# **EXECUTIVE SUMMARY**

This review identifies key issues and lessons about how the overall regulatory framework affects the ability of microfinance institutions (MFIs) to become more market-oriented and integrated with the financial system. Many countries in Africa are looking to sustainable microfinance to expand access to financial services as a linchpin of the strategy to reduce poverty. Donors are demanding better performance in terms of financial sustainability and outreach of microfinance institutions (MFIs), to better leverage their support. As MFIs grow and begin mobilizing commercial resources beyond grants, central banks are increasingly being called upon to regulate and supervise MFIs under existing or new legal and regulatory frameworks.

Recognizing that legal and regulatory structures are key to modernization, financial sector reforms in many African countries over the past decade have sought to allow banks to operate on a commercial basis, free from official intervention but within the norms of prudential supervision. Reform measures have included liberalizing interest rates, eliminating administrative credit allocation, strengthening the role of central banks in regulating and supervising financial institutions, restructuring state-owned financial institutions, and allowing entry of local and private banks into the market.

In most cases, however, progress in the formal financial system has not been accompanied by expanded access to financial services for large segments of the population. Basic deposit, payments and credit services have remained costly and beyond reach because of the poor state of roads and communications and because of complex conditions and difficult collateral requirements of commercial bank finance. Microfinance methodologies offer the potential both to make financial services available to the poor and to become commercially viable. But in the underdeveloped financial markets typical of African countries, most central banks lack both a clear understanding of microfinance methodologies and the staff to supervise them. Legislation intended to promote microfinance may impose untenable supervisory burdens, while an excessively restrictive approach may constrict innovation and expansion. This paper summarizes the findings of three country studies undertaken by the World Bank on microfinance regulation in Benin, Ghana and Tanzania to better inform its advice and project design regarding the appropriate balance among the objectives of promotion, performance, and prudential supervision.

## **Tiered Structure of Microfinance Institutions and Corresponding Regulation**

The objective of integrating microfinance into the financial sector does not mean that all MFIs need to be regulated. The aim is to build strong regulated and unregulated institutions of all types to provide services on a sustainable basis under shared performance standards and to encourage the regulatory authorities to develop appropriate prudential regulations and staff capacity. This involves defining different tiers of financial institutions with different degrees of regulatory requirements. Lower tiers of institutions serving the lower end of the market can enable non-bank microlenders to seek greater formalization without actual licensing from a central bank.

As the industry grows, adding a licensing tier that permits MFIs to mobilize savings and other commercial sources of funds legally can encourage capacity building and innovation aimed at selfsufficiency and greater outreach. Another approach is to open a special window for microlending as a product that enables commercial banks, as well as alternative specialized institutions, to benefit from different cost and regulatory structures. Licensing of rural and community banks can also facilitate the emergence of new types of MFIs serving specific markets. On the other hand, premature creation of special tiers with easy entry may result in weak institutions and risks overwhelming inadequate supervisory resources. Hence licensing of MFIs should be designed to balance promotional and prudential objectives.

vi