CEGSDISCUSSIONPAPERSERIES

No. 2015-CEGS-02

Policy Sector and Currnent Challenges of Microfinance in Nepal

カヤスト ラガブ
横浜国立大学 成長戦略研究センター リサーチャー
2016 年 3 月

横浜国立大学

成長戦略研究センター

Center for Economic Growth Strategy (CEGS)
Yokohama National University
79-4 Tokiwadai Hodogaya-ku
Yokohama 240-8501 JAPANCEGS
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Current Challenges of Microfinance and its Policy Sector in Nepal
Abstract
This research describes the analytical picture of microfinance in Nepal by explaining thedevelopment process, modalities of microfinance institutions (MFIs) and various microfinanceregulations. Furthermore, this research explores the current challenges of microfinance emerging in
Nepal, and claims that institutional governance is the effective method to overcome most of thoseobstacles. Institutional governance is probably a new concept for microfinance in Nepal. It simply
means the exercise of managing the political, social and economic matters and human interaction.
Institutional governance helps to interact between different institutions―public and private, andcontributes to put values on formal and informal rules which can finally contribute in order toaddress the current challenges that this research has identified. With a point of view of institutional
governance, Nepalese microfinance sector needs clear vision and policy according to theheterogeneous modalities of microfinance institutions, and coordination between the Government of
Nepal (GoN) and microfinance institutions to create the healthy environment of microfinance inorder to contribute in poverty reduction in Nepal.

Keywords: Microfinance, Microfinance Institution (MFI), Nepal, Poverty Reduction, Government of
Nepal (GoN), Nepal Rastra Bank (NRB), Regulations, Microfinance Development Banks (MFDBs)

Introduction
This research describes the analytical picture of microfinance in Nepal and observes the recent
obstacles in microfinance in Nepal. As most of us know microfinance has been recognized as one of
the effective tools of poverty reduction. Nepal also experienced the development of microfinanceover the past two decades. The earliest initiatives for establishing microfinance in Nepal date back to
the 1950’s when the cooperatives were established to provide agriculture credit for the rural poor.
However, the institutional development started in 1981 when the central bank of Nepal (Nepal
Rastra Bank, NRB) introduced the intensive Banking Program and made commercial banks toallocate 3 percent of finance to the priority sector. In 1992, the Regional Rural Development Banks(RRDBs) was initiated by the Government of Nepal (GoN) and expanded throughout the country by
establishing five RRB in five development regions of Nepal. So the period of two decades from1990s is the milestone time for the development of microfinance in Nepal. Nepal is heterogeneous interms of population density, per capita income, economic structure, economic and social
development. Microfinance has also developed according to those heterogeneous socio-economic2

conditions. Now, according to the data of ADB 2010, 18 Microfinance Development Banks(MFDBs), 16 Savings and Credit Cooperatives (SACCOs) and 45 Microfinance NGOs (FINGOs)
are providing microfinance services to the poor as formal microfinance institutions (MFIs) in Nepal.
Simultaneously, there are several obstacles and challenges have emerged with the development of
microfinance. This research focuses on those challenges and proposes a new idea of institutional
governance to cope with those challenges such as lack of national data on microfinance, complicatedpolicy related to microfinance, government’s unnecessary interference, lack of fund, high interest on
deprived sector loan, high tax rate, public deposit, complicated geographical environment, lack ofcommercial orientation, weak technical capacity, inadequate financial infrastructure, controlled
legislative framework, weak coordination, lack of savings, voice is ignored, unhealthy competition,etc. This research has proved that institutional governance is one of the effective approaches toaddress these challenges properly in time.

Background to the Research

Definition of Microfinance
There are several ways in which to explain the definition of microfinance. The International
Encyclopedia of the Social Sciences (2008) expresses microfinance as “Microfinance, also termed
microcredit, refers primarily to small, development-oriented loans made to low-income borrowers
with the aim of helping them to develop commercial activities or start businesses”. The World Bankin its Microfinance Handbook has defined microfinance as “the provision of financial services to
low-income clients including self-employees, includes both financial and social intermediation. It is
not simply banking, it is development tool” (Ledgerwood, 2000).
The National Bank for Agriculture and Rural Development (NABARD) in India has defined
microfinance as “provision of thrift, credit, and other financial services and products of very small
amounts to the poor in rural, semi–urban, or urban areas for enabling them to raise their income
levels and improve living standards” (Bashyal, 2008).
In simple words, microfinance is termed as the financial services rendered to the deprived groups ofthe people and small entrepreneurs in savings, credit, remittance, rural insurance, etc. to help them indeveloping self–employment opportunities and various income generating activities. Small size ofloan, group savings, small-scale entrepreneurs, diversified utilization and simple and flexible terms
on credit (without collateral) are the determining characteristics of microfinance.
The concept of microfinance mainly related to rural development and target group focusedprograms specially that of lending to agricultural and related business with an objective of attaining
growth with social justice. People who normally live below poverty line demand such credit(Bashyal, 2008).
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Microfinance has been particularly recognized as an effective development intervention for basic 3
reasons: (I) The services provided through microfinance can be targeted specifically at the poor andthe poorest of the poor (II) These services can make a significant contribution to the socio–economic
status of the targeted community and (III) The institutions that deliver these services can develop
within few years, into sustainable organizations with steady growing outreach. Moreover, thepurposes of microfinance can be distinguished in four ways: (a) Poverty Alleviation, (b) Promoting
Agricultural Production, (c) Investing in Small Entrepreneurs, and (d) Empowerment of Women.

Development of Microfinance in Nepal
Nepal is one of the least developed countries in the world having US$ 426.48 GDP per capita(World Bank, 2014). The Nepalese economy is predominantly an agricultural economy. Around 80
percent of the population lives in the rural area of the country engaging in the agricultural sector. The
average GDP growth rate of the agricultural sector is 1.0 percent (ADB, 2007). Although more than
80% of the population is involved in agricultural sector, the growth rate is comparatively low. By theend of Tenth Year Development Plan, in 2007, about 31 percent of the population was found to beliving below the poverty line which was 42 percent before the Ninth Year Development Plan (Sigdel,
2007). At the declaration of Microfinance Summit Nepal 2010, the average number of the poor
people has come around 25 percent. But it could not be distinguished as the real aspect of thepoverty reduction, it might also the result of the income gap between the rich and poor people in
Nepal.
Nepal has been witnessing planned development efforts since the last more than five decades. The
objectives envisaged in most of the plans aim at reducing poverty since the Sixth Five Year
Development Plan in 1980. However, the intensity of poverty in the country calls for massive andgenuine efforts. Microfinance is one of the effective tools for poverty reduction.
The microfinance sector in Nepal has expanded considerably in recent years. The earliest initiatives
for establishing microfinance services in Nepal can be dated back to the early 1960s when the firstcredit cooperatives were established and primarily intended to provide credit to the agricultural
sector (Sinha, 2001). So the cooperative movement became the first vehicle of microfinance in
Nepal, as 13 cooperatives provided flood victims access to financial services adapted to their
specific needs. In parallel, rural finance institutions were established such as the Agricultural
Development Bank Limited (ADBL)1, which aimed at providing credit and marketing support toagriculture.
In 1974, the two state-owned commercial banks, Nepal Bank Ltd. and Rastriya Banijya Bank were1

The former name of ADBL is Agricultural Development Bank of Nepal (ADBN). ADBN has converted to ADBL
after it was distinguished as Class ‘A’ financial institution according to the Bank and Financial Institutions Act(BAFIA), 2006.

4directed by the central bank, Nepal Rastra Bank, to invest at least a portion (first 5 percent toincrease as high as 12 percent) of their deposit liabilities in the ‘small sector’. This marked the
beginning of the directed credit system in Nepal. In 1976, the scope of the small sector was
broadened to include agriculture, cottage industry and services, and has since then been called the‘priority sector’. The credit didn’t reach the poor, as only influential and well-connected people, withcollateral, were able to access the program. This led to the development of targeted initiatives, suchas the Intensive Banking Program (IBP) in 1981, initiated by the government and the central bank,through partnerships with commercial banks. Under this approach, group guarantee for loan
repayment were used instead of physical collateral.
Starting in 1975, the Small Farmers Development Program, implemented by the Agricultural
Development Bank of Nepal, mobilized farmers groups using a credit plus approach, and was thefirst experience of group-based lending in Nepal. Unfortunately, it failed due to political pressure fora fast expansion, overemphasis on credit, high delinquency levels and the overall not satisfactory
performance of the system.
In 1982, the Cottage and Small Industries Project and the Production Credit for Rural Women allprovided new directions to priority sector lending, focusing on project viability rather than collateral,and therefore provided a financing window to the poor through commercial banks collaborating withlocal development organizations. The commercial banks perceived this program as more of an
obligation towards the central bank than a business interest.
In 1990, the GoN established the Rural Self–Reliance Fund (RSRF), with the objective ofproviding wholesale loans to NGOs, cooperatives and other financial intermediaries for on lending
to the poor. The Microfinance Department of NRB acts as the secretariat of the RSRF andmanagement committee headed by the NRB deputy governor oversees the fund.
In 1992, the GoN, following a recommendation from the NRB, established Regional Rural
Development Banks (RRDBs) in each of the five development regions of Nepal, modelled on theGrameen Bank methodology. It is called Grameen Bikash Bank (GBB). The majority of theownership is in the hands of government, Nepal Rastra Bank (the central bank) and publiccommercial banks, while other private commercial banks have small equity stakes. During the same
period, private initiatives led by NGOs, such as Nirdhan and the Center for Self-help Development,
also used the Grameen Bank methodology, resulting in a generally more efficient and successful
replication. In the 1990s, with technical assistance from GTZ, local branches of ADBL under the
Small Farmer Development Program, started to be reorganized into federations of small farmers
groups, the ‘Small Farmer Cooperatives Limited (SFCL); each operating as an autonomous
cooperative.
With the promulgation of the Development Bank Act in 1995, Nirdhan was the first NGO (1998) totransfer its microfinance portfolio into an autonomous microfinance rural bank (Nirdhan Utthan
5Development Bank). Since 2000, three other microfinance rural banks were created through thesame process first initiated by Nirdhan, with DEPROSC Development Bank in 2000, Swabalamban
Bikas Bank Ltd and Chhimek Bikas Bank in 2001. Acknowledging the poor performance of the
GBBs under public ownership, the central bank started a restructuring program, which will lead
ultimately to the privatization of the five GBBs.
With the view of providing a source of wholesale fund to regulated microfinance institutions(MFIs), the Rural Microfinance Development Center (RMDC) was established in 1998, and later on
opened its lending to other MFIs. In 2001, the Small Farmer Development Bank (SFDB) wasestablished under the Development Bank Act to provide wholesale funds to Small Farmer
Cooperatives Ltd. (SFCLs), which were formed after the transformation of Small Farmers
Development Projects, promoted under the Small Farmers Development Project, into cooperatives.
SFDB is owned by ADBL, the Ministry of Finance, two commercial banks, and a group of SFCLs. It
is envisaged that SFCLs majority ownership will grow over time.
Generally, the MFIs in Nepal can be divided into two types: i) Community Based MFIs, such as
SACCOs and SFCLs; ii) Commercial Oriented MFIs, such as MFDBs, GBBs, FINGOs, etc. So there
are several modalities of MFIs in Nepal.

Modalities of Microfinance Institutions in Nepal
There are several models of MFIs that exist in Nepal. Every model has important contribution in
the financial sector of Nepal.
1. Small Farmer Cooperatives Limited
Previously it was the Small Farmer Development Project under ADBL, which has beentransferred to the local community under the Cooperative Act, 1991.
2. Priority Sector and Deprived Sector Credit Programs
There is the mandatory provision for all commercial banks to disburse 2% and 3% of the totalloan portfolio to priority and deprived sector credit program respectively. By mid-July 2007, thepriority sector credit program phased out.
3. Rural Microfinance Development Banks
To provide the banking facilities for the socio-economic upliftment of the deprived people in therural areas, 5 regional rural development banks (GBBs) were established with the initiative of
the government (CBN) and some other financial institutions. Later, 4 private sector MF
development banks (Nirdhan, Swabalamban, Deprosc and Chhimek) were also established.
4. Financial Intermediary Non-government Organizations (FINGOs)
Out of about 10,000, only 47 NGOs are licensed by CBN for financial intermediary. They
usually form the groups and collect deposit through MFIs as well as they obtain wholesale credit
from MFIs and disburse it to the group members.
65. Savings and Credit Co-operatives
The cooperatives have been introduced in Nepal since 1956. About 8000 cooperatives areregistered in Cooperative Department of the Government of Nepal. Some near about 2600
cooperatives are involved with the savings and credit programs. Of them, only 19 cooperatives
are licensed by CBN for limited banking transaction and 199 cooperatives are associated withRSRF (Rural Self Reliance Fund).
6. Wholesale Microfinance Institutions
RSRF: To increase the income and render employment opportunity for the deprived people in
the rural areas, GoN has established the Rural Self Reliance Fund (RSRF) in 1991 with the seedcapital fund of Rs. 20 million and added another Rs. 20 million in 2004/05.CBN has provided a
total amount of Rs. 253.40 million from its profit in this fund in different periods. In F.Y.
2006/07, the Government of Nepal is injecting the amount of Rs. 50 million in the fund. RSRF
provides the wholesale credit for on-lending purpose to the deprived people through MFIs,
cooperatives and NGOs and long-term loan to the sector like tea, cardamom and cold storage
through ADBL.
RMDC: To provide the wholesale loan to MFIs, Rural Microfinance Development Centre(RMDC) is established in 2000.
SKBBL: To provide the wholesale loan to Small Farmer Cooperative Limited (SFCL), Sana
Kisan Bikas Bank Ltd. (SKBBL) is established in 2002.
7. Donor Sponsored Microfinance Programs
There are 6major donor funded MF programs those are running in the country of which are now
in inactive stage. They are PCRW, MCPW, TLDP, PAPWT, RMP and CGISP. All these
programs are focused to reduce poverty and have contributed to the facilitation of MF to thetargeted groups and assisted in capacity building.
PCRW: To improve the socio-economic status of rural women by accessing them to institutionalloan for their productivity, the project Production Credit for Rural Women (PCRW) was
launched in 30 November, 1982.
MCPW: To increase the economic status of the rural and urban women by providing
micro-credit for their micro business, the project Micro-Credit Project for Women (MCPW) was
launched in 15 December 1993.
TLDP: To increase the income and employment of the rural poor by engaging them in livestock
management and productivity, the project Third Livestock Development Project (TLDP) was
launched in 1997.
PAPWT: To increase participation of the deprived poor in Western Terai for theirsocio-economic upliftment, the project Poverty Alleviation Project in Western Terai (PAPWT)
was launched in 1998.
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RMP: To increase the socio-economic status of rural poor, the project Rural Microfinance
Project (RMP) was launched in 1998.
CGISP: To increase the agriculture productivity by providing the irrigation facilities to thedeprived community’s farmer for the poverty alleviation program, the project Community
Ground Water Irrigation Sector Project (CGISP) was launched in March, 1999.
There are different opinions about the typology of microfinance institutions. Some scholars say two
types: formal and informal MFIs; and some say three kinds of MFIs: formal, semi-formal andinformal. In recent days, some practitioners distinguish MFIs in 2 types: (1). Community Based:
SACCOs, SFCLs, and (2). Commercial Oriented: MFDBs, GBBs, FINGOs. This research will
mainly distinguish the MFIs of Nepal in three types 1) Formal MFIs: Government/NRB mandated
models and rural development banks, 2) Semiformal MFIs: NGO and Savings and Credit model withexternal fund and, indigenous model, SACCOs, Microfinance Development Banks, National
Cooperative Development Bank, and 3) Informal MFIs: landlords, friends, relatives.

Policies and Regulations Related with Microfinance in Nepal
Microfinance is an effective tool for reducing poverty, and for making microfinance effective,
appropriate microfinance policy is needed. Furthermore, it is also important to cover the demand of
microfinance at the local level, and make it easy to access for the poor. There is no single statementby the government addressing this challenge; statements by industry associations or by the central
bank which can also include Nepal’s national microfinance policy. Policy is the statement andcommitment made by the broader stakeholders who provide direction, regulation, promote bestpractices and also makes provision of supervision. In the Nepalese case, those stakeholders could be:-

The government-

Central bank of Nepal-

The donors-

The industry groups such as Nepal Microfinance Banker’s Association (NMBA), National
Federation of Saving and Credit Cooperatives (NEFSCUN), Microfinance Association of Nepal(MIFAN)The Development Bank Act- 1995 and Financial Intermediary Act- 1998 were the instances ofsome regulation related to MF sector. The prudential regulation for MF development banks cameinto existence in 2003. This regulation became effective from January 2004 with some amendments.
Followingly, BAFIA- 2006 permits to run MF business while 1st Amendment of Financial
Intermediary Act (1998)- 2002 facilitates FINGOs for doing limited financial intermediation as small
savings, group savings, micro-credit and agent banking.
a. Nepal Rastra Bank Act, 2002
b. Bank and Financial Institutions Act (BAFIA), 20068

c. Cooperative Societies Act, 1992
d. Financial Intermediaries Act, 1998
e. NRB Directives for Microfinance Institutions, 2003

a. Nepal Rastra Bank Act, 2002
This Act defines the role of NRB in formulating effective policies, developing secure, healthy andefficient payment system, regulating, supervising and inspecting banking and financial institutions
and promoting and striving of a credible banking and financial system. It prohibits NRB to buy shareof CBs or financial institutions. NRB, however, plays a developmental role through a special fund,the Rural Self-Reliance Fund (RSRF), which operates with and interest rate below market rates.
NRB's financing role through RSRF undermines the steady development of other apex institutions inrural and microfinance sectors. The justification for continued operation of RSRF is based on theneed for serving weak institutions that cannot meet the eligibility criteria of criteria of otherwholesale lending institutions.

b. Bank and Financial Institutions Act (BAFIA), 2006
This umbrella Act, “Bank and Financial Institutions Act” (BAFIA) came into force in 2006 and it
replaced the Bank and Financial Institutions Ordinance (BAFIO) of 2004. All the commercial banks,development banks, finance companies, microfinance development banks are regulated under thisumbrella act as Class A, Class B, Class C and Class D institutions, respectively. A small
Microfinance Development Bank (MFDB) can be established with a paid up capital of Rs. 10
million to operate in three districts outside Kathmandu valley. For operating in 4-10 districts outside
Kathmandu, the MFDB has to have paid up capital of Rs. 20 million and for a national level MFDB
the paid up capital must be at least Rs. 100 million. MFDB can increase the number of districts if it
could increase paid up capital. For an adjoining additional district, it requires to increase paid up
capital by Rs. 2.5 million. The promoters can retain 70% of the share capital and they must float theremaining 30% share to the general public. An MFDB operating in 10 districts with a capital of Rs.
20 million can operate in other five districts in the hills without any additional capital. This umbrella
Act has a provision for even a foreign bank or financial institution, in joint collaboration with a
Nepalese organization or citizen or through its subsidiary organization having its full share, canprovide microfinance services in the country with the permission from NRB and the Government of
Nepal. Under this act, NRB has the responsibility to supervise, warn the Board of Directors and eventake over management in case some wrong things happen to a bank and also initiate actions forliquidation if required by circumstances.

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c. Cooperative Societies Act, 1992
The Cooperative Societies Act was introduced in Nepal in 1992. Under this Act, cooperatives canbe formed with 25 persons as its members. These autonomous institutions are entitled to formulate
their own bylaws or operational procedures through their General Assembly (GA) meetings. Eachcooperative will have a Board of Directors and an Accounts Committee (AC) consisting of members
duly elected by the members through General Assembly using one-man one vote principle. The termof Board members and members of Account Committee (AC) is also determined by the GA but notexceeding 5 years. The Board appoints a management team or prescribes other body that carries out
the day-to-day activities of a cooperative. The AC is responsible for internal audit and accountable toGeneral Assembly for accounting and financial operations. Under the act, the Department of
Cooperatives is fully authorized to register, supervise, appoint auditor, take necessary actions for
improvements and reforms and liquidate all types of cooperative societies.

d. Financial Intermediaries Act, 1998
In 1998, NRB introduced the Financial Intermediaries Act in order to regulate the financial
intermediary NGOs carrying out microfinance activities. This was claimed to be a significant step inboosting up NGOs to undertake microfinance activities for the poor. However, this Act did not
permit FINGOs to accept savings deposits from their clients, which is considered to be a vital aspect
for sustainable operation of microfinance services. Consequently in 2001, this act was amended
allowing FINGOs also to accept saving deposits from their members. According to this Act, an NGO
intending to carry out microfinance activities is required to obtain license from NRB. The FINGOs
need to maintain a minimum of Rs. 100,000 as their capital to get license. After receiving licensefrom NRB, they can apply for funds from the wholesale lending institutions, such as RSRF, RMDC
and Commercial Banks. The FINGOs are required to renew their license every two years. The NRB
is responsible for supervision of the FINGOs to ensure that they are performing well to the interestof the target groups and the institutions that provide them financial support.

e. Nepal Rastra Bank (NRB) Directives related to Microfinance Institutions
NRB issued ‘Directives’ for the microfinance institutions with the objective of promoting healthy,organized, transparent and standard operation of microfinance banks. The main features of the‘Directives’ are summarized under the following headings:
Minimum capital adequacy requirement:• 4% primary capital (paid up capital, share premium, general reserve, retained earning loss)• 8% primary and supplementary capital (loan loss provision, asset revaluation reserve and otherreserve)
Fund mobilization:
10• It can mobilize fund up to 30 times of core capital through group savings, borrowing anddebentures.
Compulsory reserve and liquid assets:• It is required to maintain compulsory minimum reserve of 0.5% of total borrowed fund with NRB
or any other Class A Commercial Bank.
• It is also required to maintain liquid assets of 2.5% of individual, group and special saving ofmembers. The liquid assets are defined as cash reserve at hand, investment in government bonds,
investment in NRB bonds and deposit in commercial banks.
Expansion of Branch and Geographical Area
• MFDBs must take permission from NRB prior to expanding branches and geographical areas.
Norms of Corporate Good Governance• MFDBs should clearly spell out rules for the appointment of Board of Directors and CEO andspecify their functions and job responsibilities.
Loan Limit to Individual Group Member• Extension of loan up to NRs. 60,000 per member without collateral security.
• Extension of loan up to NRs. 150,000 to individual member for starting microenterprise withcollateral security.
Interest Rate and Service Charge• MFDBs are given freedom to fix interest rate on deposit and loans and advances, service charge
and penalty interest rate for overdue loans.
Reporting Requirement
MFDBs, FINGOs and Cooperatives licensed by NRB are required to report to the Financial
Institutions Regulation Department and Bank and the Financial Institutions Regulations Department
according to the Unified Directives and other directives related to MFIs. If they fail to comply withthe prudential norms of reporting or reporting late, they are penalized according to the Bank and
Financial Institutions Act (BAFIA), 2006. Non Bank Financial Institution Supervision Departmentof NRB is supposed to monitor and supervise the operations of the MFDBs and other forms of MFIs.
However, owing to the lack of adequate manpower and trained staff it has not been able to dischargethese responsibilities effectively and many MFIs are short of complying with the requirements of the
NRB Directives.

f. Financial Intermediaries Regulation 1999
After the promulgation of Financial Intermediary Act 1998, the Nepal Rastra Bank introduced
Financial Intermediary Regulation in 1999, which was amended in 2003. The regulation has
specified the documents to be submitted by an NGO to the NRB for obtaining a Financial
Intermediary license along with Rs. 25 as license fee. As per the regulation, it has to be renewed
11every two years by paying Rs.100 as renewal fee. The FINGO has to classify outstanding andoverdue loans in four categories such as good, sub-standard, doubtful and bad, and create a reserve
for loan loss provision. There is no need to make provisions for good loans (0-3 months) however
for the other categories, the rate of loan loss provision should be 10% for substandard loans (3-6months), 50% for doubtful (6 months to 1 Year) and 100% for bad loans (above one year) at the endof the fiscal year. The regulation has restricted the FINGOs to purchasing shares and debentures
without NRB permission taking loan by board members and their family members and purchasing
fixed or movable property for commercial purpose.

Analytical Framework of the Research
Recently, governance related issues and inclusive microfinance are hot topics in Nepal. The
practitioners of microfinance say that the role of the government is much more important to develop
the microfinance sector effectively. Traditionally, the term “governance” was used in reference togovernments and large companies; the term governance is now applied to microfinance among otherareas. Governance in microfinance sector generally refers corporate governance. Governance isdefined broadly as the system of people and processes that keep an organization on track and guides
major decisions. Governing bodies define and uphold the organization’s goals and mission, guidemajor strategic directions, manage risks, maintain an organization’s health over time, and ensureaccountability throughout the organization (CGAP, 2010).
According to OECD (1999), corporate governance is typically defined as a system, or a set ofmechanisms, by which an organization is directed and controlled. However, corporate governance isinsufficient to cover diversified development of microfinance and heterogeneous MFIs. So thisresearch has proposed a new concept of governance, institutional governance by which all kinds of
MFIs and policy and governance related with GoN as policy maker and MFIs as practitioners.
Concept of institutional governance covers the public and private aspect of governance. In public
aspect, governance represents as policy maker and control the MFIs. In other hand, in private aspect,
governance represents MFIs which operate through the policy made by public aspect and control
internal management of private aspect. The concept of institutional governance is the coordination ofthese public and private aspects of governance which still lack in the sector of microfinance in Nepal.
Before discussing the concept of institutional governance in detail, this research has observed thecurrent challenges of microfinance in Nepal.

Current Challenges of Microfinance in Nepal
As this research describes the background with analytical observation of the development of12microfinance in Nepal and, modalities and regulations of MFIs, this research has found several
challenges emerging in the current situation of Nepalese microfinance sector.

Lack of National Level Data on Microfinance
The national level of data and survey on the microfinance sector has not been available yet.
Furthermore, the study, research and the informative aspects are weak in microfinance sector.
Without these progressive phenomena, it is difficult for the microfinance institutions to achieve theobjective of poverty reduction, one of the top priorities of the GoN.

Complicated Policy Related to MicrofinanceAs described before, microfinance institutions run under different Acts such as Bank and Financial
Institutions Act (BAFIA), Co-operative Societies Act, Financial Intermediaries Act, etc. Hence, it isconfusing and complicated for the institutions as well as for the users too. The GoN should come up
with a single legal framework of microfinance to cope with the complexity of the policy.
Government’s Unnecessary Interference
The GoN sometimes announces some policies which disturbs the financial activities of MFIs. The
government arbitrarily announced the policy considering the poor people such as exemption of loan,
Biseshwor with the Poor, Jagriti, Youth Employment Programme, etc., which do not encourage the
MFIs and affect their management system.

Lack of Fund
According to the direction of NRB, commercial banks, development banks and finance companies
have to provide deprived sector loan by 3, 2 and 1.5 percent of their transactions to microfinanceinstitutions (MFIs) respectively. However, credit on micro hydro, hospital, youth for employment &small housing is countable in microfinance which is almost half of the resource altered for MFIs
from last year. MFIs are expanding areas in villages, and unreached districts but resources arelimited. The NRB and the government should deeply initiate availing at least 3 percent of deprived
sector loan to the MFIs.

High Interest on Deprived Sector Loan
As formal microfinance regulator of the country, the Central Bank of Nepal, NRB has set the policyof deprived sector loan for the resources of fund to the MFIs. According to this policy, every
commercial bank, development bank and financial companies have to provide 3, 2 and 1.5 percent of
their transactions in low interest rate (3-5%) respectively. However, in recent days, according to theinterview of the related persons from the MFIs, those banks have raised their deprived sector lending
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rate (6-9 percent) which is the higher rate for the microfinance institutions. Due to high interest rate,
cost of funds has increased, has had negative impact on poverty reduction and makes it difficult for
MFIs to their microfinance services. So the government of Nepal should take effective steps toreduce deprived sector lending rate to strengthen the microfinance institutions in their quest forbroader service areas.

High Tax Rate
As it is mentioned before, according to the Bank and Financial Institutions Act (BAFIA), 2006, allfinancial institutions are divided into four categories by the NRB. MFIs lie in category "D". In thesecategories there are different types of rules for their establishment, but the corporate tax is same asfor other commercial banks. The profit of MFI's is lower than other banks and financial companies.
The GoN charges a corporate tax rate of 30 percent which is a maximum higher rate for MFIs. If the
Nepalese government exempted corporate tax for MFIs, the rebate amount of tax would be used to
expand services to poor families, institutional strengthening and capacity building of its staff as well
as client too.

Public Deposit
The BAFIA 2006 has a provision that microfinance institutions can accept public deposit with theapproval of the NRB. It has been essential that public deposit be opened to maintain the fund scarcity.
However, the NRB is positive. It has collected some deposit from the members in small amounts andis learning the banking transaction to the poor. In other South Asian countries like Bangladesh,
public deposits have been continuously and successfully permitted. Hence, Nepal should follow
other countries’ good examples.

Complicated Geographical Environment
Nepal is a geographically diversified country. The southern part of the country, Terai is a plain area
which covers approximately 20 percent of the country, and the rest are mountainous and hilly
regions. While lack of cultivatable land is the biggest challenge for the hilly and the mountainous
regions, the difficulty of constructing infrastructure constrains economic development. In particular,
the lack of adequate transportation has hindered area development projects. In contrast, projects inthe more easily accessible parts of the hilly region and the Terai region have met with success. The
microfinance program is no exception.

Lack of Commercial Orientation
One of the significant challenges is the orientation of commercialization. Through the case study, it
was clear that neither the MFI staff nor the customers have commercial thoughts towards
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microfinance activities. By observing through the monthly center meeting, nearly one third of themembers were absent and so other members paid for them. Center meeting is important for the users,
for paying their installment and getting approved or the new loan. In contrast, bank staff was not so
persuasive by including the absent members. They claim it is difficult for them to control thediscipline of the meeting.

Weak Technical Capacity
Another burning challenge is the weak technical capacity. The operating system is done mostly byhand. Thus, it is inefficient, time-labor consuming and an expensive operating cost. To cope with thisproblem, it is inevitable to have a skilled staff, which is also helpful for the capacity development of
the users.

Inadequate Financial Infrastructure2

Financial viability refers to the capacity of MFIs to provide continued access to financial services
in the long-term. To do this, MFIs must ensure that the savings and credit services provided meet theneeds of their clients and do so in a financially sustainable manner. To reach financial viability,
effective financial management is required including: ensuring that there are enough capital funds tomeet credit demand; generating adequate revenue to cover operating costs (financial
self-sufficiency); and maintaining useful and accurate financial reports (financial reporting).
Continued reliance on subsidies impedes ability of an MFI to reach financial viability. Mostly, MFIs
in Nepal have access to adequate capital funds. The main exceptions are indigenous NGOs /SACCOs and those organizations providing financial services in more remote areas. To befinancially self-sufficient, an MFI must generate enough revenue to cover all of its costs and earnenough excess revenue to increase its capital base (retained earnings) in order to provide services toa growing client base with increased financial needs. Expenses of the MFIs include: operating costs;
financial costs; loan losses and the cost of capital. The primary source of funds to cover these
expenses is interest revenue generated by loan portfolio. At present, most Nepalese MFIs are notfinancially self-sufficient. The inability of the Nepalese MFI to reach financial viability is primarily
attributable to low rates on loans, high loan losses, lack of well-trained staff and small client base. To
achieve financial self-sufficiency, MFIs must reduce their loan losses, develop more efficient
operating procedures and increase their outreach. In addition, interest rates should be increased to a3level where they will cover all costs based on the most efficient delivery of services .

2

Financial viability refers to the capacity of the MFIs to provide continued access to financial services in the long-term.

3

During the initial stages in the development of a microfinance institution, costs will be greater than revenue. Clientsshould not be expected to pay interest rates high enough to cover these initial costs i.e. the first three to five years, norshould they be expected to cover the costs of inefficient operations.

15

Controlled Legislative Framework
The policy framework for inclusive finance is fragmented. The legislative and regulatory
requirements are extended even to very small providers of financial services to members. There iseven a debate on whether Savings and Credit groups at village level should be registered andsupervised to receive external credit. While consolidation and stream-lining is taking place under thereform projects and the limited supervision capacity of the Central Bank is recognized, the new
Microfinance and Co-operative Ordinance appears to remove the supervisory responsibility for MFIs
and SACCOs from the Central Bank, counter to their integration in an inclusive financial sector.

Weak Coordination
The financial service providers have not coordinated their efforts to any large extent, neither interms of outreach (mapping, expansion planning) nor performance (no industry performancemonitoring takes place). The top-down regulatory environment does not encourage lateralcollaboration and protectionism and to some extent competition has been seen to hinder the sharingof experience for mutual benefit. The microfinance network, Microfinance Association Nepal
4(MIFAN) established in 2001, failed after a couple of years, mainly due to a lack of clear vision,commitment and funding. At present, there is no network of Financial Services Providers (FSPs)
serving the Bottom of the Pyramid (BOP) – the poor and the low-income population. Limited
coordination extends outside of the industry; coordination among donor agencies, with and within
the government is also weak. Overall consensus among all stakeholders and adherence toperformance-based, results-oriented good practices in a sector approach to the development of an
inclusive financial sector has yet to be attained.

Lack of Savings
MFIs provide credit to the poor who invest in the formal or informal sectors to generate income. A
good indicator of a successful investment is the savings generated. Microfinance programs in Nepal
have largely failed to help the borrowers manage their savings. The MFIs researched for the casestudy, have comparatively low savings than loans by observing their progress figure.

Ignored Voices
Sometimes the voice of MFIs is ignored by the government. Especially, when the customers of
MFIs want to get some skill training, the MFIs hardly achieve the cooperation from the government.

4

Microfinance Association Nepal (MIFAN) is reorganized at 2007 with the participation of 10 FINGOs. This
organization mainly focused on expanding memberships to all NGOs as financial intermediaries (FINGOs) as soon as
possible, and to cordially invite all financial NGOs to join the association.

16

Unhealthy Competition
As ascertained before, microfinance focus especially in Terai region breeds the challenge of
unhealthy competition among the MFIs and severe duplication. Some customers get the loan fromvarious MFIs. MFIs are only focusing to increase the outreach and forget the real objective of
microfinance. This exacerbates the problem.

Institutional GovernanceAs stated before, Institutional governance is the exercise of managing the political, social andeconomic human interaction. There are few scholars who defined the institutional governance. The
definition of Dahal (1996) on governance also supports the definition above to some extent. He
stated that “Governance applies to the exercise of power in a variety of institutional contexts, theobjects of which is to direct, control, and regulate activities in the interests of people as citizens,
voters and workers”(Dahal, 1996: p.5).
As described before, the general concept of governance is state-focused, and corporate governanceis firm (corporation)-focused. However, each concept ignores what has been developed by the other.
In order to discuss the institutional governance of MFIs, the linkage of the state and each financial
institution is important. So the concept of institutional governance should include two dimensions;the public dimension as a government policy on microfinance, and the private dimension as MFIs’
internal rules and management. The linkage of the indicators of institutional governance will be
discussed later.
Institutional governance is applicable for various institutions including social norms and humanrelations. Rules and regulations are created to be obeyed. However, some informal elements such as
culture, life-style, geographical variations, and informal rules of society are difficult to measure theextent of being followed since they exist exogenously. Institutional governance is inevitable forputting value in sharing and co-operating those informal rules. So it needs the mechanism of
informal rules, discipline and interest for functioning the formal policies, rules and regulation. In thisregard, institutional governance is important for the different sizes of MFIs, which corporate
governance lacks. As a supportive factor for the above explanation, Canadian International
Development Agency (CIDA) explains that governance encompasses the values, rules, institutions,and process through which people and organizations attempt to work towards common objectives,
make decisions, generate authority and legitimacy and exercise power.
Indifferent from this definition, the concept of corporate governance in microfinance seems toprovide a benchmark for strategic planning and control (i.e., the objectives), and it provides a
specific benchmark for each institution rather than “a standard for the industry” (Labie and Mersland,2011). As there are several types of financial institutions, as well as MFIs with various objectives, it
17

is difficult to deal with the development of MFIs by the general governance theory. Furthermore, thetheory of corporate governance is also insufficient to handle the challenges of MFIs, as it is quite
obvious that microfinance is practiced by a wide variety of organizations, not all of whom have thesame priorities. So the concept of institutional governance is appropriate to gain the main objectiveof microfinance institutions―achieving financial sustainability and financial self-sufficiency inorder to address several challenges that have emerged in current microfinance sector in Nepal.

Conclusion and Recommendation
There is no doubt that microfinance is one of the effective tools for poverty reduction in Nepal. As
this research shows Nepal has witnessed tremendous development of microfinance within two
decades since 1990s. However, the development of microfinance has also created several obstacles
and challenges that this research has shown in detail. As the hot discussion of governance andconcept of inclusion microfinance, it is nearly impossible by ignoring the concept of institutional
governance. Every MFI operates internal rules, regulations and management by itself whether NRB
also draws up microfinance acts and policies without particular consultation from MFIs, and lack of
coordination between MFI and the GoN often occurs. Unless these two aspects link each other,sound development of microfinance should be difficult in Nepal.
The governance of microfinance also has been addressed in two aspects; general governance andcooperate governance. However, each concept is insufficient to tackle the issues in MFIs because of
the MFIs’ unique features (Kayastha, 2012). The main objective of MFIs is reducing poverty but
they also pursue profits as financial institutions. These two goals seem incompatible, but by
improving the institutional governance, both goals can be achieved. Institutional governance is avery wide concept which has public aspect and private aspect but the concept contributes to the link
between the government and MFIs by addressing both aspects.

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Dahal, Dev Raj (1996) The Challenge of Good Governance: Decentralization and Developmentin Nepal, Centre for Governance and Development Studies, Kathmandu-

Kayastha, Ragab (2012) Institutional Governance of Microfinance Institutions in Nepal,
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-Labie, Marc and Mersland, Roy (2011) “Corporate Governance Challenges in Microfinance”, The
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