Can Self-Regulation Protect Microfinance Clients?
Last month the Smart Campaign launched its certification program, For those who care about client protection, this is an important and welcome milestone in what has been an impressive journey, which has included a broad spectrum of activities by funders to promote client protection.
In the first post in this series, Philippe Serres describes a project by the French development organization AFD and the Cambodian Microfinance Association (CMA) to support implementation of the Client Protection Principles, including support for MFIs seeking to undergo the Smart Certification process itself. Notably, this support comes alongside client protection requirements that funders like AFD, Proparco and FMO have been incorporating into their financing agreements with MFIs. Thus, not only are MFIs being supported in their bid to strengthen client protection, they are increasingly required to do so by their funders.
In many respects, this is an exercise in self-regulation of client protection practices. The arrival of Smart Certification presents a unique opportunity to take these efforts to the next level and apply this self-regulation to the entire microfinance market in Cambodia and beyond.
Effective self-regulation rests on two key components: a transparent and consistent standard to measure compliance and a credible mechanism to insure that it can be enforced. Smart Certification provides that standard. What could provide its enforcement?
Some may ask - is enforcement necessary? Several MFIs in Bosnia and India have already become Smart Certified, and one can expect quite a few others to follow suit in the coming months. Is not the positive brand image of being Smart Certified sufficient to create its own momentum?
I don't believe so. The trouble is that some of the most important Principles of Client Protection, including prevention of over-indebtedness, require a coordinated approach in order to be effective. Experience has shown that, when left unconstrained, aggressive lenders can – and do – reap the benefits of their destructive practices, while spreading risk across the entire industry. It matters little whether a client's 1st and 2nd lenders are responsible. What drives over-indebtedness is that other lenders are willing to provide her with the 3rd or 4th loan, and beyond. This places the original lenders in an impossible position of either having to walk away from their established clients or keeping them only at the cost of undermining their commitment to avoid over-indebtedness.
The requirements that AFD, Proparco and FMO have incorporated into their financing agreements with MFIs in Cambodia show a plausible path. But what if these requirements went further, by making funding conditional on Smart Certification and bringing all major MFIs under that rubric? The power of the funders is considerable: 92% of borrowings of the 8 largest Cambodian MFIs come from the broad spectrum of social and development investors that can be considered part of the microfinance investment community (Figure 1), nearly all of whom have endorsed the Smart Campaign. Meanwhile, the largest five of these funders account for a third of all MFI debt funding.
The leading investors also share something in common – most are Development Finance Institutions (DFIs), whose impact is magnified further still through their funding of Microfinance Investment Vehicles (MIVs). And a similar pattern holds for equity investments. Indeed, in a country like Cambodia, few if any leading MFIs can claim to be independent of DFI funding.
Their role as funding leaders puts the DFIs in a perfect position to kick-start enforcement of client protection by mandating that MFIs become Smart Certified as a precondition for investment. Because MFIs maintain multiple funding relationships, the impact of such a mandate would quickly propagate through the market (Figure 2). After all, it does not matter who mandates the certification – it would redound to all of the certified MFI’s investors. As a result, as a critical mass of MFIs become Smart Certified through the mandate, even MIVs that receive no DFI funds would see many of their investees in the country becoming certified.
Reaching critical mass of certified MFIs would have two important outcomes: first, it would isolate the few remaining large MFIs unaffected by the mandate, at which point it's likely that they would choose to become Smart Certified rather than risk being singled out in front of their regulators, politicians, and the local media. Second, as the mandate is rolled out across more countries, the same dynamic would emerge among funders and investors, whose portfolios would become increasingly populated by Smart Certified MFIs. At that point, it's likely that investors would themselves start to apply the mandate rather than be singled out for having lower rates of Smart Certification than their competitors. In effect, by kick-starting the process, the original mandate could credibly push the microfinance sector from an equilibrium where Smart Certification is regarded as desirable but optional, to one where it is seen as required.
Of course, when considering mandating Smart Certification, it's critical to apply it carefully and avoid unwanted side effects. Given the complexity of the process, it's unrealistic and unreasonable to expect young or small MFIs to become Smart Certified, and in any case, certification of thousands of MFIs is difficult to achieve in practice. But it's also not necessary. In Cambodia, there are 32 licensed MFIs, but the largest 8 MFIs account for 91% of total clients in the country, according to MIX Market. This is consistent with most countries, where 80% of the microfinance market is split between four MFIs or fewer (Figure 3).
This market share of 80% is a reasonable target for achieving the necessary critical mass. A sensible approach would be to set the target at a specific size to hit this threshold – in Cambodia, this amounts to assets of $40 million or 90,000 borrowers. At the same time, the threshold doesn't mean a free pass for smaller MFIs, but instead provides an incentive to include Smart Certification into their growth plans, since they too would fall under the mandate once they hit that threshold.
Finally, because the mandate would target leading MFIs, it would mostly apply to large institutions that should generally be able to afford the cost of Smart Certification and the sometimes costly changes it may entail. The few smaller MFIs that still fall within the mandate may need some amount of subsidy, perhaps along the lines of the Rating Fund, though the total sum required is likely to be modest.
AFD, Proparco and FMO have essentially already begun this process in Cambodia. What remains is to formalize those requirements to include Smart Certification, set the institutional size at which the mandate would be applied, along with a timeline by which Certification would have to be completed.
Meanwhile, their provision of funding and technical support to help implement client protection will help smooth the path towards Certification. With this approach, Cambodia could well become the first country where all leading MFIs become Smart Certified and thus set the standard for others to follow.
----- The author is an independent microfinance consultant based in Brussels, Belgium.