Dear Dr. Addison, please review the Business Rules and Sanctions for Microfinance Institutions
The call for a regulatory review is opportune in this COVID era, when market dislocations have called into question the structural resilience of the NBFI sector and its response to the widespread distress. As COVID-19 subsides and a semblance of normalcy is restored, the several thousands of micro-, small and medium enterprises that rely on micro-credit to fund their working capital will come knocking on the doors of operators, but help may not be readily available.
The issue of why over 600+ micro-creditors spread across Ghana’s 16 regions may not have sufficient firepower (capital) to lead a rebound of trade in local commodities markets should be a matter of policy concern. One way to address this through policy is to reform the rules, strengthen supervision and provide capital to support MFIs that meet the new standards.
Background
The enactment of Non-Bank Financial Institution Act, 2008, Act 774 into law, was an auspicious period in Ghana’s economic history, which was characterised by a medley of policy packages leaning toward an expansionary tilt.
The Act, providing a clear framework for prudential supervision and market discipline, proved insufficient years later, as it served as a minimum threshold for regulating an increasingly complex sector.
As a result, the Bank of Ghana – following extensive stakeholder engagements – disaggregated the MFI sector into four tiers with Finance Houses, Rural and Community Banks, and Savings and Loans companies taking the slot for Tier-1 classification (see Figure 1). Institutions with the name extension ‘Microfinance Companies’, Credit Unions and deposit-taking FNGOs occupies Tier-2; while non-deposit-taking FNGOs and micro-credit companies are classified as Tier-3. Tier-4 is reserved for individual micro-credit and Susu operators.
The sheer complexity and nuances as one crosses from one tier to another clearly warranted the Bank of Ghana’s satellite agency regulatory approach, whereby prudential reporting and monitoring are outsourced to sub-sector association bodies. To further decentralise the regulatory approach, a rules-based model that was responsive to the specific nuances of each sub-sector was introduced to help standardise activities.
As acknowledged by the regulator, the model adopted in designing The Business Rules and Sanctions for MFIs was “to ensure a gradual introduction of prudential, financial and risk management standards into the operations of the MFIs” (Business Rules, 2017). In proffering a rationale, the introductory text to the Rules further stated that the new regulatory approach was being cautiously undertaken “…so as not to unnecessarily stifle the operations and development of MFIs…” Suffice to say, two overarching principles were at play in shaping the regulatory framework that governs the MFI sector today; gradualism and proportionality.
In 2011, the Bank of Ghana released Public Notice No. BG/GOV/SEC/2011/04 to outdoor and cement a new era of prudential regulation. Hopes were high, even as academics and researchers praised the policy – precipitating a torrent of development capital that later poured in to ‘save the poor’. After almost a decade and 347 licence revocations later, fresh questions about the philosophical underpinnings of Ghana’s MFI regulatory model seem justified. Obviously, the facts seem to bear out the argument that the gradualist approach has not yielded the much-vaunted robust risk management and corporate governance systems which were expected. It’s fair to say the jury is still out on the Proportionality principle as well, it seems.
The question then is: has the principle of proportionality worked in realising the stated policy outcomes? This analytical inquiry is even more urgent considering the devastating impact that COVID-19 has wrought. If the 23.4% of Ghana’s population who are considered ‘poor’ (see GLSS 7) are to participate in an economic rebound after COVID-19, then access to microfinance services, particularly micro-credit, is key.
As of December 31, 2019, micro-credit, with its 663+ members scattered all over Ghana, represents the largest MFI sub-sector group that has the reach to drive the productive inclusion agenda. Credit Unions, FNGOs and other market participants are also important actors in this space. Unfortunately, it may be hard to argue that the majority of actors within the MFI space have the balance sheet resilience to drive growth at the bottom of the pyramid.
Proportionality and Business Rules
The principle of proportionality encapsulates the basic idea that any reaction to an action, or any response to stimuli, must be commensurate in ways that are deemed to be intuitively reasonable.
As the saying goes, “you don’t kill an ant with a sledge-hammer”. The application of this principle cuts cross several fields and disciplines – law, ethics, finance etc. In risk management, it may express itself as watered-down mitigation measures designed in response to low risk events or situations.
Within the context of a risk-based regulatory model, that kind of simplistic approach could get tricky. Take the Tier-4 micro-credit sub-sector for instance – Rule 11(3) of the Business Rules prohibits Tier-4 operators from taking deposits from the public. As a result, this sub-category of MFIs can only rely on their own funds and market borrowings to finance operating assets. Additionally, Tier-4 operators per the regulation are required to register under the Business Names Act, 1962, Act 151, as sole proprietors with no minimum capital requirement. The confluence of these three variables – sole proprietorship structure, non-deposit-taking licence, and debt-only capital structure – lowers the risk that Tier-4 operators pose to the entire financial system. Considered from a risk-based regulatory perspective, the exposure is low. There are three countervailing arguments to this reasoning.
First, a direct corollary of this low risk classification is the lowering of some essential corporate governance requirements for Tier-4 operators. Case in point is Rule 21(4), which mandates the formation of an Advisory Committee, akin to a board of directors for limited liability concerns.
In cases where there is compliance with this rule, it is tokenistic at best; and in cases of non-compliance, the same Guidelines (see Rule 21(4)(ii)) provide what appears to be a cop-out, effectively undermining the policy intent of Rule (21(4). But this is hardly surprising, because foundational principle shrouded in the agency theory of corporate governance as established in Berle and Means (1932) is absent. Boards are designed to represent the interests of shareholders (or stakeholders), and clothed with powers to exercise executive oversight. In this case, the ‘board’ is only advisory and has no real ‘skin in the game’.
The implications for risk management and financial management are dire and can be felt in areas such as meetings (see Rule 21(5)), internal controls (see Rule 33(2)), audit (see Rule 25(1)) and prudential reporting (Rule 52), to name a few.
Secondly, allowance to engage in market borrowings (see Rule 38(3)) radically transforms the risk profile of an operator, especially in situations where the monitoring functions of the sector oversight body is hampered by resource constraints. The risks associated with borrowing from HNWIs and/or commercial actors relates to breaches of tenor (shouldn’t be less than 90 days) and gearing (shouldn’t be more than 8 times equity). This also means that regulatory arbitrage could be rampant within sub-sectors where compliance monitoring is lax.
Summary of Arguments
In this article, the following key arguments have been put forth:
1. The outlook for economic rebound post COVID-19 is dependent on a robust non-bank financial sector led by MFIs, particularly supply-side actors serving the bottom of the pyramid. But the resilience of the latter’s balance sheets is doubtful, as the sector is yet to fully rebound from the recent reforms.
2. The principle of proportionality that has shaped regulatory response to issues in the MFI sector has not had any demonstrable positive impact on corporate governance and risk management in the sector.
3. Regulatory inconsistences have added to the already complex dynamics in the MFI sector, particularly in tiers with non-deposit taking licence.
4. There is a need for harmonisation and realignment of policy approaches with consensus in the corporate governance literature.
Key Recommendations
1. Allow Tier-4 operators to register as limited liability concerns, or at least partnerships. This will free-up the capital structure to accommodate contributed or partner equity. It may also create incentives for greater accountability at the firm level as investors and/or partners seek to protect their assets.
2. The monitoring and evaluation function within sub-sector associations must incorporate a decentralised structure that is organised around zonal-based compliance teams. Zones should have reporting lines to the head of monitoring and evaluation at the secretariat.
3. Engage the Institute of Chartered Accountants (Ghana) to fashion-out annual audit projects for non-deposit taking operators at concessional fees, to be charged as part of annual licensing fee.
4. Enforce Rule 31 (Management Information System) as part of the licencing requirement for new entrants to the sector.
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