for different models of micro finance institutions; 2. To identify issues related to policy and regulatory framework from the perspective of stakeholders; and 3. To suggest measures and a regulatory framework for MFIs with the aim of enhancing their sustainability and growth.1.2 METHODOLOGY • The study reviewed the policy and regulatory framework of the microfinance sector. Available literature on principles, issues and practices of regulation and policy framework of several countries were also reviewed. • Individual consultations were held with forty-four microfinance institutions, policy making organizations, donor agencies and INGOs. • The national Microfinance Summit held in February 2008 in Kathmandu proposed a national Taskforce Committee be formed to prepare and suggest policy and regulatory issues in micro-finance to the next Summit to be held in February 2010. The Microfinance Secretariat formally constituted the Taskforce and conducted a series of nine meetings with members, the NRB governor, and NRB officials. The outcome results of a desk-top audit and field review were submitted to this Committee. The final comments of the Committee including final draft recommendations were then submitted at a wider stakeholders meeting including the National Steering Committee members on January 26, 2009. The model draft Microfinance Act and stakeholder suggestions on it are attached as Annex-1-2.1.3 LIMITATIONSThe study focused on the regulatory environment, reviewing current practices andrecommending how to reform them. It did not focus on the depth of outreach, sustainabilityfactors and probability of sector growth. This was due to the availability of resources. As aconsequence, there exists further scope for study in each of these areas. CMF Nepal 3
  12. 12. Microfinance Market Environment2 MICROFINANCE MARKET ENVIRONMENTAn unstructured form of microfinance service started in the 1950s when several saving andcredit co-operative societies were formed in Chitwan district. Available study data indicates thatwhile this informal financial system (SACCOs) remains dominant the microfinance sector hasundergone many changes. The sector has experienced a rapid growth of institutions (MFIs) andsignificant progress has been made in terms of client out-reach, savings and credit managementservices. The number and outreach of microfinance institutions in Nepal has increasedsubstantially over the last 13 years.Market OutreachThe table below shows the microfinance market in Nepal by category of financial model. Thenumber of institutions in each category, the number of clients served per institution, and thetotal client base are shown. This information was gathered mostly from secondary sources. Table 1: MFI Categories and Clients MFI Categories Number Number of Clients (Range) Client Base of MFIs MFDBs 10 20,000-96,000 455,782 SACCOs 4,432 100-5,000 686,453 FINGOs 47 5,000-40,000 343,596 SFCLs 219 500-1,500 139,368 Sources: NRB (2008), CMF (2008), Department of Cooperative (2008), SKBBL (2008).SACCOs account for 42 percentof the market. The 10 MFDBsaccount for 28 percent and the47 FINGOs for 21 percent ofthe microfinance customerbase. The rest of the market iscovered by SFCLs.Figure 1: Market share 2.1.1 OUTREACH GROWTHFigure 2 below shows the annual microfinance outreach growth from 2004 to 2008 of each MFIcategory. The FINGO category has the highest growth rate but has had a declining rate since2006. SFCLs have a positive growth rate in comparison to other categories from 2006 to 2007. CMF Nepal 60
  13. 13. Microfinance Market EnvironmentThe aggregate annual average growth rate of all MFIs is nearly 23 percent. The unexpectedgrowth of SACCO clients in 2008 was due to the growth in the number of SACCOs. There wasonly limited growth in 2007, however, among the other MFI categories. This indicates the needexists for an enabling policy and regulatory environment to boost outreach MFI Outreach (2004-2008) 75% 70% 70% 70% 65% 62% 62% 60% 55% 50% 51% Outreach growth 45% 40% 37% 35% 33% 30% 25% 22% 21% 20% 19% 19% 17% 16% 15% 15% 15% 12% 11% 10% 8% 5% 2% 0% 0% 2005 2006 2007 2008 Fiscal Year MFDBs SACCOs FINGOs SFCLs Aggregate outreach Figure 2: Outreach growth 2.1.2 MARKET PENETRATIONAs discussed earlier, the potential microfinance market comprises the 31 percent of thepopulation that live below the poverty line. The table below shows the current outreach andmarket potential of each development region. The data used to estimate the market potentialand the coverage of MFIs came from CMF reports. CMF Nepal 5
  14. 14. Microfinance Market Environment Table 2: Current Microfinance Market Size and PenetrationDevelopment Number of Microfinance Percent ofRegions Clients Market PenetrationEastern 306,388 2,543,536 12%Central 472,810 2,806,561 17%Mid-West 117,126 1,043,790 11%Western 237,772 1,518,415 16%Far Western 49,657 766,722 6%Total 1,183,753 8,679,024 14%Sources: CBS (2007), CMF (2008). Note: Market penetration is based on 2007 client base data.Table 2 shows that a small percent of the microfinance market is being reached. It also showsthat those that are being reached come from the Eastern, Mid-Western, and Central regions.The vast majority of microfinance recipients live in the Terai as indicated in Table 3. However,Table 3 also indicates that the hills and the mountain areas have a high number of possibleneedy clients. Table 3: Microfinance Market by regional type Eco-zone Number of Microfinance Market Percent of Market Clients Size Penetration Terai (plain 743,423 3,153,752 24 areas) Hills and 440,330 5,525,272 8 mountains Total 1,183,753 8,679,024 14Sources: CBS (2007), CMF (2008).Table 4 shows that the majority of microfinance clients live in only 13 districts primarilycentered in the Central and Eastern regions. CMF Nepal 6
  15. 15. Microfinance Market Environment Table 4: Market Concentration in 13 districts Microfinance Concentration of Market ( 31% of SN Districts clients Total Pop) Total Population Regions 1 Morang 88,795 291,900 941,614 E 2 Sunsari 60,200 220,361 710,842 E 3 Rupandehi 55,026 249,755 805,662 W 4 Bara 55,046 196,708 634,542 C 5 Jhapa 54,484 234,203 755,494 E 6 Kathmandu 43,823 395,794 1,276,754 C 7 Chitwan 43,765 165,694 534,496 C 8 Sarlahi 40,627 221,499 714,513 C 9 Dang 35,985 161,674 521,528 MW 10 Parsa 35,604 174,627 563,312 C 11 Nawalparasi 33,800 196,220 632,969 W 12 Dhanusa 32,441 231,695 747,402 C 13 Bake 27,468 135,968 438,608 MW Total 607,064 2,876,098 9,277,736 51 % share of total market penetration by 13 districts 21% penetration in the microfinance market of 13 districtsThe policy and regulatory measures that are to be formulated must be able to encourage MFIsto expand their services to the underserved target groups and into other districts. In addition,support in reducing operational cost through innovation, research and ICT infrastructure canalso help MFIs expand their services beyond these 13 Terai and hill districts. CMF Nepal 7
  16. 16. Policy and regulatory environment3 POLICY AND REGULATORY ENVIRONMENT3.1 DEFINING MICROFINANCEMicro-finance has emerged as a powerful tool for poverty reduction. Historically, differentforms of intermediation and development strategies have not been able to trigger povertyreduction economic activities. This has caused policy makers and practitioners to re-thinkmicrofinance as an emerging tool for poverty reduction. This re-thinking reflects the paradigmshift in rural development attitudes world -wide.Microfinance has been defined in different ways to suit both academics as well as MFpractitioners. Its origin, however, can be traced back 50 years when development focused on aplanned approach. As a consequence of this approach, rural development programs, especiallythose lending to agricultural, agro business and related businesses had the objective of attaininggrowth with social justice.The Asian Development Bank (ADB) defines micro-finance as “the provision of a broad range offinancial services such as deposits, loans, payment services, money transfers and insurances tothe poor and low income households and enterprises.”The World Bank defines it as “the provision of financial services to low income clients, includingthe self employed. It includes both financial and social intermediation. It is not simply banking, itis a development tool.”Similarly, Rachel Rock defines it as the “development of small amounts of short term workingcapital and in some cases, long term investment loans and provision of deposit facility to smallscale business and households.”“Microfinance is the supply of loans, savings, and other basic financial services to the poor"(CGAP).A microfinance institution (MFI) is defined as an organization that provides microfinanceservices, ranging from small non-profit organizations to large commercial banks. CGAP broadlydefines an MFI as any organization—credit union, downscaled commercial bank, financial NGO,or credit cooperative that provides financial services to the poor.Nepal’s National Microfinance Policy 2008 defines microfinance as the financial services thathelp poor communities develop their professional skill and become involved in income relatedactivities by offering self employment opportunities through micro saving, micro credit, andmicro credit insurance/micro credit security activities. CMF Nepal 60
  17. 17. Policy and regulatory environment3.2 PRINCIPLES AND CHARACTERISTICSMicrofinance encompasses key principles that have evolved over the years through theinteraction of stakeholders, researchers and academicians. These principles clearly demonstratethat MF has created its own development and academic identity.Key Microfinance Principles: 2 1. “Poor people need a variety of financial services, not just loans. 2. Poor people are bankable, can pay loans and can also save. 3. It is a powerful tool to fight poverty. 4. It means building financial systems that serve the poor. 5. It can pay for itself, and must do so if it is to reach very large numbers of poor people. 6. It is about building permanent local financial institutions. 7. Micro-credit is not always the only answer. 8. Interest rate ceilings hurt poor people by making it harder for them to get credit. 9. The role of government is to enable financial services, not to provide them directly. 10. Donor funds should complement private capital, not compete with it. 11. The key bottleneck is the shortage of strong institutions and managers. 12. Micro-finance works best when it measures and discloses its performance.”Characteristics of Microfinance: Microfinance possesses characteristics which separates it fromother forms of finance. Some of these characteristics include: 1. MF is mostly collateral free 1. MFIs go to clients rather than clients go to MFIs 2. Simplified savings and loan procedures 3. Small size of loans and savings 4. Repeat Loans 5. Loan sizes increases when there are repeated loans or in subsequent cycles 6. Interest rate is usually between that charged by money lenders and formal banks 7. Free use of loans (no restrictions on specified purpose) 8. Loan repayment considers incomes from business as well as other sources 9. Loan and saving products within manageable numbers3.3 BEST PRACTICESInitiatives to develop microfinance have attracted the attention of development agencies, i.e.the United Nation proclaimed 2005 as the “Year of Micro-credit”. From the variousdevelopment agency initiatives a number of MF models have been developed and practicedover the years. As a consequence of this experience, a large knowledge base has developedwhich in turn has led to the development of guiding principles, often termed ‘best practices’,which can help MFIs achieve sustainable operations for longer periods of time.International ‘best practices’ include: building effective management information systems(MIS); offering outreach services to attract a larger number of clients (vision of growth);2 CGAP CMF Nepal 60
  18. 18. Policy and regulatory environmentpromoting and diversifying savings services; offering services that fit client needs; diversifyingloan products; and simplifying loan procedures. In addition, there exists the need to motivateclients to repay loans which focus on high repayments; attain operational self sufficiency (OSS)and financial self sufficiency (OSS) by charging adequate and appropriate interest rates and fees;involve clients when designing services; promoting effective governance characterized bydemocratic and transparent decision-making; and properly targeting clients..‘Best practices’ also includes a focus on financial services (provision of business developmentservices as a separate but parallel intervention not as a part of, or, condition of finance);development of institutional linkages; implementation of incentives systems that promoteefficiency and maintain quality; and implementation of an internal control system thatminimizes financial and credit liquidity, interest rate charges, transactional and operational risksand the risk of fraud. It is regrettable that the majority of MFIs in Nepal can not follow these‘best practices’ due to the absence of a proper infrastructure, regulatory environment andmarket standards.3.4 WHY ENABLING REGULATORY ENVIRONMENTThere is no unanimous opinion among MF practitioners and regulators on the issue ofregulation for microfinance operations. Some say the “Market is the best regulator” whileothers argue that MF should be left outside the purview of formal regulation. The later envisionsa scenario where MF works are viewed as noble social work versus as a professional financialactivity.The general consensus that has emerged, however, is that some conducive, facilitative orgrowth oriented regulation could boost the MF sector. According to Fukaya and Shadagopan(2001) “The motivation for regulatory intervention is based on the assumption that anasymmetry of information exists between the lender and the borrower.” They argue thatregulation has to match the actions of the institutions (Agent) and the clients (Principal) in sucha way that the actions of the agents are controlled, decision making power of the agents arerestricted and provide incentives in doing so by harmonizing the benefits to principal and theagents. In summary, the reasons for an enabling regulatory environment are: • The possibility of a ‘run’ on an MFI due to a lack of information to the stakeholders (investors). • The opportunistic and risky behavior of an agent even for MFIs that do not take deposits may pose a serious threat to the functioning of the MFI. • The need for consumer protection in order to ensure stability. • The protection of wholesale lenders (some could be banks in which case public funds are involved, others could be bilateral or multilateral agencies where returnable funds may have as a condition the requirement for appropriate regulation and supervision before disbursement to the MFI). CMF Nepal 10
  19. 19. Policy and regulatory environment • The need to ensure a healthy development of the sector through performance standards • The need to facilitate linkages with commercial sources of finance. • The need for the prudential regulation of savings • The opportunity for banks to become involved in direct microfinance.Once microfinance activities start various needs emerge according to changes in the market.The enabling regulatory environment creates a competitive market for microfinance. Itdetermines the size of the micro enterprise sector, the supply of credit, the assessment of thecredit gap, the interest rate setting, the number and types of institutions, the capitalrequirement, the product design, etc. It also protects the quality of a portfolio throughdocumentation requirements, group guarantees, insurances, and either the CAMEL or PEARLSrating systems. In addition, the enabling environment builds the institutional capacity of anagency, obtains timely and adequate financial information and establishes effective off andonsite supervisory mechanisms and handles potential insolvencies.Nepalese experience and studies suggest that building an enabling and sound regulatoryenvironment is very important for an efficient and effective microfinance industry. The enablingenvironment in the Nepalese context consists of creating a legal framework; developing selfregulatory norms; ensuring good management practices and governance; developingappropriate internal control and institutional rating systems; and public disclosure of norms,deposits and credit insurance schemes as well as the development of performance standards.Generally, non bank MFIs are not subjected to prudential regulation when they do not acceptpublic deposits (McGuire and Conroy 1999). This study suggests that for most non-bank MFIs,prudential regulation is not always effective in preserving financial health. Suggestions arisefrom observation that leads one to find ways for developing institutions that are sustainable,self regulated and governed with sound performance management systems. Additionally, theseactions can be supported by the use of independent credit rating systems and the disclosure offinancial and social performance information. If these actions are taken, it will facilitatewholesale funds, and better enable commercial banks and foreign financial institutions toprovide funding to MFIs. Ultimately, this will lead to self-led supervision under performancecriterion and strong loan repayment performance.3.5 PRINCIPLES OF ENABLING ENVIRONMENTGlobally practiced enabling regulatory environment principles include: 1. Competitive neutrality: The regulatory environment needs that all types of MFIs play on a level field. There should not be any discriminatory policies for any type of MFI (Government owned/ Private/ Cooperatives/ Banks/ FINGOs, etc.). 2. Negative effect of regulation: Regulations that effect efficiency should be minimized to allow for reducing the cost of intermediation. 3. Do not mix social objective (political agenda): Avoid self-interest in promoting financial markets. CMF Nepal 11
  20. 20. Policy and regulatory environment 4. Avoid institutional failure: The purpose of regulation and supervision should be to do this. 5. Provide competition: Regulation must rely, as much as possible on the self-interest of the economic agent. 6. Regulatory framework should not be static: Markets always innovate and find ways to avoid regulation. Therefore, there must be a strong will on the part of regulators to discover changes.The regulatory framework should be flexible enough to regulate different intermediaries indifferent manners as required.3.6 THE ROLE OF GOVERNMENT AND THE CENTRAL BANKThe role of Government and Central Bank has been discussed earlier. From the 1950s until the1980s most countries pursued a guided rural, small or micro- financial approach. The aim was toprovide funds to poor rural people at concessional rates, sometimes together with otherinterventions to replace the traditional informal sector, which was considered as exploitative.Consequently, many governments and central banks launched directed credit programs. Duringthe 1990s this approach was criticized as financial repression.Rapid outreach was not considered possible due to a lack of funds. Ultimately, the poor did notbenefit due to the non availability of funds at the required time. (Uprety, 2005) The success ofGrameen Bank Bangladesh model in reaching a large number of poor people without agovernment subsidy and intervention has led many policy makers and practitioners to rethinkand act in different ways. Today, MF theorists have the view that role of the government andthe central bank should only be to facilitate and not control. This will be discussed more in thesection on the Analysis of the Nepal MF Policy Framework.3.7 IMPACT OF MICRO- FINANCE IN NEPALThere are only a few studies available on the generic impact of microfinance services in Nepal.Generally, however, it has been found that MFs can contribute to poverty reduction byencouraging the acquisition of new assets, income growth, women empowerment, betterhealth care and better education for the client’s children. Some specific observations made byDhakal and Uprety, 2005 include:  MF services are not very diversified.  Micro- credit has been used for both production (66 percent) and consumption (36 per cent) activities.  MF contributes to a reduction in a client’s household poverty (56 percent reported an increase in their income after participation).  MF has served to lessen the dependency on moneylenders by reducing the average interest rate. CMF Nepal 12
  21. 21. Policy and regulatory environment  Participation in income generating micro- enterprise activities has increased income and employment as well as created more employment in the ratio of 1:1.28.  Access to financial services has had a significant impact on clients for a wide range of economic and social indicators including: increased income, improved nutrition, higher quality food and clothing, better housing, lower child mortality, lower birth rate, higher family planning practices adoption, better health care, better education for their children, women empowerment and participation in social and political activities. Thus, MF is directly helping Nepal to attain its MDG goals.3.8 REGULATIONS FOR MICROFINANCE INSTITUTIONSThe term regulation is understood differently by organizations depending on their place insociety. Broadly, regulation in banking and finance can be referred to as "binding rulesgoverning the conduct of legal entities and individuals, whether they are adapted by a legislativebody (laws) or an executive body (regulations)” (CGAP, 2003). Regulations can be furtherdescribed as: 1. Self-Regulation; 2. Prudential Regulation; 3. Non-prudential Regulation; and 4.Enabling. Regulation.Self-Regulation: Regulation and/ or supervision by a body that is effectively controlled by theentities being regulated or supervised based on predetermined performance criterions or ratingsystem (PEARLS rating system is applied by many MFIs as self-regulation norms in manycountries).Prudential Regulation: Regulations aimed at protecting the financial system as a whole as wellas protecting the safety of small deposits in individual institutions. Many such regulations stemfrom the BASEL principles and CAMELS rating, which may be a burden to some smaller MFIs toadhere to especially for those who do not take public deposits and to regulators.Non-Prudential Regulation: Outside of a central banks purview there are regulations covering"fit and proper", "dos and donts" maintained by various government bodies, industryassociations, audit firms, rating tools, etc. Many believe that an MF portfolio covering 2 percent(on average) of total financial asset does not pose a safety soundness risk to the financial systemand thus does not require prudential regulation.Enabling Regulation: Regulation having a positive outlook that allows MFIs easy entry andinvolvement in new activities is considered as an enabling or promoting regulation.The worldwide issues in regulation and supervision are: the movement of deposit vs. on-deposit taking; small vs. large outreach volume; donor funded vs. commercial fund accessedMFIs; and rating services availability etc.3.9 ESTABLISHMENT CRITERION 3.9.1 GENERALBased on the above theoretical understanding of regulation and supervision, an analysis ofthe existing MFI regulations in Nepal is possible. MFIs in Nepal are subject to many CMF Nepal 13
  22. 22. Policy and regulatory environmentdifferent types of regulations including the establishment of criterion, prudential and non-prudential regulation (a few regulations could even be termed enabling).Minimum Capital RequirementThe minimum capital requirements to establish a Banking Finance Institution (BFI) aredetermined based on the category type and functional area. The establishment norm for MFIsis considered as facilitative and promotional but does not reflect on the future return to theequity holders. Table 5: Minimum Capital Requirement: NRs in Millions Category of Central Regional From 4-10 From 1-3 Priority Financial Level Level* Districts* Districts* Areas *** Institution Commercial Bank 2,000 - - - - Development Bank 640* - 300** 300** 20 200 100 Finance Company 300** - - 300** 10 200 100 Microfinance 100 60 20 10 - Development Bank + 5 Hill districts*Outside Kathmandu Valley only*Includes leasing business***Priority areas where there are less than 5 bank branches / VDCs or municipalities havingno banking services.Facts1. Promoters must invest at least 51 percent of the required equity, while 30 percent can be set-aside for the general public (of which 5 percent can be allocated to staff members).2. Joint venture partners can invest up to 85 percent in the equity of a bank or financial institution. If Joint venture partners invest less than 50 percent, 30 percent needs to be set- aside for the general public. If they invest 50 percent or more than 15 percent needs to be set-aside for the general public.3. Individual, firms or companies must submit their latest tax clearance certificates, source of fund and for a company their audited balance sheet for the last 2 years as well as a record of their retained profit. In the case of micro-finance development bank companies are required to submit at least one-year’s balance sheet. CMF Nepal 14
  23. 23. Policy and regulatory environment4. Promoters of a bank or financial Institutions need to deposit 5 percent of paid-up equity at the time of application; 45 percent at the time of receiving the Letter of Intent (LOI); and the remainder at the time of receiving the operating license from Nepal Rastra Bank (NRB).5. Promoters of a bank or and financial institution must have a clear financial record. If they were blacklisted in the past they need to have completed at least 3 years after their names were deleted from the black list by the Credit Information Center.6. At least one third of the promoters should have a bachelor’s degree.7. The investment limit for a single person, their family or firm is a maximum of 15 percent of the paid-up equity. A type D or Micro-Finance Development Banks is set at a maximum of 25 percent.8. Banks and financial Institutions in various categories (type A, B, C and D) have a maximum establishment expense limit of 0.5; 1.0; 1.5 and 2 percent respectively. Banks and financial institutions must submit 0.01 percent of their issued capital as a licensing fee at the time of application (non refundable).9. Banks and financial Institutions must start operations within 6 months from the date of approval of the NRB license. If they do not, their license will automatically be cancelled.10. Microfinance Development Banks (MFDBs) can expand branches at a cost in the ratio of NRs 2.5 million in capital per branch.Other conditions can be found in the licensing norms, Bank and Finance Institution Act and NRBregulations relating to the incorporation, corporate governance and other topics that need to befollowed as a precondition. Banks and MFIs are also required to disclose other matters asmentioned in the laws, regulation and policies. 3.9.2 LICENSING NORMS FOR FINGO SFacts:1. The minimum capital requirement is NRs. 100,000. The capital of Non-Government Organizations (NGOs) is defined as membership fees, reserves and capital grants.2. NGOs must have at least 500 members in the Kathmandu Valley and Terai and 300 in other districts (with at least 50 percent women member) to apply for a financial intermediation license.3. At least 2 working committee members must have a Bachelor’s degree and 50 percent SLC level qualifications.4. At least 2 members of working committee must be trained in micro-finance.5. Working committee members should not have been blacklisted by any bank or finance institutions and also have no criminal offences.6. NGOs must have at least 3 years of continuous experience in the social sector. CMF Nepal 15
  24. 24. Policy and regulatory environment7. Priority will be given to NGOs having worked in PCRW, MCPW and having functioned as the credit agent of a commercial bank or as a borrower from RSRF with satisfactory results. NGOs also targeting dalits and disadvantaged ethnic group will also be given priority.8. A business plan and other documents need to be submitted as required by the NRB together with the application for a license.9. NRB has suspended taking any application for a FINGO license since 2004. 3.9.3 REGISTRATION NORMS AND SACCOSFacts:1. There should be at least 25 persons to organize a co-operative society. All corporative societies are not necessarily MFIs as they may focus on micro-finance for a targeted group. In either case, the registration requirement is the same.2. Members of a co-operative society can be individuals, firms, and international co-operative alliance member institutions (maximum 20 percent of paid-up share).3. Single shareholder limit is a maximum of 20 percent.4. Voting right is "one member, one vote" and not on the basis of number of share owned, as per the principles of co-operatives.5. SACCOs can issue and sell shares to members on the basis of open to all principle at any time.6. Working area can be 5 VDCs or all the wards of a municipality or the 5 adjoined wards of a greater / sub greater municipality.7. Branches can not be opened without the prior permission of the Department of Cooperatives (DOC).3.10 REGULATIONS FOR MICRO FINANCE DEVELOPMENT BANK (MFDB)Micro Finance Development Banks are type D financial institution as defined in the Banking andFinancial Institutions Act, 2006, and are regulated by NRB. Therefore, they are regulated by theBank and Financial Institution Act, 2006, Nepal Rastra Bank Act, 2003 and other regulationsissued by the Nepal Rastra Bank from time to time. Some of the major regulations affectingperformance are:1. Board of DirectorsMicro Finance Development Bank, like all other banks and finance institutions are required toorganize a management board having 5 to 9 directors. One member should be a professionaldirector appointed from the list of professionals published by NRB. A professional directorrequires a masters degree qualification and 5 years of experience at the executive level.Unfortunately, these qualifications make it difficult to find sufficient interested professionals. CMF Nepal 16
  25. 25. Policy and regulatory environment2. Permissible Activities• Lending as per NRB directives• Micro-credit provision in accordance with NRB directives• Borrowing from local and/or foreign institutions for micro lending or strengthening micro- finance systems• Providing services to promote microfinance i.e., training and conducting seminars.• Taking deposits (with or without interest) from the public as per the conditions stated by the NRB.3. Capital Adequacy Ratio (CAR)The CAR is set at a lower rate for MFDBs than other BFIs. CAR - primary capital 4% and totalcapital fund 8 percent of risk weighted asset. [For commercial banks, development banks, andfinance companies the CAR is 5.5 and 11 percent. Recent changes for type A, B and C BFIsrequire a minimum CAR of 8 percent and additional capital provision as per BASEL II regulations]Risk Weights applicable to Micro Finance Development Banks (MFDBs) % Cash 0 Balance held at Nepal Rastra Bank 0 Nepal Government/Nepal Rastra Bank securities Balance with other Banks and FIs 20 Loans against govt. securities 0 Accrued interest to be received (Government securities) 0 Loans against other Bank and Finance institutions FDs 20 Balance held with Foreign Banks 20 Money at call 20 Investment in shares/debenture 100 Loans 100 Fixed assets 100 Other assets 1004. Loan Loss Provision Categories LLP % Pass - Principle not overdue or due up to 3 months 1% Sub-standard - Principle overdue from 3 to 6 months 25% Doubtful - Principle overdue from 6 to 12 months 50% Loss - Principle overdue from more than a year 100%A term loan (more than one year) installment due is counted as the total due and provisionneed to be made accordingly. A loan to a missing borrower and a miss-utilized loan arecounted in the loss category whether overdue or not . CMF Nepal 17
  26. 26. Policy and regulatory environment5. Single Borrower LimitThe loan limit of a Micro Finance Development Banks (MFDB) involved in wholesale lending isthe same as for a commercial bank and financial Institution - that is a maximum of 25% of corecapital to a single borrower (MFI). The loan limits for an MFDB at retail is:• Maximum of NRs. 60,000/- per person (group member) - Group guarantee and collateral free.• Micro-enterprise (Income generating occupation having less than 10 persons involved) loan to group members (graduated) up to NRs. 150,000/- (with collateral).• Micro Finance Development Bank (MFDB) can invest only up to 25% of their total lending in a micro-enterprise portfolio.6. Accounting Policy and Financial ReturnsAccounting and reporting formats for MFDBs have not been issued separately. Informally theywere advised to use the same format (prescribed for commercial banks, development banks andfinance companies) that process is complicated, lengthy and basically unnecessary for them tocomplete. Even so, this does not facilitate nor provide the required information for an MFcomparative database.7. Regulation for Minimizing Transaction RiskThis is a common regulation for all types of banks and financial Institutions. Many of theprovisions under this regulation may not be applicable to MFIs i.e. gap analysis.8. Regulations on Corporate Governance Duties of the Board of Directors:Maintain Minimum Acceptable Behavior: To commit to compliance to Nepal Rastra Bankguidelines; not to interfere in the day to day operations; and to disclose any involvement in thetransaction of the concerned MFI.Not to be involved against the MFIs Interest: The Board of Directors of a bank or a financialinstitution cannot be a Director of another bank or financial institution (Bank and FinanceInstitution Act, 2006). Appointment of Chief Executive Officer (CEO)A qualified, experienced and capable person must be appointed as CEO.CEO/Staff Discipline: Maintenance of confidentiality, CEO is not to abuse the position andinformation received; maintains trustworthiness; does not act against the interests of theinstitution; and needs permission for part-time work to be approved in advance. CMF Nepal 18
  27. 27. Policy and regulatory environmentShareholders: (with more than 1% of shares), Board of Directors and staff are restricted fromborrowing from the bank (except loans) as per staff rules and in pledging collateral for others inthe bank.9. Regulations on Investment• Investments can be made according to the investment policy approved by the MFDBs Board of Directors.• There is no restriction to invest in Government and Nepal Rastra Bank (NRB) securities.• Banks and financial institutions can only invest in listed companies, and only up to a maximum of 10 percent in a single company and in total 30 percent of its own primary capital. Banks and financial institutions can invest up to 20 percent in a related company but that amount needs to be deducted from its primary capital for calculation purposes.• The valuation of an equity investment or debenture has to be made on the basis of the purchase price or market price whichever is less. If the market price is less, then a provision has to be made for the purchase price in the same amount. A bank or a financial institution can not invest in the equity, debenture or hybrid capital instruments of another BFI. Banks and financial institutions in type A, B and C categories can, however, invest in type D (Micro Finance Development Bank) securities10. Regulations on Compulsory Reserve (Liquidity)• MFDBs are required to maintain 2.5 percent of their deposit liability in the form of liquid assets. Liquid assets are defined as cash in the vault, investments in Government and Nepal Rastra Bank securities, and deposits in commercial banks.• MFDB’s are required to maintain a compulsory reserve with the Nepal Rastra Bank, and where there is no Nepal Rastra Bank branch with a commercial banks in a current account for 0.5 percent of their member’s deposit and borrowed fund• Liquidity is calculated monthly on a daily average basis.• There is a limited penalty provision for non-compliance.11. Branch Expansion MFDBs are allowed to open, close or merge their branches within approved geographical areas.They are required to inform Nepal Rastra Bank, however, within 15 days of doing so. Three toten district MFDBs can expand their branches into an additional 5 hill districts with the samecapital. They can also expand branches at the additional capital ratio of NRs 2.5 million per onedistrict.12. Interest RateMFDBs are not restricted to a fix flat rate. They can fix interest rates at any time by placing anannouncement on their notice board. Like other banks and financial institutions, they are not CMF Nepal 19
  28. 28. Policy and regulatory environmentrequired to publish a change in the national newspaper, but only need to inform the NepalRastra Bank after the change.13. Financial Resource Mobilization• MFDBs can mobilize financial resources (deposits, borrowings and debentures) up to 30 times their core capital (subject to maintaining a CAR of 8 percent)• MFDBs are not permitted to collect deposits from non-members.• Borrowing from foreign sources requires the approval of the Nepal Rastra Bank (NRB).• The Issuance of debentures and debt instruments is conditional. Banks and financial institutions must have completed 5 years of operation, public shares must have been issued and their listing has occurred at least 3 years before. In addition, any initial operating loss has already been recovered.• If excess resources have been mobilized, they should be brought within limits within 3 months time. Until this happens the bank or financial institution cannot announce or distribute a dividend or mobilize further resources.3.11 REGULATIONS TO SAVINGS AND CREDIT CO-OPERATIVE SOCIETIES (SACCOS)SACCOs are registered in accordance with the Co-operative Act, 1992 and operate according tothe Acts, rules and bylaws. All SACCOs are not Micro Finance Institutions. Many of them have,however, adopted micro finance principles and practices in their operations. There are noseparate regulations for such co-operatives. Some of the SACCOs (16 out of 3000) have alsoreceived limited banking licenses from the Nepal Rastra Bank but only a few are involved inmicrofinance. Even so, the Nepal Rastra Bank regulations are also not specific regardingmicrofinance formicrofinance for SACCOS.SACCOS, worldwide, are governed by the ‘Seven (7) Principles’ of co-operatives and theinternational practices of credit unions. Each SACCO is an autonomous institution governeddemocratically by its member.Nepal has had some bitter experience in the co-operative field. During the past 5 years morethan 100 co-operatives have lost members money. There are also co-operatives abusing the co-operative principles and acting as financial institutions without appropriate regulation and theabsence of prudential supervision. This has created a negative image for the functioning offinancially sound co-operatives.According to the Co-operative Act certain general regulations govern co-operatives. Theseregulations include:1. Registration: At least 25 persons residing in the described geographical area and agreeing to apply co-operatives principles can apply for registration.2. Bylaws must be in accordance with Cooperative Act and its rules. CMF Nepal 20
  29. 29. Policy and regulatory environment3. The annual general meeting (AGM) for shareholders must be conducted within 6 month of the end of the fiscal year.4. The Board of Director must be appointed for a maximum of 5 years by the AGM (members 5 to 11); an audit committee (1 co-coordinator and 2 members); and other sub-committees must also be formed based on the approved bylaws.5. SACCOS can generate resources by issuing shares to individuals, members and other agencies, and foreign co-operatives (international co-operation alliance) up to a maximum of 20 percent for all categories; accept savings from members (individuals only); and issue debt instruments with the approval of Government.6. The principle of one member one vote applies as opposed to the normal company practice of one share one vote.7. Co-operatives can accept savings and provide loans to members and also conduct other banking activities with members with NRB approval.8. Co-operatives must transfer 25 percent of their surplus (annual profit) to a reserve fund as per their bylaws. They can only distribute a maximum of 15 percent in dividends to shareholders from the net surplus.9. Co-operatives can merge or separate in accordance with the law.10. Co-operatives are subject to supervision by either a registrar or another designated person.11. Co-operatives should follow the PEARLS rating system while supervising co-operative societies.12. Co-operatives can not discriminate by categorizing members as promoters, general members and share only members.13. Co-operatives can fix interest rate spreads of not more than 6 per cent.14. Co-operatives can mobilize member deposit up to 10 times the cooperatives share capital. If the co-operative‘s capital has eroded, however, it can still collect (receive) deposits.15. Co-operatives can lend up to 5, 10 or 20 percent of their capital to an individual for the first, second and third loan respectively. They can also take collateral and can lend based on a group guarantee. They can not lend, however, to more than 49 percent of their members at any time. Lastly, they need to maintain a minimum debt equity ratio of 80:20 while lending.16. Co-operatives should maintain at least a10 percent liquidity in relationship to their total savings. This does not take into consideration borrowing, however, which may cause them to fall into a liquidity trap. At least 2 per cent of any liquid asset should be cash in the vault or cash at a commercial bank. Liquidity data should be published monthly and must be submitted quarterly to the concerned district co-operative offices. CMF Nepal 21
  30. 30. Policy and regulatory environment17. NRB regulated SACCOS can mobilize resources up to 10 times their share capital but must maintain a cash reserve of 0.5 percent and liquid assets of 7 percent which are subject to a single obligatory limit of 10 percent. A loan loss provision also exists with similar bank and financial institutions and corporate governance regulations.18. NRB has barred co-operative from purchasing each others share. This was done after finding artificially created amounts equal to the amount of share transactions without cash being involved with the aim of deceiving regulators. The 1, 25, 50 and 100 percent loan loss provisions also apply to ‘pass loan’ when they are: 6 months, 12 month and more than 12 months over due.3.12 REGULATIONS FOR FINGOSThe Act for Financial Intermediation by societies was promulgated in 1998. Under the provisionsof this Act, forty-seven (47) FINGOs provide their memberships with microfinance services.There are only a few regulations for the operations of a FINGO. The legal licensing requirement,the NRB conditions mentioned earlier and performance regulations which include:1. FINGOs can only work with groups of poor people. Poor people are defined as those who do not posses more than 6 Ana or 10 dhur in a municipality and 20 ropani or 1.5 bigha in another area. Poor people also do not have permanent employment, have no access to the loan facilities of commercial banks and financial Institutions and have annual incomes of less than NRs. 5,500.00 per year.2. The lending limit for group members is NRs. 60,000.3. A FINGO must prepare and implement rules and bylaws approved by the NRB.4. The geographical working area of a FINGO is determined by the NRB in accordance with the recent regulations that they can only work in one district.5. FINGOs must avoid client duplication with other MFIs.6. Reporting formats and the frequency of need to be set by the NRB.7. The NRB has introduced the PEARLS rating system into its inspection and supervision manual for FINGOs. It has not yet, however, directed the use of PEARLS as a rating tool or asked for any disclosures.4 MICRO-FINANCE POLICY, 2065 (2008) The Government announced a National Microfinance Policy 2008 after the conclusion of Microfinance Summit 2008. Briefly, the major points of this policy are (see Annex-2 for more details): • Availability of microfinance services will be made simpler as per geographical diversity and for rural and urban poor. Standards will be set for identification of the poor and MF services flow system will be strengthened. CMF Nepal 22
  31. 31. Policy and regulatory environment • Support will be made available to MFIs for their strengthening, institutional development and wholesale financing from the public and private sectors • Programs addressing poverty will be implemented in a co-ordinate manner. • Micro enterprise and similar skills will be promoted. • Local community institutions and saving credit groups involved in MF will be legally recognized and linked to other MFIs. • Micro saving will be encouraged. • A second tier institution (STI) will be established under the NRB for effective regulation, supervision, monitoring and evaluation of MFIs. • A Micro Finance Development Fund will be established and funds available from domestic and donor agencies will be mobilized through this Fund. • A survey will be conducted to gather information on MFI outreach and activities. • Capacity building of MFI practitioners will be done through training. • A simplified policy will be adopted for MFI deposit mobilization depending on their services and share capital. • A flexible policy will be adopted on the corporate and deposit tax system for MFIs.Most microfinance experts view this new policy as a way for the Government to orient,emphasize and dominate policy. The role of Government, the private sector and donor agencieshas not been clearly mentioned in this policy. Large scale micro finance outreach can only beachieved by strengthening private initiatives, i.e. the expansion of micro finance in Bangladesh(Grameen, ASA, BRAC and many other micro finance institutions/programs) has been mainlydue to private initiatives with limited regulation. CMF Nepal 23
  32. 32. Survey Findings5 SURVEY FINDINGSA rapid assessment survey based on qualitative interviews and using a checklist was conductedto gauge market participant’s perception of microfinance policy and regulatory issues. Thesurvey also identified suggestions for the improvement and practical implementation of anenabling microfinance policy and regulatory environment for Nepal.5.1 SURVEY COVERAGEThe survey was conducted in forty-four (44) organizations including various types of MFIs, policyformulating agencies, donors and INGOs. Table 6: MFIs and Organizations surveyed during Policy Diagnostic Organizational Type No of MFIs Percentage MFDBs 7 15.9 FINGOs 6 13.6 Co-operatives 16 36.4 SFCLs 4 9.1 Policy Organizations 6 13.6 Donor Agencies / INGOs 5 11.4 Total 44 1005.2 POLICY ISSUES AWARENESSEighty percent of the respondents said that they were aware of microfinance policy issues. Theawareness level on policy issues was found to be sufficiently high to meet the needs of thesurvey.. CMF Nepal 60
  33. 33. Survey Findings Table 6: Level of Awareness Awareness MFDBs Co-operatives SFCLs FINGOs Policy Donors/ Organizations INGOs No % No % No % No % No % No % Yes 6 86.0 9 56 4 100 6 100 6 100 4 80 No 1 14.0 7 44 100 0 0 0 0 1 20 Total 7 100 16 100 4 100 6 100 6 100 5 1005.3 POLICY ISSUES RAISED BY THE ACTORS 5.3.1 CO-OPERATIVESCo-operatives responded on various issues of concerns including:• Currently, the minimum number of persons required to form a co-operative is 25. Fifty-six percent expressed this as adequate while 44 percent believed this is too low and proposed that at least 100 people should form a co-operative society.• Most of the respondents opined that the minimum paid-up capital should be at least NRs. 1000 per person while the remaining stated that it should be left to the members. In terms of the area of operation, 69 percent stated that the existing area policy was appropriate.• The interest rate spread of 6 percent that was recently introduced by the Department of Co- operatives was view as suitable by 50 percent of respondents while 31 percent do not see any reason behind it and 13 percent believe that there should be no regulation at all.• The Loan Structure ratio with a maximum of 80 for the cooperative and a minimum of 20 for an individual was also thought to be correct, but many of the respondents felt that it should be 70: 30 or even 60:40.• Eighty-seven percent stated the PEARLS system introduction should use selected indicators instead of all 44 ratios.• Sixty-three percent expressed a strong opinion that co-operatives should not be taxed, 31 percent suggested to have a 5 to 10 percent tax rate and 6 percent felt it should be in the range of 10 to20 percent.• Most of the respondents were in favor of audit uniformity (similarity of formats), easy of access to wholesale, improvements in accounting systems (4 Ledgers), and showed concern regarding duplication, and emphasized the need to have a system of credit information and insurance. CMF Nepal 25
  34. 34. Survey Findings• Regulatory restriction on dividend payment to members (not exceeding 15 per cent) invoked a mixed response. Some were happy with the current regulation while others suggested it should not be regulated.Other suggestions included: • Transactions with non members should be allowed within the rules and regulations • Loans should be available at low interest rates. • If more than 10% of cooperative members want, this should be the quorum necessary to convene an AGM • Priority should be given to selecting women for decision making position • Co-operative categorization should be done according to the tax rate; and be regulated • The NRB should be more flexible in regulating cooperatives. • Unhealthy competition should be removed • Permission should be required to open a branchSFCLs, a special category of small farmer co-operative, have almost similar views. On taxationissues 100 percent of the SFCL respondents suggested that there should not be tax on co-operatives. Other suggestions given by SFCLs included: • Corporate governance should be strengthened in cooperatives • Government should have a concrete policy towards cooperatives • There should b a flexible environment for the smooth operation of cooperatives • Farmers should be given ownership • Flexible policy is needed to introduce new products in the cooperative • Frequent monitoring is required • The Central SFCL Federation should be more active 5.3.2 FINGO SMost FINGOs selected were well aware of the policy and regulatory issues. They showedconcern on the geographical area restriction (recent NRB circular), the licensing restriction foran unknown period, taxation and most argued for a new approach in provisioning. Almost all (83percent) were against board member’s personal guarantee for obtaining wholesale funds. Somealso expressed that the MF loan limit of NRs. 60,000 should be raised to NRs. 100,000. Otherssuggestions given were: • According to their progress and performance FINGOs should be given permission to expand their working area, especially in the hill areas, • While paying down a loan an IC note should be allowed • Should be reachable for the poorest of the poor • No Tax on MFIs CMF Nepal 26
  35. 35. Survey Findings 5.3.3 MFDBSMost of the MFDBs interviewed believed that the capital requirement was sufficient forestablishment purposes. They also believed that the capital adequacy ratio was acceptable. Interm of liquidity requirement 50 percent of the respondents said it was acceptable. On resourcemobilization all opined that NRB should allow them to have access to public deposits with someconditions attached.Some suggestions provided by MFDBs were: • The NRB should give permission to collect deposits • The corporate tax rate (31.5%) should be zero • Government should scrap the deposit tax rate for MFIs • Establish a Microfinance Department and unit related to microfinance in the Ministry of Finance • The NRB Microfinance Department should be strengthened and have more specific terms of reference • Development Banks, FINGOs and cooperatives should act together for the betterment of MF policy • Transactions with non members should be permitted • Some accounting procedures not related to MFDBs should be removed • The MF Act should be formulated and further monitoring and regulation should be strengthened • In Grameen banks the board of director’s structure should be supported by the NRB as board members are located in Kathmandu. As it is very difficult to conduct a board meeting outside the Valley, NRB should manage to depute members from the local level. 5.3.4 POLICY ORGANIZATIONS Policy organizations refer to organizations that make and implement policy and regulations on financial services. They are the NPC, Ministry of Finance, NRB, Beema Samiti and Women development division. All of them are well aware of the MF policy environment. Most of them agree on the non involvement of the Government in financial services to the poor. Rather, they stress the need to provide funds and capacity building services to MFIs using a systematic approach. All agree that donor organizations should work with local partners rather than provide the financial services themselves.Some of their suggestions include: • NRB’s monitoring, policy making, amendments and linkage development should be strong, • Buildup capacity of MFIs, • A free Interest rate regime is very necessary • Wholesale fund organizations should make funds available on demand • Research on product diversification CMF Nepal 27
  36. 36. Survey Findings • Enterprise development should be encouraged • Micro insurance products need to be developed. MFIs, MFI networks, Government, the NRB and Beema Samiti should have the necessary discussions • CMF and NRB should have close linkages in the area of research, training, policy development and study • Cooperatives, MFIs, and small enterprises should be structured in one form for development • Monitoring, supervision, tools development, financing should be done by NEFSCUN for financial co-operatives • Identify enterprises for the poor should be prioritized • Business and market linkages are necessary for microfinance promotion • Other federation should meet their members needs, provide advocacy & support to strengthen them and integrate MFIs • On the spot training/capacity building should be provided • Associations should act as good network for sustainable MF and also for benchmarking, monitoring and supervision • Suggestions can also be expected for developing implementation mechanisms • Facilitation on development work with network and associations i.e. CMF 5.3.5 DONOR AGENCIES / INGOSMost donor agencies and INGOs (80 per cent) are aware of the policy environment. They are infavor of an enabling and regulatory role for Government. In their own programs they also havegiven an emphasis on providing MF services in the hills and mountains areas, the necessity of anMFI tax rebate facility, embedding micro-insurance and health insurance services within theservices provided by MFIs and MFI capacity building. They also believe that MF wholesale fundsand programs need to be restructured.High operating costs, dispersed populations, lack of economic opportunities and infrastructure,a rigid MF model, the absence of a clear cut MF policy, lack of coordination between donors,lack of an appropriate microfinance act and the absence of BDS services at the community levelare considered some of the hindrances to MF sector growth.Some of their suggestions include: •Services should reach into the hill areas •Private social investment should serve as a good indicator rather than public social investment •Only the deprived sector should get microfinance services •There should be more awareness program based on local development •Plans for community awareness building should be linked •The National Planning Commission (NPC) and Ministry of Finance (MOF) should help develop new plans for microfinance •The Microfinance Act should be promulgated soon •Government should only play an enabling role CMF Nepal 28
  37. 37. Survey Findings •Existing MFIs need strengthening •Promote increasing the number of MFIs •Coordination with the Poverty Alleviation Fund (PAF)Overall, stakeholders in the micro-finance sector are interested in the development of thesector in Nepal. Therefore, it is time for stakeholders to implement suitable strategies, policies,plans and programs to support the sector. CMF Nepal 29
  38. 38. Recommendations6 RECOMMENDATIONSThe study team incorporated the issues raised by the Taskforce and made recommendations tothe various stakeholders including: Government, the NRB (Central Bank), apex funds (wholesalelending micro-finance institutions and programs), microfinance institutions and others.6.1 LEGAL/REGULATORY FRAMEWORK • The current legal arrangement for regulation and supervision of banks and financial institutions appears to be acceptable to MFDBs and FINGOs. • Most MFDBs viewed the proposed Micro-Finance Act (earlier draft) as not suitable for the growth of the sector. It was also found not suitable for regulation and supervision purposes. The main reason was a mix-up of MFIs and non-MFIs, equity based and non- equity based organizations in the same legal framework. MFDBs, FINGOs, SACCOS and even CBOs need to have different legal identities to better address their separate activities If there is commonality in some areas of activities, they can be addressed by the reform of regulations for each. Therefore, it is important that each type of MFI have its own required legal framework reviewed separately to accommodate ‘best practices’. • There could be an STI established for supervision purposes only for the various types of microfinance institutions. This STI would be subject to the regulation and supervision of the NRB. The supervision of SACCOS, other than NRB licensed ones is an issue that must be dealt with separately. • Access to Public Deposit: The Bank and Financial Institution Act, 2006 has a provision that MFDBs can access public deposit with Nepal Rastra Bank approval. This provision needs to be activated but not for everyone at this time. Nepal Rastra Bank could set conditions and based on fulfilling such conditions MFDBs could be permitted to have access to non-member deposits. This is also necessary for future MFI growth in outreach, expected phasing out of the deprived sector credit directives, shrinkage in donor funds, wholesale fund not being expended as expected and providing financial services to local residents who are not members of MFDBs but poor villagers. Some conditions that could be set include: - Experience of at least …. years. - Having a net profit in the last….. years. - Having a capital base of NRs. …. million - Having written off all pre-operational expenses. - Can provide only saving services in the program area and cannot access current (demand) deposits. - Subject to higher liquidity requirement as other DBs and FCs for non member deposit. CMF Nepal 60
  39. 39. Recommendations - Subject to fund management policy approved by the board of directors. - Not exceeding a percentage of total resources - MFDB has not been penalized by NRB.• Establishment and Expansion: The MCR regulations required for the establishment of MFDBs is reasonable except for the expansion provisions, which needs to be updated.• The BASEL principles on capital and supervision may not be suitable for MFDBs, FINGOs, and SACCOS. Their use would also be burdensome to the Central Bank or other designated bodies. Therefore, drawing on CGAP, ACCION and WOCCU practices and experiences, it would be better to use the PEARLS rating system.• Loan Loss Provision: Currently, the loan loss provision is similar for all banks and financial institutions based on due date periods (0 to 3 month, 3 to 6, 6 to12 and above 12 months for the overdue category). Better methods for micro finance institutions exist i.e. minimum of 1 percent and adding as per PAR. (Portfolio at Risk) Some microfinance institutions have the provision that if the due date is more than 6 installments (GBBs own regulation) or 2 percent flat with an evaluation at the end of every year. If some microfinance institutions are comfortable with the higher percentage for LLP (within 5 percent limit), it should be agreeable to the tax authorities.• Micro-enterprise Loan: Nepal Rastra Bank accommodates micro-enterprise loans not exceeding NRs. 150,000 to members using the ‘ladder’ model (enhancement approach) with collateral. This approach appears to be abused by some MFIs. Instead, ladder model loans could be restricted to graduated members only (new member needs) otherwise MF may face a crisis after some time. If it is strictly for graduated members, collateral could be considered as optional with appropriate risk management tools adopted (Insurance, marketing network, guarantee, etc.).• MFIs having experience over X years would be allowed to enter into a micro enterprise loan at a higher limit (i.e. 500,000) within their working area if the enterprise focused on local employment generation.• Lending methodologies: There is the need to develop innovative individual lending methods apart from the traditional group lending methods. The focus on women is well understood but single men in rural or urban areas should not be excluded. Another important area for reform is in the lending methodology applied, i.e. MFIs should be allowed to lend to local, community-based SACCOS, SCOs, SHGs, CBOs, and user groups of different types and village banking units. This will reduce MFIs operational costs dramatically and allow them to increase outreach more quickly. It also ensures that more MF services will reach the hilly districts. (Uprety, 2002) MFIs need to develop their loan assessment guidelines for this to ensure safety and soundness.• Regulations on Corporate Governance: The regulation that restricts any bank or financial institution Board member from being on the Board of Directors of another bank or financial institution has affected MFDBs and FINGOs. The Board of member of any bank or financial institution could be allowed to be on the Board of at least one CMF Nepal 31

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