Microfinance law: towards a diagnostic framework

Timothy R Lyman

Legal and regulatory rules can have a tremendous impact on the prospects for successful microfinance institutions in any country. A ‘diagnostic’ framework is a tool for microfinance practitioners and their legal advisers to help them identify and organize conceptually the applicable existing rules and potentially also a platform from which to argue for legal and regulatory reform.
   
Globally, non-profit organizations (NPOs) typically provide the legal nest within which microfinance institutions [1] (MFIs) are ‘born and raised’. Non-profit legal status generally corresponds well with the social objectives of the microfinance movement: to provide capital to the business initiatives of the needier members of society who lack access to the conventional commercial sources of capital. For this reason microfinance practitioners seldom question the appropriateness of this category of legal entity for the work of MFIs, particularly new ones.   

What is ‘microfinance law’?
   
The available non-profit legal structures, however, often do not fit as comfortably with other attributes of microfinance. For example, by fostering businesses (even very small ones) microfinance opens the door to questions about the appropriate relationship between the social objectives of non-profit MFIs and the commercial objectives of their borrowers. In addition, frequently there is tension between the accepted social and legal conception of appropriate ‘non-profit, public benefit purposes and activities’ for NPOs and the highly businesslike behaviours in which MFIs must engage in order to achieve (or at least approach) the goal of self-sustainability. MFIs must themselves strike a delicate balance between the social objectives of serving needier and riskier borrowers and the practical economic necessity of consistently achieving an excess of revenues over expenses.    

Achieving this balance under the legal rules applicable to NPOs, however, is usually only the first step. The most formidable legal challenges facing many MFIs may arise not under rules governing NPOs but rather under legal and regulatory provisions relating to lending activity – and particularly under those provisions designed for formal financial intermediaries of the conventional commercial banking and financial sector. The laws and regulations that govern the banking and financial sector have an obvious additional relevance for those MFIs that become ready to branch out beyond microcredit activities to offer other financial services and raise capital from depositors and investors.   

Although many microcredit borrowers do not operate formal businesses (and therefore avoid many of the legal requirements that affect formally registered businesses), the legal environment in which borrowers’ businesses operate always remains an issue of great interest to their MFI lenders. In fact, legal issues relating entirely or primarily to microcredit borrowers can be among the more critical determinants of an MFI’s success or failure.   

‘Microfinance law’ – the universe of legal provisions and administrative regulations that directly or indirectly affect MFIs – includes all three of these general topics:

  • NPO-related rules;
  • rules governing formal financial intermediaries and financing activities;
  • the rules applicable to small businesses.


The legal challenges facing MFIs result partly from the frequent ‘lack of fit’ caused by the fact that, generally speaking, none of these three bodies of law tends to develop with microfinance specifically in mind. But perhaps equally often the challenge lies in making these three hitherto entirely independently conceived (although potentially overlapping) sets of rules work harmoniously together.   

Towards a diagnostic framework: some things to look for
 
A diagnostic framework for the different bodies of law and regulation that affect MFIs can serve a number of useful purposes. By facilitating an understanding of the relevant rules and principles separately, a diagnostic framework provides insight into the points of tension where the rules and principles overlap or collide. This, in turn, can provide practical ideas for addressing problems that arise in practice under the rules and principles as they exist. Also, by linking the rules and principles in a more comprehensive analytical fashion, a diagnostic framework offers a means of identifying specific inadequacies in the rules and principles as they exist and therefore provides the basis for a ‘wish list’ of adaptations to achieve a more ideal legal and regulatory environment for microfinance.    

NPO-related law

An initial diagnostic task with respect to the legal and regulatory issues that face MFIs based upon their status as NPOs is to identify the relevant conceptual categories into which the issues fall.  Three categories of NPO-related law and regulation merit analysis:

  • provisions relating to setting up, registering and operating NPOs and to the legal powers of such organizations (‘status rules’);
  • special provisions applicable based upon the specific types of activity engaged in – of which, in MFIs’ case, lending activities are the most important (‘activity rules’);
  • provisions relating to the tax and other fiscal treatment of such organizations, their activities, their capital and their revenues (‘fiscal rules’).    


Status rules The following questions require attention, among others:

  • Is fostering microenterprise recognized as an appropriate purpose for NPOs?
  • Are there specific relevant limitations on NPOs’ legal powers, such as a prohibition on lending or borrowing, or a requirement that all assistance provided by NPOs be gratuitous or at a below-market rate of return?
  • Is there a clear legal path to transform into types of legal entity other than an NPO, if, for example, an MFI becomes ready to provide financial services beyond just lending or wants to raise capital from investors or the general public?   


Activity rules  A critical threshold question is whether an MFI organized as an NPO, merely by making loans, subjects itself to treatment as a regulated financial intermediary. Even if not, financing activities alone may subject MFIs to rules which are unrelated to their status as NPOs but none the less merit consideration, as discussed below.   

Fiscal rules  MFIs organized as NPOs need to know how their activities and revenues will be accounted for and taxed. This raises the following issues, among others:

  • Do the relevant accounting and tax rules impose significant relevant taxes, such as a tax on capital or on net interest income?
  • Are they silent or so ambiguous as to leave NPOs exposed to capricious taxation?
  • If the country in question has value added taxation (VAT), is the appropriate VAT treatment of NPOs serving as MFIs clear? Are ‘zero rating’ or other VAT preferences available for microfinance activities?
  • Do the relevant accounting rules permit full recognition of actual expenses in determining any income that is subject to tax, or are artificial caps placed upon deductible expenses?    


Law relating to formal financial intermediaries and financing activities
Despite significant potential variation from country to country, a few basic types of laws and regulations, which almost invariably exist in some form for the conventional banking and financial sector, are likely also to affect MFIs:

  • regulatory provisions – basic rules which, in a well-conceived system, aim at guaranteeing stable and efficient financial markets and financial institutions (‘regulatory rules’);
  • supervisory provisions – basic rules for monitoring compliance with the applicable regulatory provisions (‘supervisory rules’);
  • laws and regulatory provisions on the tax and other fiscal treatment of the regulated financial sector and financing activities, including accounting rules (‘fiscal rules’);
  • laws and regulatory provisions on loan documentation, loan collateral, the mechanics of loan collection and realization on collateral and related issues (‘lending-related rules’).   


Regulatory rules  The first and most important question for NPOs that wish to engage in microlending is whether the relevant provisions include within the sphere of regulated financial institutions organizations that engage only in lending activities with donated capital. A primary objective of regulatory rules for the formal financial sector is to protect the public and the markets against certain risks that arise only in the context of true ‘financial intermediation’ – a term used in the commercial banking and financial sector to refer to the activity of a financial institution that attracts capital from depositors or investors and uses that capital for making loans. It is common, therefore, for the regulatory rules that define the parameters of the regulated financial sector to include within those parameters only true financial intermediaries and to leave to other bodies of law any regulation of lending activity undertaken by itself. If the regulatory rules in question do not extend to MFIs engaged only in lending with donated capital, there remain a number of other issues of interest, looking forward to a time when ‘credit only’ MFIs may want to branch into other financial services and take on the role of true financial intermediary. Perhaps chief among these issues is the practical feasibility for smaller-scale institutions to become regulated financial intermediaries under the relevant regulatory rules.   

Supervisory rules  These are supposed to implement the regulatory rules. If MFIs engaged only in lending donated capital are not included within the regulated financial sector, they are therefore likely to avoid supervision by the relevant financial institutions supervisory agency. Avoidance of supervision is not necessarily a good thing for the broader microfinance sector. In fact, MFIs might well have on their legal and regulatory ‘wish list’ some sort of body (perhaps itself an NPO rather than a governmental agency) with the power to identify and stop dangerous and risk-taking behaviour within particular MFIs that could lead to financial failure at a high cost to the public reputation of the microfinance sector as a whole.   

Fiscal rules  Here the concerns for MFIs largely mirror those discussed above with respect to the fiscal rules applicable to them as NPOs. The specific articulation of the rules, however, is likely to vary between those designed with NPOs in mind and those geared to the conventional banking and financial sector. Legally required accounting treatment for regulated financial institutions and their lending activity (such as loan write-off rules and ‘provisioning’ for loan losses) is likely to require special attention.   

Lending-related rules  This is the category of formal financial sector law and regulation most likely to affect MFIs, including those organized as NPOs and engaged only in lending donated capital. These rules are typically found spread through a large number of different laws (and, in civil law countries, different provisions of the civil code). They also frequently vary significantly from country to country. The more important questions to be asked do not, however, vary so dramatically, and include, among others, the following:
 

  • Do different lending rules pertain to regulated financial institutions and other types of lender?
  • What requirements of basic contract law (or, in civil law countries, the law of obligations) apply to loan structuring, negotiation and documentation, in order for a lender’s claim to be enforceable?
  • What sorts of collateral are legally available to lenders, and do quirky limitations apply that could be especially troublesome for microfinance (such as limitations on the number of co-guarantors)?
  • Is unsecured or ‘undersecured’ lending legally limited?  
  • Are interest rates controlled (which can prevent MFIs from charging sufficient interest to achieve self-sustainability)?
  • Do workable systems (including not only legal rules but also functioning courts or administrative bodies) exist for lenders to collect on delinquent loans and realize on collateral with respect to loans in default?
  • Are lenders permitted sufficient flexibility to restructure loans in trouble?   


The basic legal rules applicable to small businesses

Potentially any type of legal or regulatory burden on the poorest borrowers will also have at least an indirect adverse effect on MFIs that lend to them. A threshold distinction needs to be drawn, however, between formal and informal sector borrowers. In many parts of the world informal sector borrowers frequently operate more or less entirely outside the relevant small business-related laws and regulations. The relevant legal rules thus may have little impact on their business success or creditworthiness. But even informal businesses may feel the effect of legal rules if operating informally carries significant legal risks for them (and therefore also for their lenders), such as the possibility of a visit from the financial police or comparable legal authority. Moreover, to the extent that MFIs may hope to assist at least some of their informal sector borrowers to grow into formal sector business entities, legal and regulatory conditions for (and barriers to) entry into the formal economy become highly relevant.    

The range of legal and regulatory provisions in any given country that determines in practice whether a business will fall inside or outside the formal economy are too varied to catalogue here. Critical questions to investigate include the following:

  • Are there available legal procedures for registering sole proprietorships and extremely small businesses?
  • Do the threshold requirements of formal business registration include effective financial barriers to smaller-scale entrepreneurs, such as unrealistically high minimum capital requirements?
  • What ramifications does formal registration of a business have for its employees?
  • Are the relevant accounting and tax rules clear and are tax burdens manageable?

In addition to these questions, the ramifications of formal business registration for microentrepreneurs as borrowers warrant analysis. For example, are registered businesses subject to different collateral requirements from individual borrowers? Do the same requirements of basic contract law (or, in civil law countries, the law of obligations) apply to both types of borrower with respect to loan structuring, negotiation and documentation? Are the mechanics of loan collection and realization on collateral easier in the case of formally registered business borrowers than in the case of unregistered borrowers?

Developing the diagnostic framework

Microfinance as a global movement is driven by its creative innovators and visionaries and the intrinsic merits of its social objectives. Its success certainly does not depend upon the prior establishment of a clear, harmonious and hospitable legal and regulatory environment. The best designed programmes do not begin by asking the question: what legal forms are available to MFIs and what legal limitations constrain them? Instead these programmes start with the identification of a good market for their particular type and methodology of social investment.

This is as it should be. However, when the moment arrives to define an appropriate legal structure for the programme envisaged (or perhaps for its next stage, if it already exists and is ready now to transform itself into a different type of programme), a diagnostic framework may help to identify and work out the issues that must be dealt with and understand the challenges that may arise in dealing with them. Perhaps of greater long-term utility, through application and development in specific decision-making contexts, the diagnostic framework can provide a basis to learn from others’ experience and focus support for microfinance-related legal and regulatory reform.

1
The term ‘microfinance institution’ as used here includes both ‘credit only’ organizations and all manner of depository and investor- or member-owned financial institutions serving needier populations.

Timothy Lyman is a partner specializing in charitable, NPO and microfinance law with the US law firm of Day, Berry & Howard, Boston, MA, and Hartford and Stamford, CT. He serves as legal adviser to the Microfinance Centre, Warsaw, Poland, and as legal consultant to the World Bank in Bosnia and Herzegovina for microfinance issues.


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