Prudential Regulation and Supervision for Agricultural FinancePrudential Regulation and Supervision for Agricultural Finance 6. Enhancing Farmer’s Financial Management Skills. ...

Agricultural Finance Revisited

Food and Agriculture Organization of the United Nations (FAO)Deutsche Gesellschaft für Technische Zusammenarbeit (GTZ)

No. 5

PrudentialRegulationandSupervisionforAgriculturalFinance

Agricultural Finance Revisited

Prudential Regulationand Supervision

for Agricultural Finance

Michael Fiebig

Food and Agriculture Organization of the United Nations (FAO)

Deutsche Gesellschaft für Technische Zusammenarbeit (GTZ)

No. 5

AFR_5_EN.QXD 6-08-2001 19:53 Page c (1,1)

The designations employed and the presentation of material inthis publication do not imply the expression of any opinion what-soever on the part of the Food and Agriculture Organization ofthe United Nations concerning the legal status of any country,territory, city or area of its authorities, or concerning the delimi-tation of its frontiers or boundaries.

All rights reserved. No part of this publication may be reproduced, storedin a retrieval system, or transmitted in any form or by any means, elec-tronic, mechanical, photocopying or otherwise, without the prior per-mission of the copyright owner. Applications for such permission, with astatement of the purpose and extent of the reproduction, should beaddressed to the Director, Publications Division, Food and AgricultureOrganization of the United Nations, Viale delle Terme di Caracalla,00100 Rome, Italy

© FAO 2001

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Preface

i

Financial intermediation involves someone else handling one’s money.Many issues are involved here. First, and perhaps most obviously, thereis the issue of trust and security, and the means of enforcing this. Second,there is the matter of institutional viability and reputation. Third, costissues have to be faced. Fourth, in this mini-list, is the issue of sharingof responsibility for the regulation process between those actors in theimmediate vicinity of the deposit accepting institution, and authorities from regional or central bodies, or the government itself.

The importance of these issues is matched with the difficulty of design-ing and implementing suitable measures. In this book, the author,Michael Fiebig, takes a pragmatic approach, and makes extensive use ofexample material drawn from a variety of institutional types in a number of developing countries.

FAO and GTZ hope that this volume will be a useful adjunct to the lit-erature on strengthening the provision of affordable and sustainablerural financial intermediaries.

The full list of volumes in the series is given below.

1. Agricultural Finance Revisited: Why?2. Agricultural Finance: Getting the Policies Right3. Better Practices for Agricultural Lending4. Sources of Funds for Agricultural Lending5. Prudential Regulation and Supervision for Agricultural Finance6. Enhancing Farmer’s Financial Management Skills.

R.A.J. Roberts J. LangeChief Head of DivisionMarketing and Rural Finance Economic Development andService Employment PromotionFAO GTZ

Preface

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Acknowledgements

iii

The author would like to acknowledge the valuable comments and sug-gestions on the various drafts made by Gabriela Braun, Thorsten Giehlerand Sylvia Wisniwski in GTZ. Comments received from Alfred Hannigand Stefan Staschen on earlier drafts are highly appreciated. The supportand constructive criticism given by Richard Roberts is very much appre-ciated. I also thank Pekka Hussi, Åke Olofsson and Anthon Slangen ofFAO together with Carlos Alba, Andrea Bohnstedt, Jürgen Brennecke,Ramon Rosales, and Richard Rosenberg for their valuable inputs.

The empirical work concluded for this study has benefited substantiallyfrom the contributions of Gustavo Birbuet, Victor Chiriac, andRigoberto Rivera, in addition to other discussants in Bolivia, Hondurasand Uganda. The author wishes to thank the Bank of Uganda/GTZProject Financial System Development for the opportunity to study andparticipate in the microfinance regulatory policy making process inUganda.

I further wish to thank GTZ colleagues Jürgen Klenk and MartinaWiedmaier-Pfister for logistical and organizational support including thediscussion of the case studies bolstered by their country experience.

Acknowledgements

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PRUDENTIAL REGULATION AND SUPERVISION FOR AGRICULTURAL FINANCE

iv

ABBREVIATIONS

ABI The Agricultural Bank of IranACCION ACCION InternationalAIRAC Asociación de Instituciones Rurales de Ahorro y

Crédito, Inc.BAAC Bank for Agriculture and Agricultural

Cooperatives, ThailandBancoSol Banco Solidario, SA, BoliviaBPR Bank Perkreditan RakyatBRI Bank Rakyat IndonesiaCAF Corporación Andina de FomentoCAMEL Capital Adequacy, Asset Quality, Management,

Earnings and Liquidity ManagementCAR Capital to Asset RatiosCARD CARD Bank of the PhilippinesCARE CARE PhilippinesCGAP Consultative Group to Assist the Poorest FAO Food and Agriculture Organization of the United

NationsFENACOAC The Federation of Savings and Credit

Cooperatives, GuatemalaFFP Fondos Financieros PrivadosFINCA Fundación Integral CampesinaFODESIF Fondo de Desarollo del Sistema FinancieroGTZ Deutsche Gesellschaft für Technische

ZusammenarbeitIDB Interamerican Development BankIPCA Inspectora y Protectora de Cooperativas de

Ahorro y Credito de HondurasMFI Microfinance InstitutionMFRC Microfinance Regulatory Council of South AfricaMIS Management Information SystemMSE Micro- and Small EnterprisesNAFIBO Nacional Financiera Boliviana

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Abbreviations

v

NGO Non Governmental OrganizationOECD Organization for Economic Cooperation and

DevelopmentPARMEC Projet d’Appui à la Réglementation des Mutuelles

d’Epargne et de CréditPEARLS Protection, Effective financial structure, Asset

quality, Rates of return and cost, Liquidity, andSigns of growth

PFF Private Financial FundsROSCA Rotating Savings and Credit AssociationsUSAID United States Agency for International

DevelopmentWOCCU World Council of Credit Unions

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Table of Contents

vii

Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iAcknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iiiAbbreviations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ivIntroduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix

1. An Analytical Framework for Regulation and Supervisionof Agricultural Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.1 A Clarification of Terms . . . . . . . . . . . . . . . . . . . . . . . . 11.2 Rationale for Prudential Regulation and Supervision . . . 21.3 Principles of Prudential Regulation and Supervision . . . . 31.4 Regulators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51.5 Supervisors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61.6 Regulatory Policy-Making Process . . . . . . . . . . . . . . . . . 71.7 The Specific risk Profile of Agricultural Lending . . . . . . . 10

2. External Regulation and Supervision . . . . . . . . . . . . . . . . . . . 152.1 Triggers for the Involvement of External Regulation . . . . 152.2 Costs and Benefits of External Regulation . . . . . . . . . . . 212.3 Legal Framework for External Regulation . . . . . . . . . . . 232.4 Requirements of External Regulation

and Their Implications for Agricultural Lending . . . . . . . 262.4.1 Preventive Regulation: Entry Requirements . . . . . 262.4.2 Preventive Regulation:

Ongoing Requirements . . . . . . . . . . . . . . . . . . . . 292.4.3 Protective Regulation . . . . . . . . . . . . . . . . . . . . . 42

2.5 External Supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . 442.5.1 Requirements for an External Supervisor . . . . . . 442.5.2 Audits as Information Base for Supervision . . . . . 442.5.3 Supervisory Approaches and Tools . . . . . . . . . . . 462.5.4 Staff Capacity . . . . . . . . . . . . . . . . . . . . . . . . . . 542.5.5 Costs of Supervision . . . . . . . . . . . . . . . . . . . . . . 562.5.6 Operational Independence, Credibility

and Enforcement . . . . . . . . . . . . . . . . . . . . . . . . 572.5.7 Delegation of Supervisory Tasks . . . . . . . . . . . . . 59

3. Internal Regulation and Supervision . . . . . . . . . . . . . . . . . . . 633.1 Issues of Owner Control . . . . . . . . . . . . . . . . . . . . . . . . 63

Table of Contents

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viii

3.2 Issues of Internal Control . . . . . . . . . . . . . . . . . . . . . . . 663.3 Connecting Internal Regulation

with External Regulation . . . . . . . . . . . . . . . . . . . . . . . . 71

4. Self-Regulation and Self-Supervision . . . . . . . . . . . . . . . . . . . 754.1 Setting Industry Standards . . . . . . . . . . . . . . . . . . . . . . . 754.2 Self-Supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 764.3 From Self-Regulation and Self-Supervision

to Delegated Supervision . . . . . . . . . . . . . . . . . . . . . . . . 77

5. Regulation and Supervision by Funding Sources . . . . . . . . . . . 795.1 Industry Standards Required

by Funding and Rating Agencies . . . . . . . . . . . . . . . . . . 795.2 Governments and Donors . . . . . . . . . . . . . . . . . . . . . . . 805.3 Wholesale Financial Institutions . . . . . . . . . . . . . . . . . . 825.4 Commercial Fund Providers . . . . . . . . . . . . . . . . . . . . . 845.5 Relations Between Market and External Regulation

and Supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

6. Findings: A Regulatory and Supervisory Perspectiveon Agricultural Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89

Glossary of Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

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Introduction

ix

Prudential regulation and supervision are currently among the mosttalked about topics in development finance and major issues in financialsector reform around the world. Regulatory issues have been a continu-ous discussion for the traditional banking sector. However within themicrofinance discourse it is relatively new. At the same time, a numberof developing countries have recently revised or are revising their frame-work of regulation and supervision to cater to small financial interme-diaries. In addition these adjustments are devised to facilitate the entryof larger existing intermediaries into the provision of financial servicesto poorer segments of the population. Much of the comment focusesnarrowly on the details of facilitation of small sized, short term loans topoor people (microcredit). As represented in the AFR series, most micro-credit approaches significantly exclude rural smallholders who concen-trate their income generating activities in the agricultural sector. Thispublication seeks to broaden this subject.

The other AFR publications have dwelled upon technological challengeson the institutional level plus the comprehensive policies relevant toagricultural finance. This edition will target the framework of pruden-tial regulation and supervision conducive for the development of ruralfinancial markets that include agricultural producers, specifically smallfarmers.

The key question posed in this publication is:

“Does the provision of financial services to rural farm householdsrequire a specific prudential regulatory and supervisory setting to pros-per? If so, what adjustments need to be made in order to facilitate thisprovision with a conducive prudential regulatory environment?”

In Chapter 1, an analytical framework is presented for the study. First,the terms regulation and supervision are defined. Then, rationales andprinciples of prudential regulation and supervision are furnished beforethe variety of regulatory and supervisory institutions are described.Finally, the structure and characteristics of a regulatory policy-makingprocess are outlined and the specific risk profile of agricultural financeis analysed. Chapter 2 focuses on an in-depth discussion of the defini-

Introduction

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tions of triggers for external regulation. The costs and benefits of exter-nal regulation and supervision from the perspective of a financial insti-tution involved in agricultural lending are analysed among different lev-els of external regulation, analyses in detail principles and rules of out-side direction of agricultural finance and options for supervisors along-side oversight of external regulation.

Next Chapter 3 pertains to internal regulation and supervision concen-trating on owner and management issues. It addresses possible interfacesbetween external supervision and internal regulation. Chapter 4 con-centrates on self-regulation and self-supervision. Self-regulation is seenas standards defined by an apex body with regulatory (and eventuallysupervisory) powers by financial institutions. Chapter 5 analyses theregulatory and supervisory functions of different funding sources, whichimpact on agricultural lenders’ decision-making. Finally, Chapter 6 sum-marizes the results of the preceding chapters and synthesizes an answerto the key question. Throughout these chapters, empirical examplesillustrate, underline and support the argumentation of the author foradjustments of regulation and supervision to the characteristics of agri-cultural finance.x

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An Analytical Framework for Regulation and Supervision of Agricultural Finance

1.1 A CLARIFICATION OF TERMS

The term regulation refers to a distinct set of rules that structures theactions of market participants according to clear principles. This set ofrules is established by a regulatory institution, which in the area offinancial markets can be a legislative body, a central bank, or financialmarket participants. Regulation includes not only legal aspects and self-set performance standards, but also “invisible institutions” (Arrow,1974) such as behavioural norm systems and patterns founded in asocio-cultural setting. When investigating prudential regulation, oneshould bear this view in mind and not adhere too closely to written lawsalone. More narrowly, prudential regulation of financial institutionsrefers to the structuring of financial institutions’ actions according to acollection of rules and norms. The thrust of this study is the controlmechanisms installed by various actors with diverse sets of rules, crite-ria and norms that influence financial institutions’ actions and their out-comes.

Supervision, as a next step “gives meaning to regulation” (Rock andOtero, 1997). At first it is necessary to collect information on the degreeof compliance with the rules to support enforcement. This informationneeds to be processed and connected to possible sanctioning mecha-nisms to be able to enforce the rules. All these activities are carried outby one institution or by a group of supervisory institutions. These arenot necessarily the same institutions as the regulators. There actuallyexist good reasons for separating these functions. For example in such acommon scenario, when the national parliament decides on the estab-lishment of a new banking law, a superintendency is assigned to overseecompliance. The superintendency may issue more specific regulations onthe basis of the law, at the same time delegating some of the superviso-ry tasks to a private company. This would mirror segregation of legisla-tive and executive duties.

Prudential regulation can be summarized as the “What”, supervision asthe “Who” and the “How” of the structuring of financial institutions’actions.

1

1 An Analytical Frameworkfor Regulation and Supervision

of Agricultural Finance

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2

1.2 RATIONALE FOR PRUDENTIAL REGULATION AND SUPERVISION

In this section the rationale behind prudential regulation and supervi-sion shall be analysed. Generally, commercial fund providers, share-holders and depositors clearly have an interest in monitoring what hap-pens to their funds. However, difficulties arise for this monitoring,which form the basic argument for what is called “external” prudentialregulation and supervision carried out by public institutions.

Savers, other commercial funding providers and owners entrust theirmoney to financial institutions and delegate the task of investing themoney wisely. Financial institutions have thus been described as “dele-gated monitors” (Diamond, 1984). However, while owners usuallyinstall information and control mechanisms for their investment, saversknow very little about a financial institution’s business conduct.Information gathering is difficult and costly, especially for small savers.The monitoring of the use of these funds has the characteristics of a pub-lic good, which leads to a suboptimal solution if only left to marketforces (Chaves and Gonzalez-Vega, 1992). It opens the possibility forowners and management of a financial institution to behave oppor-tunistically and take excessive risks. Their profit participation has nolimits, while losses are only paid up to their capital share. Against thisbackground, depositor protection is introduced as the most importantoverall aim of prudential regulation and supervision.

Many countries have experienced bank runs where depositors line upbefore weak and endangered banks to withdraw all their savings beforethe institution is closed down. These bank runs emerge from asymmet-ric information distribution between savers and financial institutions.Depositors cannot differentiate between temporary liquidity and severesolvency problems due to difficulties in assessing the solvency of a finan-cial institution. Thus, once a significant number of depositors withdrawtheir savings a chain reaction may destabilize the whole financial systemthrough liquidity drainage. This is another major reason for prudentialregulation and supervision, which can be translated into the regulatoryaim of achieving safety and soundness of the financial system.

A third reason for external regulation, which is not always mentioned,is the assurance of a competitive market structure. This touches on the

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3

“safety and soundness” argument, but takes it a step further. A well-functioning financial system provides important capital allocation con-tributions as well as payment transfer services to the real economy. Astable financial system is based on financial institutions striving for effi-ciency while competing for their customers. Clients on the savings andthe loan side of financial intermediaries profit from this competitionthrough well-priced, well-customized products. However, as pointed outearlier, financial intermediation involves complicated asymmetric infor-mation situations, where savers are not able to monitor satisfactorilywhat financial institutions are doing with their money. Pyramidschemes, which finance high interest rates on deposits by mobilizing newdeposits, are a drastic example of where a free market situation can lead.This potentially impedes trust in the entire financial system. The build-ing of a competitive market structure remains an objective of regulationand supervision.

1.3 PRINCIPLES OF PRUDENTIAL REGULATION AND SUPERVISION

“What makes prudential regulation prudent?” To answer this questionit is necessary to outline regulatory principles, which have emerged inacademic and practical discussions on regulatory issues1.

Competitive neutralityRegulation should allow for a level playing field. This means that thereshould not be different rules for different institutions for explicit issuesdue to aspects that are not material to the subject. Fair competitionbetween financial institutions is the objective. However, this does notimply that all regulatory rules should be the same for all types of finan-cial institutions. For example, governance issues and size considerationsmay limit the risk taking capacity of a small financial entity.

EfficiencyRegulation should ensure allocative, operational and dynamic efficiencyof financial institutions. Allocative efficiency refers to an optimal appro-priation of financial resources. Operational efficiency is employed tominimize transaction costs in financial intermediation. Dynamic effi-

1 See Chaves and Gonzalez-Vega (1992), Jansson (1997) and Staschen (1999)

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ciency refers to the adaptability of a financial institution to changingenvironments.

Subsidiarity and incentive structuresRegulation should fit into incentive structures for owners, managers andclients of financial institutions. These actors, together with external reg-ulators should complement each other. External regulation should onlytake over the roles that other regulatory sources of market participantsand owners cannot assume.

Cost-benefit analysisRegulations should be reviewed from a cost-benefit perspective. Asevery single transaction cannot be monitored, overregulation can ham-per innovation. An optimum balance between control and the marketshould be the goal.

Dynamic perspective and financial deepeningAlthough small financial institutions may be costly to regulate andsupervise, financial deepening combined with the development of a com-petitive market structure that spreads across various financial services,sectors, client groups and geographic regions should be taken intoaccount. A dynamic or prospective approach may incorporate small butgrowing financial institutions earlier than a static approach to regula-tion. Still, it must be acknowledged that regulation alone will not sufficeto develop a new market niche. Instead, the driving force for innovationprimarily lies with the management and owners of the financial institu-tions.

Government prudential regulation and social missionKeeping an institution consistent with its original mission and objec-tives, including social goals, is generally a concern to boards and gov-ernment. Prudential regulation (“external”) should not consider socialmission issues. It should not set inappropriate rules and regulations,which unnecessarily retard innovation and alter market outreach.Similarly, it should not treat a risky endeavour involving poor and/orrural and/or agricultural clients differently than a risky endeavourinvolving an urban trader.

4

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1.4 REGULATORS

Four actor categories can be identified when looking at the participantsthat influence financial institution’s decision-making and impact on theoutcomes of these decisions. For the topic of prudential regulation andsupervision, it is useful to have these different actors in mind to be ableto assign their roles2:

The first most commonly applied source of regulation is external regu-lation, which is originated through legal norms, enacted by govern-ments, ministries and parliaments. These legal norms can be scatteredover a variety of laws, including banking laws, cooperative acts and landreform laws. External regulation also includes the norms and regula-tions inaugurated by specialized supervisory agencies and central banksto differentiate and detail the unspecified terms and voids left by the rel-evant laws.

A second set of sources of regulation is owners and managers of finan-cial institutions. Owners hold shares or are members of financial insti-tutions. By commercial law and/or on a contractual basis they are theprime governors of financial institutions’ actions. Individuals, privatesector companies or the government can be owners of an agriculturallender. NGOs are a specific type of institution, where owner identifica-tion is usually difficult because the equity providers do not receive vot-ing rights of any kind. Instead, many NGOs are governed by boards,which have been installed by some other entity or group of persons.Boards can even be self-nominated. Owners usually delegate substantialparts of their governance and daily authority to managers, whom theymonitor through boards and member/shareholder assemblies on a regu-lar basis. Ideally they install an internal control system to monitor man-agement’s actions. Managers put into practice an internal governancestructure and an internal hierarchy within the financial institution.

5


2 Van Greuning et al., (1998) define seven players in this context, namely Boards ofDirectors, management, external auditors, internal auditors, external commercial fundproviders, the public and government regulators. Both, internal and external auditorsserve various of the other actors as agents and cannot be considered sources of regula-tion on their own. In addition, the public is defined as clients or as represented by gov-ernment, NGOs or other pressure groups via the external regulatory policy-makingprocess and thereby not as a direct source of prudential regulation.

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Owners and managers, as generally agreed, are the persons primarilyresponsible for success and failure of financial institutions.

Financial institutions can engage agents to carry out specific tasks.When a group of financial institutions founds a joint apex institution toaccomplish definite regulatory tasks, it belongs to the third regulatorysource group, self-regulation. This concept is well-known from cooper-ative movements all over the world, which are members of federations.These federations collect member institutions’ data and carry out audit-ing services among a wide range of other services.

A fourth source of regulation can be illustrated. The different sources offunds, argued elsewhere in the AFR series (see Giehler, 1999), provide adiverse set of incentives to financial institutions. For the purposes of thispublication, differentiation is made between governments and donorswholesale financial institutions, commercial fund providers and deposi-tors. These four subsets of actors impact the action and conduct offinancial institutions in significantly different ways .

The four regulatory groups of actors interact. Depositors usually preferexternally regulated entities to non-regulated ones due to a perception ofincreased safety. Commercial fund providers may prefer regulated enti-ties as well and use the data disclosed by bank supervisors, rating agen-cies, auditors and other entities for their investment decisions. Externalregulators usually interact with the other groups of actors, for exampleby requiring certain owner characteristics and internal governance struc-tures.

All four regulatory actors exploit their competitive advantages in gov-erning a financial institution’s action. It is important not to expect toomuch from just one regulatory source. For instance, external regulationcannot substitute for good owner and management control of a finan-cial institution’s action.

1.5 SUPERVISORS

Supervisors are the institutions that monitor the fulfilment of the regu-lations set by the four actors. These may or may not be the same insti-

6

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tutions as the regulators. Additionally, combinations of multiple super-visors and supplementary institutions may be put into place. These sup-plementary institutions include external auditing firms, which con-tribute to superintendency work. Another example is former self-regu-latory and self-supervisory institutions that have discretionary power asdelegated supervisor of legally established prudential rules.

Generally, supervisors require incentives to administer the rules and reg-ulations. They also need to have accurate and timely information, pos-sess the capacity to process the information collected and be able to actonce deviations from the regulations have been identified (sanctioningpower). Table 1 summarizes four requirements for every potential super-visor.

Among the regulators defined by funding sources, owners, depositorsand commercial fund providers do have their own capital at stake. Thisgives them a strong interest in supervising the financial institution withwhich they have entrusted their money. Donors and government usual-ly have a much weaker incentive for supervision, as they provide publicsector/taxpayers’ money. Self-regulatory/supervisory institutions may beinvolved in potential conflicts of interests, as their owners are the veryinstitutions they have to sanction. Supervisors of external regulation(external supervisors) are often part of the public service and thus derivetheir incentives to supervise from their mandate including political andnormative pressures.

Information availability is a basic issue for all supervisors. In this area,external and internal auditors play a major role. Sufficient capacity toprocess the information obtained is an issue for every actor. In the caseof agricultural finance, special skills and technical knowledge arerequired.

1.6 REGULATORY POLICY-MAKING PROCESS

There is no best solution for regulating rural financial intermediaries.Solutions need to be adjusted to the exceptional institutional landscapein a country and should be a result of a continuing policy-makingprocess that involves all relevant actors.

7

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In the process of defining and selecting the role and extent of externalregulation, it must be certain that subjects of external supervision can-

8

Table 1

Supervisors and requirements for adequate supervision

By decree / publicadministration

By decree / publicadministration,remuneration fromsupervised institu-tion or centralbank/ superinten-dent, monetaryresponsibility fordecisions made

Capital at stake,profit distribution,possibly: reputationat stake

Remuneration(e.g. performancebased), reputationat stake

Control by mem-bers / affiliates ofself-regulatory insti-tution.

Limited, objectivesusually social andnot financial

Money at stake

Money at stake

Ext

erna

l su

perv

isor

sD

eleg

ated

supe

rvis

ors

Ow

ners

Man

agem

ent

Don

ors

and

gove

rnm

ents

Com

mer

cial

fund

pro

vide

rsD

epos

itor

sSe

lf-r

egul

ator

y an

d se

lf-s

uper

viso

ry

insi

tuti

ons

Knowledge andadequate resourcesrequired

Knowledge andadequate resourcesrequired

Depending oncapacity of owners

Depending on qualification of management

Knowledge andadequate resourcesrequired, mayinvolve conflicts ofinterests

Limited, with littlestandardization e.g.in the area ofmicrofinance

Usually high due toinvestment interestand more moneypotentially at stake

Limited: depositorshave problems ofidentifying 'good'deposit-takers

By decree / legalpowers laid downin laws/decrees

Delegation fromexternal regulator/external supervisor

Voting rights inshareholder companies

Hire and fire, proceduresinstalled by owners

Usually weak:depending on dis-cretionary powersgiven by memberinstitutions / affili-ates on a contrac-tual basis

Withdrawal ofsupport

“Get moneyback”, dialogue

“Get moneyback”

Collected fromexternal auditingsources, on-site andoff-site supervisorymeasures

Needs to be collected by on-siteand off-site supervisory measures

External and inter-nally audited finan-cial statements,management infor-mation systems

Management infor-mation systems,internal auditing

Needs to be collect-ed by on-site andoff-site supervisorymeasures

More or less regu-lar on-site visitsand off-site report-ing requirements

Usually difficult toobtain, relying onexternal audits andon-site visits

Usually difficult toobtain

Incentives tomonitor

Availability ofinformation

Processing tocapacoty

Sanctioningpower


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9


not be the predominant designers. Safety and soundness considerationsas reflections of the interests of depositors and society as a whole haveto be weighed against propositions of the financial institutions them-selves.

Prime decision-makers usually are central banks and bank supervisionauthorities, Ministries of Finance and parliament. In many countries, adistinction between legislative (policy makers/regulators) and executiveinstitutions (supervisors) has proven successful. There are additionalstakeholders usually involved in such a policy formulation process.These include supervisory institutions as well as financial institutionsthemselves, financial and non-wholesale financial institution, donors,the general public and possibly client groups.

As Coffey has underlined, “the essence of successful policy making isthat it captures the views of all the stakeholders in the delivery of thepolicy, backed up by relevant analyses of key data.” (Coffey, 1998). Amutual learning process is a key part of the policy making process, ifnew institutions are to be included or adjustments made to sustain pre-cise financial technology developments.

There is a danger of ‘getting lost’ in the regulatory process when stake-holders who pursue their own interests are able to dominate it. Table 2,assembles an overview of objectives which may be followed by theactors in the regulatory policy making process.

The table does not imply that in every country context the actors followthese listed objectives. Instead, it offers a range of possibilities, wherecertain motivations may dominate in some cases. Note that the regula-tory policy-making process is a process of balancing diverse sets ofobjectives. In this process, governments as well as supervisory institu-tions are not simply agents of public interest, but follow a variety ofobjectives. Indeed, in the discussion of regulation for microfinance it hasbeen put forth repeatedly that donors are the driving force in the processof including new financial intermediaries in the external regulatoryframeworks in some countries. Also, as Christen and Rosenberg (2000)stress, governments thinking about introducing new regulation aim at arather vague “Doing something about microfinance”.

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1.7 THE SPECIFIC RISK PROFILE OF AGRICULTURAL LENDING

Generally, risk categories to be applied in rural financial intermediationshould not differ from other financial intermediation. Instead, the risks

Table 2

Actors in the regulatory policy-making process

Actors

FinancialInstitutions

Government

Supervisory institutions

Donors

Commercial fund providers

Depositors/Clients

Objectives

• License for deposit mobilization• Access to government, donor, and wholesale finan-

cial institution resources• Positive signal to depositors and commercial fund

providers• Promotion and proliferation of financial services• Legitimization as being part of the formal

financial sector

• Safety and soundness of the financial system• Protection of the payment system • Protection of depositors• Control and influence over financial sector

activities• Response to donor requests

• See government• Maintenance of a manageable workload

• Standards that will strengthen financial institu-tions

• Promotion and integration of new actors and newfinancial services into the financial system

• Safe, sound and profitable institutions• Early warning signals that can trigger commercial

fund providers’ timely exit

• Safety of deposits• Increased access to financial services• Acceptance as valuable clients to formal financial

institutions

Source: Based on Valenzuela and Young (1999)

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should be identified on a component and consolidated basis to identifyan evident risk profile. There exist numerous sets of risk categorieswhere it is possible to identify quite clearly the pertinent risks in ruralfinancial intermediation and agricultural lending3.

The following risk categories in agricultural lending institutions are dis-tinguished: credit risk, which is related directly to the agricultural lend-ing business; liquidity risk which is related to the intermediationbetween liabilities and assets; management risks along with ownershiprisks related to the particular governance structure; management capac-ities and staff quality of an agricultural lender.

• Credit risk is a central exposure category in agricultural lending.This risk category includes credit loss risk, interest rate risk, and for-eign exchange risk. These subcategories can be identified on an indi-vidual and on a portfolio level. Credit loss risks in agricultural lend-ing are characterized by covariance and contingencies prevalent inthe agricultural sector;

• Liquidity and interest rate risks originate from liabilities and liabili-ty matching in maturity with the assets of a financial institution.These include sources of funds, balance sheet structure risks and sub-sidy dependence risks (which refers to the possibility of losing accessto subsidies);

• Management and operational risks pertain to the capability of anagricultural lender to manage the discrete risks and costs of ruralfinancial intermediation, the existence of adequate internal controlsystems that prevent fraud and mismanagement, implementation ofadequate management information systems and maintenance ofoperational independence from external intrusion (again refers topossible subsidy dependence);

• Ownership risks indicate the repercussions that owner characteris-tics can have on the previous risk categories. They refer to the exis-tence of owners with deep pockets who effectively install mecha-nisms to control and supervise management and staff. Ownershiprisk is high if these systems do not exist or do not work properly.

11

3 Hanning and Braun (1999) use the same risk classification.

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This risk category also touches on the role of quasi-owners such asdonors and governments involved in socially oriented initiatives.

The complete goal for regulated entities that are involved with the agri-cultural sectors is to be a safe, stable and profitable financial institution.

12

Table 3

Specific risk profile of agricultural lending portfolios

RISK CATEGORY

Credit risk

Liquidityand interest rate risk

Management and operational risk

Governance risk

Relevance for agricultural lenders

• High degree of sector concentration increases risk of cor-related defaults (portfolio concentration risk)

• Besides behavioural risks, external risks play a particular-ly important role in default risk

• If short term lending for working capital is in the portfo-lio, high turnover may increase relevance of default risk(credit loss risk)

• Contract enforcement difficulties exist especially in ruralcontexts (legal risk)

• Loan recovery is affected by customer identification diffi-culties especially in rural contexts (address risk)

• Seasonal and contingency risks of increased loan demandcombined with decreased deposit base

• Flexibility of loan interest rates, danger of political inter-vention (interest rate risk)

• Possible state intervention in interest rate policy• Subsidy dependence encompasses irregularities of donor

money flows, donor funding possibly subject to exchangerate fluctuations, possible withdrawal of public funds

• Higher interest rate risks in longer term lending

• Due to absence of collateral, the evaluation of repaymentcapacity and willingness becomes more relevant, leading tohigher management requirements (which includes the ade-quate evaluation of agricultural sector risks)

• Requirement of knowledge in the agricultural sector forappropriate risk management

• Decentralized rural institutions imply specific internal con-trol and fraud risks due to dispersion of responsibilities

• Donor funding sources may hamper appropriate risk man-agement, impact on prudence of loan making and branch-ing decisions

• Depending on institutional type: NGOs face high, agricul-tural development banks substantial, and co-operativessignificant governance risks

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On the regulatory level it appears likely that necessary adaptations willrefer to details rather than to global issues. However, the supervisionprocess faces serious challenges in rural areas and with agricultural lend-ing portfolios.

Agricultural lending can be done by a variety of institutions that do notnecessarily focus exclusively on agricultural producers. This happens inpractice. In fact, a prudent approach towards dealing with the uniquerisks of agricultural loans is the diversification of the portfolio, forinstance including financing for non-farmers, trade activities, consump-tion credit etc. (cf. Klein et al., 1999).

Emphasis will be made on factors of agricultural lending portfoliosinstead of agricultural lending institutions. Where appropriate, impor-tant characteristics of NGOs, savings and credit cooperatives, publicdevelopment banks, savings banks as well as commercial banks andother institutional types will also be highlighted.

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External Regulation and Supervision

Much of the debate on prudential regulation and supervision centresexclusively on external regulation. External regulation, as defined here,acts with the power of the law and usually involves specialized publicinstitutions, such as central banks and specialized supervisory agencies,in addition to courts, as supervisors to ensure that the established normsare followed by the financial institutions.

This chapter will first take a look at the triggers for the involvement ofexternal regulation in regulating and supervising financial intermedia-tion. Second the costs of regulation will be considered followed by dif-ferent framework designs of external regulation. The legal frameworkfor prudential regulation usually includes many types of legal instru-ments that jointly create a system of external regulation. Following this,principles and specific rules that usually form part of external regulationwill be examined. The analyses will weigh their relevance or irrelevancewithin the context of rural financial intermediation, particularly of theprovision of financial services to small agricultural producers. Theserules are divided into preventive and protective instruments referring totheir entry point before or after the incidence of severe financial prob-lems of a financial institution. In the third subsection, supervision entersthe picture. Appropriate supervisors need to fulfil bona fide mandates towork effectively. They require valuable partners for conducting theirtasks.

2.1 TRIGGERS FOR THE INVOLVEMENT OF EXTERNAL REGULATION

Different characteristics of financial institutions trigger different formsof regulation. The most common triggers of external regulation arefunding sources and size considerations. Additional triggers are cost-benefit and supervisory capacity considerations.

Funding sourcesVan Greuning et al., (1998) proposes an approach towards defining reg-ulatory need, which is oriented at the funding sources of a financialinstitution. In their view, regulatory need can be defined by the extent to

15

2 External Regulationand Supervision

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which funding sources together with owners can and should supervisethe financial institutions’ use of their money. It is a common to exter-nally regulate all financial institutions that take deposits from the pub-lic.

SizeAnother factor in determining the role of external regulation is institu-tional size. It may be argued, that the regulation and supervision ofsmall financial entities in general is too costly and does not provide asubstantial benefit to the overall financial system, as its meaning relative

Table 4

Funding sources as triggers for external regulation

Potential reasonsfor external regulation

Quasi-monopolisticcredit markets (which maylead to persistentinefficiencies and fraudulent behaviour onthe part of financial institutions),insufficient information ofdonors, opportunisticbehaviour of institutions

Fund mobilization throughcommercial papers,large-scale depositcertificates etc.

Deposit-taking from mem-ber-clients

Deposit-taking from publicwith danger of illiquidity(runs) and opportunisticbehaviour

Type of financialinstitution

Institutions withfunds from donors

Institutions withcommercial loans orsecurities

Institutions, whichmobilize funds frommembers

Institutions, whichmobilize funds fromthe general public

Form of regulationrequired

None/only voluntary inself-regulatory institution

Registration as corporateentity, authorization fromsecurities and stockexchange agency

Registration withCooperative Authority,under banking or other law(or with private ratingagency)

Registration and compli-ance with general or insti-tution-specific banking law

Source: Adapted from Van Greuning et al., (1998)

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to systemic stability is rather small. This consideration has to be bal-anced against the risk that the failure of even a single small financialintermediary in rural areas may lead to long lasting distrust in the finan-cial sector and may substantially hamper savings mobilization efforts.

At the same time, even though the total amount of deposits involvedmay not be large, the relative importance of the small savings for clien-tele in lower income strata means that crises affect their accounts moresubstantially than larger depositors. Small informal financial serviceproviders such as Rotating Savings and Credit Associations (RoSCAs)should remain outside external regulation as long as their potentialthreat to the financial system and the serviced individuals remains low.

Cost and capacity issuesImportant factors to external regulatory and supervisory involvementare cost-benefit as well as capacity considerations of the potential super-visors. Regulation does not make sense without enforcement, andenforcement will not take place without adequate supervision. Thisimplies that once supervision is too costly or infeasible technically, thistype of regulation should be avoided. Cost aspects are analysed in moredetail in the following section, and in Section 2.5.

Supervisory capacity is another important issue to be taken intoaccount. If there are not enough qualified supervisors, even detailed andappropriate regulation cannot be implemented. Restrictions on supervi-sory capacity in the medium term can form an important justificationagainst widening the focal point of regulation and supervision.

Size of market niche and existence of best practicesInformality provides valuable opportunities for innovation. Indigenousinformal financial institutions (moneylenders, RoSCAs, savings clubsetc.) have used this informality all over the world in the area of micro-finance technology. NGOs have also benefited from their innovativefreedom from relevant external regulation. From this perspective it isadvisable to specify the external regulatory and supervisory frameworkonly once a critical mass of actors have ventured into a new type offinancial business. As Valenzuela and Young stated, “Establishing regu-lations for a market that has yet to exist can have the effect of stifling


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the very market one wishes to create” (1999). This is especially the casefor lending to small farmers, where documented successful experience isfew and far between and discussants are far away from defining bestpractices for lending technology (see Klein et al., 1999).

Within the analytical framework of four different sources of regulation,defining external regulatory need is part of the decision of allocatingspecific roles and tasks to these regulatory sources. Upfront it has to beclear that the prime responsibility of managing risks involved in servinga particular client market and more generally in managing a financialinstitution in a sustainable manner resides with the apparatus of inter-nal governance. International experience has shown, that causes of cri-sis in financial intermediaries largely occur due to lack of adequate poli-cies, administrative and internal control systems, apart from externalshocks (cf. Rosales, 1999; Hawkins and Turner, 1999).

This, however, does not imply that external regulation should step asideand let the free market, namely the owners of a financial institution reg-ulate intermediaries exclusively. Instead as the internal structuring of theinstitutions primarily and directly determines quality decision-making,implies that it is a key area for external regulatory requirements.

External regulation can and should require strong internal regulationmechanisms. These include measures of ensuring owner control over theinstitution, as well as instruments applied on the part of the manage-ment of the institution for monitoring and acting upon staff perfor-mance in various sectors. Examples are competent boards of directors,strong management information systems and good risk managementtools.

Tiered approachesWithin tiered approaches, different institutional categories are reflectedin different regulatory layers. Tiered approaches have been proposed forthe regulation of microfinance operations in Uganda and Zambia. Box1 presents the policy recommendations issued by Bank of Uganda as anexample. If observed in a static perspective, the different institutionaltypes are defined as regulatory frameworks adjusted to specific institu-tional types. In a dynamic perspective they provide stepping stones in a

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potential institutional development. This does not automatically imply auniform development path for new financial institutions, but it providesopportunities to graduate to higher regulatory levels.

Also, tiered approaches already are in operation in some countries forsavings and credit cooperatives. In Latin America Bolivia, Colombia,Costa Rica, and Ecuador provide different regulatory and supervisorysettings for open and closed savings and credit cooperatives as well ascooperative banks. (Hübenthal and Gattelet, 1998).

Bank of Uganda has actively participated in the current regulatory process of revis-ing the Financial Institutions Statute and discussions on integrating into the financialsector new entities. As of July 1999, it has proposed to include the microfinance sec-tor into the financial sector under a tiered framework. This tiered framework ismeant to reflect the concept of microfinance as a line of business, and allow a diverserange of institutions to become involved in credit provision to the low-income pop-ulation of Uganda.

The proposed framework comprises four institutional categories:

a) Commercial banks. For these institutions specific regulations for micro financingwill be provided.

b) Credit institutions. This is an already existing category of smaller financial insti-tutions that concentrate on the provision of loans, but also do have the possibil-ity of deposit-taking. They are not allowed to operate checking accounts. Forthese institutions, specific regulations will be applicable as well.

c) Microfinance Deposit- taking Institutions (MDIs). This is a special category fornew financial institutions, which will comprise a lower minimum capital andcapital adequacy and liquidity requirements geared at specialized institutions.

d) Credit-only NGOs, other non-deposit-taking institutions as well as very smallmember-based organizations (e.g. RoSCAs).

The categories a), b) and c) are proposed to be regulated under a special law,installing Bank of Uganda as a supervisory institution. Category d) institutions willbe left outside external regulation and shall rely on voluntary self-regulation.

Source: Bank of Uganda (1999)

Box 1

The Proposed Tiered Approach in Uganda

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Credit-only institutionsTable 5 summarizes the pros and cons put forward for the external reg-ulation of credit-only institutions4.

The previous chapters have outlined that the predominant rationales forexternal regulation of financial institutions are the implications of thedeposit-taking business. Proponents of external regulation of credit-onlyinstitutions put forward in many countries (finance companies forexample) are also regulated. These firms deal with institutional com-mercial fund providers and capital markets as their major fundingsources. Others accentuate setting standards for a new market segmenthelps fulfil a market development component of regulation. It wouldhelp ensure confidence by future depositors and investors. It may also beseen as a preparation phase, through which formerly unregulated enti-ties have to pull out, until being fully regulated, supervised and grantedfull deposit-taking permission. Exerting control over lending practices isanother reason offered for regulating credit-only institutions. This is

4 In the context of this discussion, however, the terminology is not uniformly used, withsome discussants defining as regulation all legal norms relevant to financial institutions(e.g. Meagher Mwiinga 1999), and others referring to prudential regulation as in ourterms external sources only (e.g. Vogel et al., 1999).

Table 5

Pros and Cons of regulating credit-only institutions

Pros

• Fulfilling a developmental promo-tion role: setting standards

• Preparation phase for institutionsto become deposit-takers

• Exerting control over otherwisenot sufficiently controlled entities

Cons

• High costs of supervision• Lack of capacity on the part of

supervisors• Primary focus should be on the

more risky financial institutions:deposit-takers

• Governments, donors, and finan-cial apexes can and should safe-guard their investments themselves

• Higher risk financial institutionscompensate investors with higherinterest rates, and thus have anincentive to limit the risksinvolved

• Danger of overregulation

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applies for example, for controls promoted in the name of consumerprotection.

However, a rather practical argument against the regulation of credit-only institutions is the high costs of the actual supervision process, andthe limited capacities of external supervisors in many developing coun-tries. Often it is simply not feasible to incorporate these institutions, anda prudent decision-making process with focus on opportunity costs andon regulatory need leads to concentration on the more risky or vulnera-ble group of deposit-taking financial institutions5.

As Rosales (1999) suggests, once regulation and supervision of smallentities becomes too costly, external regulation can at least ensureappropriate information flows to owners, depositors and commercialfund providers by enforcing uniform accounting standards and the qual-ity control of their application through qualified external auditors.

2.2 COSTS AND BENEFITS OF EXTERNAL REGULATION

The benefits external regulators intend to achieve by regulating financialinstitutions have been outlined. To compare costs and benefits of regu-lation, the costs of supervising external regulation need to be clearlyidentified. External regulation in itself has low costs, most of which aresunk costs of the introduction of new regulations. Supervision, whichfollows regulation however, is an expensive endeavour, and the morethoroughly it is implemented, the higher are the costs.

Costs and benefit considerations have to be made on the side of finan-cial institutions as well. Table 6 summarizes the major cost components,which provide the basis for an informal financial institution deciding totransform into a regulated entity.

5 In this context, it is important to reiterate that the point is prudential regulation. Thereis no doubt, that also credit-only institutions need to be embedded in a appropriatelegal framework for financial transactions, which ensures sufficient contract enforce-ment powers to lending institutions.

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It is important to bear in mind that while financial institutions do ben-efit from an appropriate external regulatory regime, there is not muchevidence that the existence of a regulatory jurisdiction makes institu-tions stronger and less prone to external (or internal fraud) shocks.Discussants on banking regulation generally agree the major role ofensuring safety, soundness and profitability of a financial institutionremains with managers and owners.

Recent studies in Bolivia have revealed that the process of formalizationincurred substantial costs for the Private Financial Funds (cf.Wiedmaier-Pfister and Monje, 1999). On average, establishing a PrivateFinancial Fund in Bolivia costs above US$ 700 000, excluding costs that

Table 6

Costs and benefits of external regulation and supervision for a financial institution

Costs

• Increased administrative costs(staff, paperwork, managementinformation systems, security)

• Reporting requirements produceregular and heavy workload

• Increased internal bureaucracy;boards, internal auditors etc., aswell as preparation of requiredmanuals

• Flexibility and speed of responsesto market developments decrease

• Minimum reserve requirementssoak liquidity

• Stricter provisioning may affectreported performance6

• Fees to be paid to the supervisor

Benefits

• Increased prestige and credibility • Possible access to deposits as

sources of funds from the public• Access to other funding sources

(financial apexes, financial mar-kets)

• Administrative and proceduralrigor: fraud prevention

• Organizational business culturepotentially increases efficiency

• Access to new and relevant infor-mation through credit informationbureaux

• Increased job security for staff ina formalized institution

Source: Compiled from Valenzuela and Young (1999) and Ramirez (1999)

6 The relevance of this cost category depends on the preregulatory provisioning of thefinancial institution. For example in the case of CARD Bank of the Philippines, provi-sioning requirements after transformation into a regulated entity were more lax thanthe internal regulations followed by CARD (Campion and White, 1999). Also, it hasto be clear that the concept of provisioning aims at anticipating probable losses on spe-cific assets. If these losses do not materialize, the earlier provisioning is offset by theearnings from interest and principal repayment. As a result, profits are only temporar-ily depressed by stricter provisioning requirements.

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were difficult to measure, such as training and staff development, oppor-tunity costs of the formalization process as well as the implicit costs ofa mandatory reserve requirement.

Who covers the costs of external supervision? Compliance costs aredirectly met by financial institutions, but who funds the supervisor forhis on-going supervision? This is solved differently across countries.Solutions range from a full coverage of supervisory costs funded by pub-lic budgets to coverage of large parts of the costs by the financial insti-tutions themselves. In the Bolivian system a substantial part of the bur-den of ongoing costs is covered through a few relating to the asset-sizeof the individual financial institutions. In a number of other countries,it is argued that the provision of a public good should be financedthrough public budgets.

2.3 LEGAL FRAMEWORK FOR EXTERNAL REGULATION

External regulation can take different forms. It usually consists of dif-ferent layers comprising laws, regulations, statutory notes and circulars.Some countries have one single general banking law, which tries toassemble all regulations, but still in most countries the operational issuesare left to statutory notes, circulars or even simply the routine decisionsof the supervisory institution. As an example, the study by Meagher andMwiinga (1999) on the Zambian laws affecting the provision of micro-finance by financial institutions comprises ten different Acts governingfinancial institutions directly or indirectly. In Bolivia, the circulars andnotes of the Superintendencia de Bancos that regulate Private FinancialFunds (FFP) are numerous.

General banking law vs. special lawsExternal regulatory norms are often scattered across disparate acts andlaws. Some institutional classifications are usually dealt with in a gener-al banking law, while others operate under specific laws. The rationaleof this division is that different institutional types for different purposesand products with different governance set-ups are allowed and regulat-ed.

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Many agricultural development banks operate under Land Reform Actsor other fixed purpose regulatory settings, whose stipulations vary con-siderably from the regulations for other financial institutions7. They aremostly also supervised by institutions outside commercial bank supervi-sion, such as Ministries of Agriculture or Finance. Box 2 provides anexample from Thailand, where recently the Bank for Agriculture andAgricultural Cooperatives (BAAC), as part of the financial sectorrestructuring following the recent East Asian financial crisis, hasswitched from a designated regulatory framework towards the generalbanking regulatory framework.

On the basis of one of the key principles of regulation described inSection 2.3, namely the establishment of level playing fields, non-differ-ential treatment of development banks and other financial intermedi-aries if conducting the same business is advocated.

Savings and credit cooperatives also operate under discrete laws in mostcountries. A survey of the governing laws throughout the world hasshown while these are specific cooperative laws, most nations do nothave corresponding regulations for those cooperatives involved in finan-cial intermediation (cf. WOCCU, 1993). As an example, the Hondurancooperative law sets the minimum capital at US$ 140 uniformly for agri-cultural production, marketing, and savings and credit cooperatives. Inaddition, many savings and credit cooperatives are being supervised bya specialized cooperative institution, often a registrar of cooperatives. Inmany cases, the institutions lack financial sector knowledge and restricttheir supervisory operations to auditing matters.

For agricultural development banks as for savings and credit coopera-tives, the detailed regulatory framework in most cases also results indetailed supervisory institutions distinct from the banking supervisor.

Levels of regulation, flexibility and innovationIt is important to distinguish the different levels of external regulation,as they entail a divergent scope for revision and adoption. The regula-tions analysed in the following sections are not always required at the

7 Examples include e.g. Agricultural Bank of Sudan, Agricultural Credit Corporation inJordan, Agricultural Development Bank Nepal, Agricultural Development BankPakistan, and Bank Pertania Malaysia.

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same legal level. The allocation of these rules differs from country tocountry. Some may lay down explicit qualification requirements in thegeneral banking law. Others may place these requirements on the levelof the superintendency’s circulars.

Where and in what form these rules are prescribed is not an arbitraryissue. Instead, prescribing in detail regulatory requirements in a law mayseriously hamper flexibility and innovation. As Christen and Rosenberg(2000) remark, regulation always includes to some degree “model build-ing”, which may restrict organizational and technological innovation8.Changing laws usually takes a lot of time. In the course of introducingreform, the contents originally intended may get lost or even reversed inthe policy-making and legislative process. Laws are usually passed byparliaments. Circulars and statutory notes in contrast are issued by cen-tral banks and specialized supervisory agencies themselves. Changingadministrative circulars usually is simpler and quicker if proven neces-sary.


The Bank for Agriculture and Agricultural Cooperatives (BAAC) is an agriculturaldevelopment bank, known worldwide for its success in providing financial servicesto rural smallholders throughout Thailand. Up to 1999, it has operated under a spe-cial law, which has put it under the surveillance of the Ministry of Finance. Recently,a shift towards the general banking supervision of Bank of Thailand has taken place.Currently, the institution is in a transition phase, which is expected to induce veryhigh costs due to the need to review the provisioning of loans. BAAC used a provi-sioning system in the past that reached a full provisioning of a delinquent loan after10 years only, sequentially writing off 10% of the loan principal in every year ofdelinquency. The general banking rules however require loans to be written off start-ing at 10% for a delinquency of 30 days. While consultations are still underway, sub-stantial losses and subsequently capital reduction are expected.

Box 2From Special Law to General Banking Law Regulation:

The Case of BAAC Thailand

8 As an example, many commentators have quoted the West African PARMEC law (cf.Berenbach and Churchill, 1998; Valenzuela and Young, 1999). The regulations stipu-lated by this law leave little flexibility for institutional forms. It also sets restrictiveinterest rate caps for the financial institutions, which hinder the profitability of the pro-vision of small loans especially in rural areas.

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2.4 REQUIREMENTS OF EXTERNAL REGULATION AND THEIR

IMPLICATIONS FOR AGRICULTURAL LENDING

Now it is time to examine pre-crisis (preventive) and post-crisis (protec-tive) measures usually taken by external regulators. Preventive regula-tion will be featured since post-crisis regulatory measures warrants inde-pendent study in a much more comprehensive framework of conceptsand practices of bank restructuring. Throughout the analysis, the detailsand requirements of agricultural lending will be highlighted. Also,potential areas of restrictive regulation will be delineated.

2.4.1 Preventive Regulation: Entry Requirements

Clear and appropriate definition of the entry requirements help assurethat only financially healthy institutions join the marketplace. Financialinstitutions with flawed governance and organizational structures, staffquality, portfolio quality or other deficiencies should not enter the mar-ket. This is one of the most powerful preventive measures an externalregulator can stipulate.

Minimum capital requirementsMinimum capital requirements for financial institutions are set to ensurethat sufficient capital is available to absorb financial shocks. Capitalrequirements also should be designed to shield the institution frombecoming a captive of bad debtors. Also, minimum capital requirementsare a commitment of the owners’ own risk resources which may be lostin the event of that the bank makes bad loans.

Minimum capital requirements vary substantially from country to coun-try. Lately, proposals to lower minimum capital requirements have beenentertained for small financial institutions involved in microfinance.Low entry capital proposals for institutions that target microfinanceoperations range worldwide from US$25 000 to US$250 000.

Concentration at the lower end and lower entry requirements are foundin Africa and South-East Asia (Valenzuela and Young 1999).

Considerations in this regard should balance the necessity to provide forstrong owners with substantial capital at stake as well as a safety net for

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the financial business of the institution on the one hand, and a non-restrictive entry opportunity on the other. In the context of agriculturallending it is important to bear in mind that for innovative lending,which extends the limits of traditional formal financial intermediation,a strong equity base should be required. Very low entry capital require-ments are unlikely to create strong enough institutions that can weatherexternal shocks and business downturns. Very low entry barriers canalso potentially overburden the supervisory institution with a myriad ofsmall institutions (see Section 2.5.5 on costs of supervision).

As an example, there are 2 420 People’s Credit Banks (Bank PerkreditanRakyat, BPR) in Indonesia today, out of which many have difficulties incompeting with commercial banks in their rural, periurban and urbantarget areas. This has resulted in substantial 37% non-performing loansin the loan portfolio of these institutions. In order to provide a disin-centive for the establishment of new BPRs, minimum capital require-ments have recently been increased from US$7 100 to US$71 000 (BankIndonesia/GTZ, 1999).

OwnersOwnership requirements are intended to promote strong owners. Theyare to provide that all owners operate in the best interests of the institu-tion (mission compatibility), and second, that members of governingbodies make all efforts to be fully informed about the institution’s activ-ities and performance (internal regulation).

In financial institutions that specialize in new or niche market segments,such as microfinance or agricultural lending, one success factor are lead-ers that provide a clear vision of serving this yet untapped target mar-kets prudentially. Owners need to be in full support of such a strategicvision. Not only do good owners bring a good financial background butalso prove to have an unclouded strategic concept for the institution.The absence of owners committed to financial performance, or a major-ity of socially oriented owners who intend to stress outreach at theexpense of sustainability may prove dangerous.

In Bolivia, natural persons are required as at least minority sharehold-ers. The transformation of a group of NGOs into a joint PrivateFinancial Fund has recently been delayed by one and a half years, asthere were no owners other than the NGOs. Honduras fully requires

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natural persons as shareholders of financial institutions. In Uganda, nat-ural or institutional owners have to be of Ugandan nationality. Kenyanbanking regulations limit the ownership percentage of a single investorto 25% unless it is a commercial bank.

Governance structure and institutional typeMany regulators require a formal financial intermediary to be a share-holding company in order to ensure owners with capital at stake and anincentive for active monitoring. In addition, savings and credit coopera-tives with members holding shares are usually permitted. Apart fromthese, governmental intermediaries are often allowed to operate withoutown capital resources apart from retained earnings. However, some gov-ernments have converted for example agricultural development banksinto shareholding companies, where government holds a majority share.

The requirement of transformation into a shareholding company maypose a serious challenge for NGOs. NGOs do not have real (holdingcapital) owners and are mostly management driven. They do not pos-sess equity conforming to capital with voting rights. Their institutionalcapital consists of retained earnings and donor grants. Problems forNGOs in transforming into a formal financial entity are described indetail elsewhere (see Campiong and White, 1999). This case will notbe analysed here, as they do not pertain to agricultural lenders.

Feasibility studiesTo assess the suitability of the new entrant into the formal financial mar-ket, customarily a detailed feasibility study is required. Detailed institu-tional information and a comprehensive business plan are components.Also, these studies are usually part of the initial evaluation of the finan-cial institution. By designing these feasibility studies, they demonstratethe capability to plan strategically. Box 3 summarizes the requirementsfor feasibility studies of Private Financial Funds (FFP) in Bolivia.

For agricultural lenders similar to financial institutions targeting othersectors, feasibility studies should include a clear strategy for attendingthis market segment. On-site, external supervisors will have to checktechnologies and management techniques as well as prior experience,which ensure an appropriate cost and risk management of an agricul-tural loan portfolio. The supervisors will be in a position to be able to

28

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judge qualitatively whether the applicant institution is prepared for serv-ing this market segment with its specific risk profile.

2.4.2 Preventive Regulation: Ongoing Requirements

Typically, banking regulation puts into place a set of requirements thatconstitutes a set of external regulatory rules (see Table 7).

Capital to asset ratios and loan portfolio classificationCapital to asset ratios are a key instrument of banking regulationthroughout the world. The rationale behind this instrument is based onthe argument that assets need to be sufficiently backed by a financialinstitution’s equity in order to be able to cushion the risks of loss. Risksthat are determinable such as reductions in the value of assets in the loanportfolio are to be covered by specific and general loan loss provision.

29

In Bolivia, a new regulatory framework for small financial institutions (FondosFinancieros Privados FFP = Private Financial Funds) was introduced in 1993. Whilethe first microfinance institution to become regulated, BancoSol, operates under anormal banking license, other former NGOs are now converting into FFPs.

To become a licensed FFP, a detailed economic feasibility study has to be carried outand submitted to the Superintendency of Banks. The Superintendency then embarkson off-site and on-site evaluation of the study submitted. The feasibility study isexpected to comprise sections on the economic, legal and political environment, thefinancial system, the market segments targeted, the expected economic impact offinancial service provision to these segments and the competition expected. It mustinclude a description of the financial products demanded by the targeted market seg-ment as well as the financial products to be provided, the prior institutional experi-ence, the designated shareholders, organizational structure and management’s quali-fication. In addition, information on management information systems and the phys-ical security situation must be provided. Finally, financial projections that reflect theabove aspects must be presented.

Once the feasibility study satisfies these criteria, it is cross-checked on-site by theSuperintendency’s bank examiners. Depending on the adjustments needed andrequirements set by the bank examiner’s team, the process of licensing has taken upto two years. In most cases, donors have financially and technically supported thepreparation of these comprehensive feasibility studies.

Source: Evaluation manual of the SBEF, 1999

Box 3Comprehensive Feasibility Studies as Entry Requirementin Bolivia

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Capital requirements address unpredictable changes in the economic orcompetitive environment9.

Putting substantial amounts of equity investments at the disposal of thefinancial institution’s asset and liability management capabilities, helpsensure strong owners, that are interested in the profitability and effi-ciency of the institution. Thus, an optimum relation between capital andasset should ensure the safety of the financial intermediation process,while at the same time it should not impose excessive costs on the finan-cial institution10.

The recommendations of the Basle Accord in 1988 have specified a cap-ital-to-weighted-assets ratio of 8% for this purpose. Assets are weightedaccording to their relative risks. And capital is divided into two differ-ent tiers, reflecting their loss risk cushion capabilities. Asset qualifica-tions range from 0 to 100%, with cash ranging at 0, mortgage securedloans at 50% and fixed assets and real estate as well as all remainingloans at 100%11.

30


9 For a discussion of capital definitions and capital adequacy requirements see Barltropand McNaughton (1992). For an in-depth discussion of the 1988 Basle Accord’s detailssee e.g. Dewatripont and Tirole (1994).

10 Due to the leverage effect, higher capital-to-asset ratios decrease the profitability ofcapital.

11 An intensive discussion of the 1988 Basle Accord is underway. (see Basle Committee,1999).

Table 7

Ongoing requirements in banking regulation

• Capital to asset ratios (CAR)• Loan portfolio classification• Liquidity management• Credit risk management require-

ments, e.g. limits on portfolioconcentration and lending restric-tions

• Provisioning and write-off policies• Product restrictions

• Credit bureau requirements• Product restrictions• Branching regulations• Internal control requirements• Qualification requirements• Reporting requirements• Change notifications

On-going requirements

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The other side of the coin is the definition of capital. The Basle Accorddefined two tiers of capital, namely core capital (Tier One) and supple-mentary capital (Tier Two). Tier Two capital cannot exceed Tier Onecapital, and long term subordinated debt as well as shares optionallyredeemable by the issuer cannot exceed half of Tier One capital. Thishierarchy reflects the degree to which capital is explicit and permanent.

The definition of capital becomes difficult in case of heavy donorinvolvement. Is it advisable to account for donor grants as capital? Oneof the basic considerations behind the capital-to-asset-ratio is to ensurethat sufficient capital is available to cushion the risks from the asset sideof a financial institution’s balance sheet. But heavy capital involvementalso ensures that owners whose capital is at stake keep strong controlover the business. Donors, however, are rather lenient owners, that usu-ally do not have, or do not process in an adequate and timely mannerfirst-hand information provided to them. Accordingly, donor grantsshould be valued at a lower ratio than other capital sources. The sameapplies to equity provided by governments directly or through stateguarantees.

Generally, the validity of reported capital relies considerably on accurateprovisioning. As an example, in agricultural development banks theamount of equity is often heavily overstated or misleading, since manybanks do not account for loan loss provisions in a proper manner.

The institutional form of savings and credit cooperatives poses specificobstacles in calculating capital. Member shares are redeemable, and theextraction of shares by many members can potentially become a threatto the equity base. Accordingly, the World Council of Credit Unions(WOCCU) recommends that only institutional capital is taken intoaccount when calculating capital adequacy (Richardson, 2000).Institutional capital is the part of retained earnings of earlier years thatis not redeemable.

Financial institutions with a loan portfolio concentrated in the agricul-tural sector can quickly accumulate arrears in bad agricultural years.Especially, if agricultural producers concentrate on the same lines ofproducts, or the volatility of yields of the different products is interre-lated, arrears may be accompanied by a decrease in deposit base. In this

31

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circumstance, having a strong capital position at the outset is essentialfor the financial institution to be able to absorb liquidity shortfalls andpossibly access fresh borrowing from other financial institutions, gov-ernment, donors or commercial fund providers.

But how can the capital-to-asset-ratio be adjusted to the conditions ofagricultural finance in developing countries? For developing countries ahigher capital adequacy rate than 8% has been proposed to cushion thespecific risks of narrow and volatile financial systems and for microfi-nance providers in particular to buffer the danger of rapidly deteriorat-ing short term credit portfolios (see Jansson 1997; Berenbach andChurchill 1997).

However, when looking at changing regulatory regimes in this regard, itis important to look at the three options for adjusting capital-to-asset-ratios to high-risk environments (overall financial system, macroeco-nomic environment or the sectoral concentration of loan portfolios).First, the overall ratio can be set higher. Second, one can adjust the riskweighting of those assets that carry a higher degree of risk. Third, onecan adjust the capital definition12.

Loans to agricultural producers may be generally classified as higherrisk, requiring a higher degree of capital coverage. One could classifythese at a percentage of above 100% in the asset qualification for thecapital-to-asset ratio. Automatically, for these parts of the loan portfo-lio, a higher capital coverage would be required. The following exam-ples demonstrates the effects of such a differentiation in comparing theresulting minimum capital requirements of a diversified and a highlyspecialized agricultural lender.

32

12 The Basle recommendations of 1988 followed the second path by differentiatingbetween loans to OECD and non-OECD public sector entities in risk weighting, tak-ing into account the instability of financial systems and macroeconomic situation ofnon-OECD countries. In the recent Consultative Paper of the Basle Committee on areform of the capital adequacy framework, a sophistication of these risk weightings isproposed (Basle Commitee 1999). One of the proposals is to utilize market rating agen-cies for the valuation of asset risks. Another proposal is to allow for the flexible settingof capital-to-asset-ratios by supervisory agencies based on their qualitative evaluationof methods and techniques applied as well as other characteristics of the financial insti-tution. These new proposals are based on the experience with the Basle Accord’s guide-lines as being in some cases counterproductive and too inflexible.

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The process of classification in practice may prove complex. Taking intoaccount the fungibility of money in farm households with a diversifiedincome structure including non-farm economic activities there may notbe a clear-cut definition of agricultural loans. A phenomenon of struc-tural arbitrage might occur with financial institutions by declaring agri-cultural loans as financing the off-farm activities of a farm household.This would then imply switching the classification and risk weightingfrom above 100% to 100%13.

Another option to be considered would be the risk-weighting of loanportfolio assets according to past repayment performance. One couldrequire a higher degree of capital coverage for institutions with contin-uously greater delinquency rates. In Argentina, interest rates and under-lying guarantees are used to classify the loan portfolio (see Box 4).

The result of assigning agricultural loans to a higher risk category wouldresult in an increase in costs of agricultural lending, as it decreases thepossible financial leverage of a financial institution. While this may

33

13 Kane defines the term “structural arbitrage” as follows: “Structural arbitrage occurswhen a firm improves its regulatory climate by substituting new or differently regulat-ed products, processes, and organizational forms for existing ones” (Kane 1988).

Example 1:Diversified agricultural lender

Cash 0% 100 0Regular Loans 125% 1 000 1 000Housing Loans 70% 1 000 700Agricultural Loans 125% 1 000 1 250

Total 2 950

Minimum capital adequacy required(8% of 2 950) would be 236.

Ris

k W

eigh

tAssets

Ass

et V

alue

Wei

ghte

d A

sset

Val

ue

Example 2:More specialized agricultural lender

Cash 0% 100 0Regular Loans 100% 1 000 1 000Housing Loans 70% 0 0Agricultural Loans 125% 2 000 2 500

Total 3 500

Minimum capital adequacy required(8% of 3 500) would be 280.

Ris

k W

eigh

t

Assets

Ass

et V

alue

Wei

ghte

d A

sset

Val

ue

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appear not desirable from a developmental perspective, the risk-basedview of a regulator may deem this appropriate.

Generally it has to be borne in mind that a differentiated risk categorysystem may within theoretical considerations provide better solutions tothe challenges of adequate capital coverage of risk lending. Reality maylook different. The process of classification creates additional costs,which have to be weighed against the benefits of differentiation. Also,these regulations form part of the agenda of supervisors, and mayenlarge their workload (and thus costs) substantially. Decisions on thistopic will have to be made on a case-by-case basis after an in-depthanalysis of costs and benefits (see Section 2.5.5).

Liquidity managementLiquidity problems are often early signals of bank failure. Many bankregulators ask for various liquidity ratios of supervised institutions tomonitor assets. To meet cash and withdrawal needs of the clients, com-mercial banks usually have to maintain minimum liquid assets. Theseliquid assets normally comprise between 5 and 10% of total deposit lia-bilities in cash and bank deposits, along with another 10 to 15% of trea-sury bills, short term government securities or other assets which can bereadily sold (cf. Sheng 1990).

Financial institutions that mobilize savings and lend in rural contextsface very particular liquidity issues. Regions dominated by agricultural

34

Argentine bank regulators have developed a complex system of calculating riskweights of loan portfolios. Minimum capital requirements for a loan depend on theoverall rating of the bank from the Central Bank, one risk factor based on the inter-est rate applied, another risk factor based on the underlying guarantee and a lever-age coefficient of 0.115 (above Basle requirements of 0.08). The interest rate risk fac-tor ranges from 1.00 to 6.00, reflecting the assumption, that higher interest ratesimply higher risks. The risk factor for guarantees distinguishes five categories, whichare grouped according to possibility of loan amount recovery.

Sources: Schreiner (1999), Jansson (1997)

Box 4Differentiated Risk Weighting: The Case of Argentina

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production face seasonal cash flow fluctuations. They face covariate cli-mate risks and seasonality effects that impact on a financial intermedi-ary lending together with savings business. A broad coverage of diverseregions and/or access to a liquidity pool can help mitigate these liquidi-ty risks. In any case, a sophisticated liquidity management system needsto be in place to prompt due action on the part of senior management.In addition, agricultural lenders that hold a substantial exposure to for-eign exchange risks due to international refinancing should be requiredto keep higher liquidity levels.

These factors indicate that banks with substantial agricultural loanportfolios may need higher liquidity ratios. Access to interregional liq-uidity pools and sufficient refinancing opportunities in cases of liquidi-ty crunches are of utmost importance for agricultural lenders. Thesearrangements may either be formalized as stand-by agreements ormade on an ad hoc basis based on trust affiliations to other financialentities, national and international apexes as well as (possibly) donors.This qualitative aspect has strong implications for supervision, whichshould assess not only static liquidity ratios, but also prospectiveopportunities for accessing liquidity.

Credit risk managementDocumentation and collateral requirements are part of requiring appro-priate credit risk management in financial institutions. In rural financialmarkets, collateral in many cases may be successfully substituted orcomplemented with co-signing, group joint liability arrangementsand/or the pledging of non-traditional banking collateral such as mov-able assets. In a static way, the appropriateness of credit risk is reflectedin the repayment performance of a loan portfolio as well as portfolio-at-risk calculations. However, the capacity to manage agricultural lendingmethodologies requires management qualifications and capacities aswell as sophisticated management information systems.

Qualitative evaluations of credit risk management systems, however, arevery seldom required and in place. Sector expertise is usually requiredfor attending certain client markets. Agricultural lending is one suchcase. Again, a qualitative assessment of active credit risk managementcapabilities requires supervisors who are directly familiar with agricul-tural lending.

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Most developing countries allow banks to determine how loans are allo-cated across sectors. In some, however, priority groups (small entrepre-neurs) and/or priority sectors are subject to prescribed minimum lendingrequirements (India, Colombia, South Korea, and Venezuela). Lendingrestrictions at times restrict the extent to which financial institutions canlend to specific sectors. While it can be argued that sectoral diversifica-tion is one of the key risk management tools for successful agriculturallenders (cf. Klein et al., 1999); setting fixed percentages by an externalregulator seems neither necessary nor opportune. As an example, a 20%portion of the loan portfolio concentrated in loans to producers of onesingle product only faces considerably higher and covariant default risk,than a 20% portion of agricultural loans to well diversified clients withincome from various agricultural products as well as non-agriculturalsources. Rather, financial institutions themselves should decide on theextent of their involvement in the agricultural sector. Supervisors ofexternal regulation should rather monitor and evaluate the effectivenessof a particular institution’s risk management system.

In many countries, insider lending or lending to staff members and own-ers of a financial institution is restricted. This is an important part oflimiting the opportunity for fraud and corruption within a financialinstitution. Also, the loan amount that can be lent to a single client isoften restricted to encourage portfolio diversification. Both issues how-ever are not specific to agricultural lending.

Among many nations, banking laws specify a maximum percentage ofunsecured loans expressed in traditional bank collateral. If this percent-age is exceeded, loans must be fully provisioned. As smaller agricultur-al loans may well be awarded on the basis of character-assessments andcollateral substitutes, this can pose severe restrictions on the extent for-mal intermediaries can provide these loans. It appears advisable to makeadjustments accordingly. This path has been taken for example by theBolivian authorities, which have recently introduced the expanded term“appropriately guaranteed” for loans, which includes non-traditionalcollateral.

Provisioning and write-off policiesProvisioning requirements are designed to ensure that the real value ofa loan portfolio is reflected in the balance sheet. This implies that an

36

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appropriate part of the loan amount and interest outstanding is written-off when recovery is improbable. While general risks of banking are tobe covered by capital adequacy, provisions should cover specific risks ofidentified potential losses

Apart from individual loan provisioning, many countries require a glob-al provisioning of usually 1-3%, which is supposed to reflect the resid-ual credit risk remaining even for healthy portfolios.

Loan provisioning is usually based on factors such as collateral values,guarantees, repayment track record and days past due. Some regulatorshave defined different loan categories, with resulting differentiated pro-visioning requirements. As an example, Table 8 lists provisioningrequirements for two of the loan categories relevant for agriculturalloans in Bolivia.

The specific provisions for microcredits in Bolivia are based on the con-sideration that these usually do not involve physical collateral or tradi-tional bank collateral, which can be easily enforced legally. Microcreditdecisions are usually based on character, group solidarity or cosigning ofguarantors and past repayment history. As case-by-case loan reviews areimpractical and too costly for a myriad of small loans, and managementdiscretion should be limited to ensure uniform classification, standard-ized procedures for portfolio provisioning are proposed (see Berenbachand Churchill, 1997). Such standardized procedures are applied in thepreviously mentioned Bolivian case14.

In collateral-based lending it may appear more appropriate to use onlythe amount of the loan not covered by the collateral as a basis for pro-visioning. However, in weak legal environments, lack of enforcementpossibilities or lengthy legal processes towards collateral realization sub-stantially decrease the actual net present value of collateral pledged. Inmost developing countries collateral fulfils more an incentive and

37

14 For a more in-depth discussion of the Bolivian case see Fiebig (2000). Generally itshould be noted that delinquency rates are influenced heavily by the rescheduling poli-cies of financial institutions. If loans become overdue, for example as a result of a badharvest, and are rescheduled or refinanced quickly, delinquency rates may not reflectunderlying default risk.

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hostage function than providing a substitute for loan repayment(Hawkins and Turner, 1999).15

38

Table 8

Loan Categories in Bolivia

Definition for“commercial credit”

Payment in order,repayment capacityfor overall loans toall creditor sufficient

Payments late to atleast one creditorwhich affects repay-ment capacity

Financial weakness-es which could influ-ence repaymentcapacity for loans tocreditors

Difficult financialsituation with insuf-ficient cash flow tosatisfy creditors indue time

Insolvency of debtor

Definition formicrocredit

Payment late up to5 days

Payment late6-30 days

Payment late31-60 days orreprogrammed loans

Payment late61-90 days or loansreprogrammed twice

Payment late morethan 90 days orloans reprogrammedmore than twice

Categories

Categories

Normal

Potentialproblems

Deficient

QuestionableLost

Provisions(principal)

1%

5%

20%

50%

100%

15 It still remains open to further investigation whether lending to groups as opposed tolending to individuals generally requires a differential treatment as regards risk evalu-ation and provisioning.

The category of commercial loans is a residual loan category for all loans that do notfall under the specific categories for e.g. hypothecary credit, consumption credit andmicrocredit regulations. A commercial loan needs to be re-evaluated every six monthsaccording to qualitative risk categories. This category requires substantial documen-tation of every single loan, which makes it an option if the loan portfolio consists ofa large amount of small loans with unconventional collateral.

Source: Circular of Superintendency, SB/291/99, June 1999

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For agricultural loans, which usually have longer terms than microcred-it and often have lump sum repayment installments, the provisioningaccording to the days past due of the latest repayment is obviously inap-propriate. For example, a two-year loan to a farmer, with a lump sumrepayment at the end of the period requires an evaluation before theamount becomes overdue. Also, late payment of loans for agriculturalproduction may well be due to a belated harvest season, an argumenturban traders cannot put forward. The default risk in agriculture is notnecessarily altered by a few days of lateness. Laxness in agriculturallending is not advocated, but a certain degree of flexibility on the partof the lender is required to deal with the external shocks characteristicof the agricultural sector. As a result, a differential treatment of longerterm and production or investment oriented credit as opposed to shortterm working capital loans should be considered.

Product restrictionsMany countries use restrictions on the range of products offered as ameasure to reduce vulnerability of financial institutions. Often, where aspecific regulatory framework for small financial intermediaries hasbeen created, these entities cannot mobilize deposits from the publicright from the start. Others, such as savings and credit cooperatives arenot allowed to mobilize savings from non-members at all or, in somecases, unless they subscribe to central bank supervision.

For agricultural lenders it has to be ensured that a diversity of financialproducts does not lead to an accumulation of risks. An approach, whichlimits the exposure of financial institutions to few financial productswith a uniform risk profile, appears to be prudent. In the Bolivian exam-ple, Private Financial Funds (PFF) are not allowed to offer credit cardsor foreign exchange services. Microcredit operations are expected to behigher risk and vulnerable business, with very definite requirements asregards policies and procedures of a Private Financial Fund (PFF).

As part of change notification requirements, offering new products oftenrequires a separate license from the supervisory institution. Requiringdetailed and well-founded feasibility studies (including demand estima-tions) for operating new products appears to is a prudent approach tobalance flexibility and diversification of products offered with the addi-

39

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tional risks involved in introducing new and unfamiliar product lines. Itcan however impose excessive paperwork, which stifles innovation.

Credit information bureausCredit information bureaus operate as an information source forlenders’ loan appraisal. In many developed countries, the provision ofinformation on the loan portfolio is a regulatory requirement. Often,also a cross-check with this database is prescribed for loan appraisalprocedures.

In rural contexts, meagre or inconsistent national identification systemsmay pose a serious problem to the effectiveness of this regulatory instru-ment. Borrowers may then easily use different names to avoid docu-mentation of their past repayment behaviour. In addition, if non-formalcompetitors, such as NGOs, work in the same areas, identification ofmultiple borrowing becomes difficult. While incorporation of non-regu-lated institutions appears desirable, the assurance of uniform loan doc-umentation and classification systems as well as the willingness of thenon-formal competitors to reveal their full portfolio may representsevere restrictions.

BranchingIn many countries, specialized supervisory agencies’ approval is neces-sary prior to opening a new branch. Sometimes hours of operation arealso set. The background of these regulations is to establish a competi-tive level playing field. However, these regulations may prove limiting ifbranches are required to be opened on a full-time basis, or in any caseneed to be in a solidly constructed building. Mobile banking units andpart-time branches are important tools to decrease the operational costsimplied by rural financial intermediation.

The requirement of full branches may increase potential costs toextremes where formal intermediaries find the opening of a new branchnot cost-covering in due time. But branching regulations can also be animportant part of limiting risks. The requirements of a well-preparedmarket analysis and feasibility study, specifically on costs may helpensure that branching is carried out on a prudent basis.

Branching regulations may include a restriction to certain geographicareas. For example, the Indonesian and the Philippine Rural Banks are

40

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confined to a municipality or subdistrict. The Municipal Savings Banksin Peru have also long been restricted to operating in one municipalityonly. Reasons for this are, again, the restriction of competition betweeninstitutions of this type and a strong bond to a specific region’s popula-tion. However, this may severely restrict the opportunities for portfoliodiversification and lead to a greater sensitivity to external shocks.Diversified agricultural lending may prove difficult under these circum-stances.

The requirements of internal auditing and risk identification mecha-nisms and staff qualification will be handled in Section 3.3.

Loan documentation requirementsIn many cases, external regulation specifies the documents each loanfolder should contain. In agricultural lending, and more generally inrural lending as in microfinance the documentation required oftenproves excessive and/or irrelevant. In these specific financial businesses,prudent loan decisions are much more oriented at a character basedassessment, or they even leave most of the loan decisions to self-select-ing joint liability groups. Often, this is a major regulatory challenge formicrofinance and rural finance.16

A specific loan documentation requirement, which may prove difficultfor rural financial institutions to meet, is a national identification num-ber for all customers. Rural borrowers may not have this identification,and the application for these numbers may be lengthy, and only avail-able in the far away major cities.

Reporting requirementsReporting requirements are the foundation for supervision. Usually,these requirements comprise topics and sets of data to be provided on adaily, weekly, monthly or yearly basis. Reports on loan portfolios areoften required on a loan by loan basis. For institutions with a high num-ber of small loans in their portfolios, this reporting requirement can beburdensome unless full computerization of loan operations and a directelectronic data connection to the supervisory institution is available.

41

16 This issue is not discussed here in extenso, as others have well documented the prob-lems various financial institutions have faced with these circumstance (see e.g.Berenbach and Churchill, 1999).

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In rural areas, reporting portfolio status or other data to the superviso-ry agency on a daily basis is expensive if not impossible. Lack of infra-structure, i.e. roads, telephones and computers on the one hand maymake daily reporting difficult Manual operations additionally increaseproblems in reporting with high frequency.

There are different ways of tackling this problem. One can be the relax-ation of centralized reporting requirements with delegation of data col-lection to the financial institution itself. External supervisors could thencheck consolidated data and, on a random on-site basis, the internalreporting to financial institutions’ regional offices. Also, reportingrequirements may well be tiered according to size of the loan and typeof loan, triggering a more detailed reporting of larger loans and loansgranted e.g. without traditional collateral.17

Change notification requirementsChange notification requirements are providing external supervisorswith important information on relevant changes in the regulated finan-cial institution. Key areas of notification usually are ownership, gover-nance structure, top management, computer systems and the introduc-tion of new products. Agricultural lenders do not pose specific issues forthese requirements.

2.4.3 Protective Regulation

Protective regulation refers to rules and regulations that address post-crisis situations. Protective measures complement preventive measures inorder to address potential moral hazard on the part of regulated finan-cial institutions. They comprise deposit insurance schemes, access to alender of last resort, as well as the formalized process of bank restruc-turing and reform.

Deposit insuranceDeposit insurance schemes ensure that depositors’ claims will still beserved once a financial institution has gone bankrupt. This reflects the

42

17 In Bolivia, this is a key entry point for donor support of formal rural financial inter-mediation. As of August 1999, various donors supported the venturing of PrivateFinancial Funds (PFF) into rural areas by providing grants for the computer andtelecommunications equipment needed for regular, partly daily reporting to the super-intendency.

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prime regulatory aim of protecting depositors. Deposit insuranceschemes vary in concepts.18 While specific regulations are often set inthe banking law, in most countries, an implicit insurance by governmenttops up or substitutes for formalized insurance. The schemes can also berun either by a public entity or private insurers. Many insuranceschemes do not cover all deposits but rather concentrate on insuringsmaller savers. Deposit insurance by cooperative federations often isdesigned as an “institutional guarantee”, which covers all liabilities of afailing cooperative.

A major problem of deposit insurance schemes is adverse incentives.While they are intended to address the limited capacities of depositorsto assess a financial institution’s solvency, an extended coverage ofpotential losses not only builds confidence, but also provides a disin-centive for market control of the financial institution. There is also adanger of adverse incentives for financial institutions. If premiums arenot set on a risk-assessment basis, lower risk institution implicitly sub-sidize high-risk institutions. Financial institutions may be attracted tohigher risk activities if assuming high risks does not result in propor-tionately greater insurance costs and if losses must only be covered par-tially.

Lender of last resortIf severe liquidity problems occur in a financial institution, which do notreflect a fundamental solvency problem, lenders of last resort step in.The central bank implicitly or explicitly plays this role. Distinguishingfinancial institutions with liquidity problems from insolvent institutions,however, is a difficult task, which in the case of agricultural lender maycoincide with high political pressure to rescue the institution. Also, “toobig to fail” considerations of substantial financial market reactions willhave to be taken into account. Decision-makers need to balance reasonsfor institutional guarantees (e.g. the danger of a continuous creditcrunch) with the regulatory aim of ensuring a competitive market struc-ture, which implies that inefficient institutions cannot be sustained in thelong run.

43

18 See Ketcha (1999) and Holway Garcia (1998) for a brief overview.

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2.5 EXTERNAL SUPERVISION

The supervision of external regulation is usually entitled to centralbanks or specialized supervisory agencies. In some countries, specifical-ly designated auditors and consultancy firms carry out all or part of thesupervisory workload. From the start it must be clear that in every spe-cific country context, an evaluation of the overall strengths and weak-nesses of banking supervision in the context of agricultural financeneeds to be performed, before reform action can be taken. It is surpris-ing, that in some cases, the design of and ambitious regulatory reformsdoes not seem to specifically evaluate the capacities of supervisory insti-tutions.19

2.5.1 Requirements for an External Supervisor

Supervisors are critical to the effectiveness of regulation. They need tofulfil some basic requirements as shown in Table 9.

In practice, banking supervisors in developing countries do not fulfilmany of these requirements. Out of 20 classified countries in sub-Saharan Africa, only three have been rated for providing a well-designedand effective system with supervisory authority amply supported at thepolitical level (cf. Mehran et al., 1998).

2.5.2 Audits as Information Base for Supervision

“It is premature to discuss bank supervision if audits are notdone properly.” (Berenbach and Churchill, 1997)

As a basis for prudential external supervision, appropriate, accurate andtimely information on financial status, accounting, internal proceduresis needed. Generally, clear accounting rules, enforced by external audi-tors are likely to make on-site and off-site supervisory work more even-

44

19 Vogel et al., (1999) also request further research e.g. in the area of supervisory proce-dures. The above is reconfirmed by a report by Meagher and Mwiinga (1999), whodevelop a comprehensive reform concept for banking legislation in Zambia withouttaking into account supervisory institutions and their qualifications and capacities.

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ly applicable and errors and weaknesses more easily identifiable(Mehran et al., 1998).

Typically, accounting standards are not in place or not enforced. Thequality of external auditing firms varies a great deal and cost consider-ations may lead to an erroneous selection of firms by financial institu-tions. Often, external auditors cannot be held accountable for the qual-ity of their reports. Auditors are liable only to a very limited extent. Inaddition, the task of auditing small rural financial institutions is oftenassigned to junior auditing firm staff, as these are not major businesspartners of the firms.

At the same time, the specific auditing requirements in rural financialinstitutions differ from traditional bank auditing. From a technical per-spective, lending with unconventional collateral “throws auditing off-balance” (Jackelen, 1998). Loan portfolio asset evaluation cannot besufficiently carried out by checking loan documentation, but insteadwarrants a qualitative assessment of collateral substitutes. Specificallyfor agricultural loans, off-balance evaluation of asset quality is required,as described above.

External audits can provide important insights into financial institu-tions, which for supervisors are difficult and costly to obtain. Close con-tact between supervisors and auditors seems imperative. In some coun-tries, supervisors even have the right to approve or disapprove auditorsfor banks, in order to ensure experience, resources and skills necessary

45

Table 9

Supervisory agencies should have...

• Capital to asset ratios (CAR)• Clear objectives and responsibilities• Good information basis• Appropriate supervisory tools• Staff capacity (qualitative and quantitative)• Sufficient funding (cost-benefits considerations, cost-sharing)• Operational independence and credibility• Enforcement/sanctioning power

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on the side of the auditors.20 Changes of auditors may also have to beindicated, and reasons given for to supervisors. Coordination betweenthese appears desirable also in order to decrease the costs of financialinstitutions themselves in hosting and satisfying information needs ofexternal auditors and external supervisors on a regular basis.

Apart from external auditors, internal audit departments play a majorrole in providing a secured information base for external supervisors.They are also one of the primary sources for on-site examinations byexternal supervisors. A qualitative assessment of the effectiveness ofthese mechanisms, as well as evaluation of the follow-up on problemsdetected by internal auditors should form part of external supervision.

The Revisoría Fiscal of Colombia provides an example of a mixture ofinternal and external auditor functions and a direct connection to banksupervision (see Box 5).

The actual quality of external and internal auditing is often limited.Bank examiners in developing countries often have to turn to reviewingauditing first, before a risk-based evaluation and more qualitativeassessment can take place. Lack of auditing quality also seriouslyimpedes the quality of off-site data analysis. Increased need for on-siteexaminations, in turn, increases the costs of supervision.

2.5.3 Supervisory Approaches and Tools

Approaches towards supervision of financial intermediation are cur-rently in a process of change worldwide. As reflected in the recent pro-posal of the Basle Committee on Banking Supervision (1999) for a newcapital adequacy framework, a re-orientation of banking supervisiontowards qualitative and risk-based assessment of methodologies, tech-nologies and tools applied is underway. Table 10 outlines the aspects ofthis emerging new view of banking supervision.

46

20 In Germany, the Federal Bank Supervisory Office uses auditing companies for spotchecks in banks. A prerequisite for an auditing company to qualify for spot checkaudits is that it has not performed the regular audit for the same bank. For cooperativebanks, specialized cooperative auditing federations carry out the auditing. They areexpected to have in-depth knowledge of the specific features of the German savings andcredit cooperatives.

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Static approach vs. dynamic approachA static approach towards supervision concentrates on historical andcurrent data provided by the financial institution. A dynamic approach

47

The Revisoría Fiscal is an obligatory external control mechanism of financial institu-tions in Colombia. The role of the Revisoría Fiscal is defined by the Constitution,detailed in the Commercial Law and further related to the financial sector by Law 45of 1990. It is established as an institution that monitors financial institutions in theinterests of their owners.

The Revisoría Fiscal is a mixture of an internal and an external auditor. Its work isof a permanent nature and covers all functional areas of the financial institution. Itis an independent institution, which informs the Superintendency of Banks on irreg-ularities and works closely together with the internal auditing departments of thebanks. It has access to daily correspondence and internal communication and carriesout on-site inspections to evaluate the physical infrastructure and the application ofprocedures. It reviews and signs all documentation presented to the Superintendencyof Banks. It also submits a special report to the Board of Administration assessing thereliability of the financial statements.

In summation, the obligatory Revisoría Fiscal plays a crucial role in controlling thewell-functioning of internal auditing, provides information to owners and theSuperintendency of Banks to identify problems at an early stage.

Source: Wisniwski (1999a)

Box 5An Auditing Zebra: The Revisoría Fiscal in Colombia

Table 10

Approaches towards supervision

Traditional approach

Static approach (concentration on historicaland current data)

Quantitative data analysis

Concentration onoff-site supervision

Modern approach

Dynamic approach (prospective analysis included), risk-based supervision

Quantitative and qualitativedata analysis

On-site and off-site supervision

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to supervision additionally includes an assessment of the intermediaries’capability to manage risks currently and in the near future. It includes aprospective analysis. This approach puts special emphasis on staff qual-ification and experience, mechanisms to identify areas of potentiallyhigh risk, and the adequacy of systems and procedures to react tounforeseen events. A dynamic approach also evaluates the opportunityof an intermediary to access liquidity when needed.

A dynamic approach to supervision is especially relevant for agricultur-al lenders. Agricultural lenders have to monitor the diverse set of specif-ic risks of agricultural lending to be able to foresee and react on up-com-ing repayment problems, and address management delegation problemsin highly decentralized institutional structures in a timely manner.Capabilities of managing risk and specifically managing delinquency ofagricultural loans are especially crucial on the credit officer level (seeKlein et al., 1999). Thus, an examiner also needs to be able to evaluateon-site the credit officer’s capacity to actively manage the default risksinvolved in agricultural lending.

Risk-based supervisionA dynamic approach to supervision that focuses on the risk managementprocesses in the institutions, is well-known among bank supervisors asrisk-based supervision. Risk-based supervision intends to separatelyidentify the overall risks of financial intermediation. Next, it focuses onthe risks most significant to the overall risk of an institution. Risk-basedsupervision also recognizes that the prime responsibility for risk man-agement lies with the management of a financial institution. It concen-trates on evaluating qualitatively how well management identifies, mon-itors and reacts to changing risk factors.

Section 1.7 identified the specific risk profile of agricultural lenders.Risk-based supervision of agricultural finance should concentrate onthese known risk factors and identify the specific risk profile in everysingle financial institution to be supervised.

Credit risk is one of the major risk areas in agricultural finance. A tra-ditional tool of banking supervision for credit risk assessment is thereview of the quality of a sample of individual credits, its evaluation andthe comparison of this evaluation to the financial institution’s internal

48

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risk assessment (cf. Basle Committee 1999a). Repayment rates and port-folio-at-risk measures based on current repayment performance providea basis for judging the current status of the loan portfolio. However,while this information is valuable, supervisors that concentrate on aqualitative and prospective evaluation will need to go beyond these fig-ures and evaluate the systems in place and management techniquesapplied. Examples of appropriate action on the part of senior manage-ment include: balance sheet action such as global or individual provi-sioning, and direct field action such as a closer monitoring of individualperformance, repeat visits of delinquent or potentially endangered cus-tomers. Due to less frequent repayments, other early warning systemsthan the time, that repayment is past due need to be installed.Diversification policies, ability to assess external risks of specific agri-cultural products, the quality of client evaluation and other risk man-agement techniques thus gain specific importance as part of a risk-basedapproach to supervision.

On-site and off-site analysisFinancial institutions’ reports should theoretically, provide the informa-tion needed to identify key problem areas to be able to address problemsat an early stage. This calls for timely, accurate and regular reports con-taining substantial information. These reports form the basis for off-siteanalysis of the status of a financial institution. In reality, off-site super-vision of this kind is rare. Lack of standardization in the reportsprovided, in addition, is topped by the lack of electronic data processing(EDP). EDP can substantially ease the burden of off-site surveillance.Common deficiencies of banking supervision in developing countriesconcern reporting systems and inadequate or non-existent off-site super-vision and/or on-site inspections. Not only do banks lack sufficientinsight into the financial situation of borrowers, but supervisors alsolack information on the overall financial situation of banks.

In agricultural finance for rural smallholders, as in microfinance, thebasic problem of off-site analysis is that the most relevant informationis difficult to trace in quantitative data sets. Credit technology, manage-ment information systems, systems and procedures, risk and cost man-agement techniques are central to these institutions’ success. Thus, therelevance of on-site inspections is substantial.

49

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Regarding the overall status of bank supervision in developing countries(but largely also in developed countries), on-site inspections are ofteninsufficient. Major problem areas include a focus on details of a bank’sfinancial statements instead of a focus on the main items. There is insuf-ficient, inadequate assessment of bank asset quality, a lack of coordina-tion of on-site with off-site supervision and non-existence of appropri-ate and detailed inspection manuals. Coordination with external audi-tors seldom takes place. One of the challenges of rural supervision isgeographic dispersion and the high requirements for qualitatively assess-ing the risk management of a rural financial intermediary.

Quantitative and qualitative data analysisTraditional approaches to bank supervision concentrate on the analysisof quantitative data. This is a convenient and practical tool as it pro-vides highly standardized information, which is easily comparableamong institutions and institutional groups. However, the nature ofquantitative analysis is basically static. There are numerous sets of quan-titative ratios developed within the deliberation of rural financial insti-tutions and microfinance institutions.21

Sensitivity analysis is a dynamic tool of supervision. Analysing alterna-tive scenarios of the future development of an agricultural lender, espe-cially taking into account different external shocks and their effects onthe overall performance is one of the tools that can provide a dynamicview.

However, quantitative data analysis does not grasp the informationneeded for prospective risk-based supervision. The capability to manageexternal shocks can best be measured qualitatively by evaluating systemsand procedures, staff qualification, access to liquidity (rating on thefinancial market, sources of funds) and management information sys-tems. A qualitative assessment of the risk profile of the agriculturallender should put the quantitative data provided for example by portfo-lio at risk data, past repayment performance and liquidity ratios intoperspective of the overall risk categories. To further clarify this pointexamples of quantitative and qualitative measures referring to the spe-cific risk categories outlined in Chapter 1 are listed in Table 11.

50

21 For detailed discussion and description of relevant financial ratios see among othersYaron (1992), Christen et al., (1994) and Ledgerwood (1999).

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Supervisory toolsSupervisory tools are designed to comprise a set of quantitative indica-tors and/or qualitative measurements to provide supervisors with a stan-dardized data set from on-site and/or off-site examinations.

51

Table 11

Examples of measuring risks quantitatively and qualitatively

Quantitativemeasures

• Repayment performance• Portfolio at risk• Percentage of loans with

documentation and col-lateralization as required

• Diversification of portfo-lio (e.g. loans for differ-ent agricultural products,regions)

• Others

• Liquidity ratios (e.g. cashand short term loans percurrent liabilities)

• Others

• Ratios supplied by man-agement information sys-tem and financial state-ments, e.g. efficiencyindicators

• Others

• Shareholder percentagesof capital: national vs.international, natural vs.legal persons etc.

• Others

Riskcategory

Credit risk

Liquidityand interest rate risk

Managementand operational risk

Governance risk

Qualitativemeasures

• Systems and procedures• Policies• Management informa-

tion systems• Loan tracking systems• Policies towards diversi-

fication of portfolio;active managementresponsive to externalfactors of agriculturalproduction

• Others

• Liquidity planning• Rating on financial mar-

kets; access to emergencyliquidity

• Others

• Vision and strategicplanning

• Market responsiveness,product development,client orientation

• External factors: marketdevelopment, competi-tion

• Staff qualification, incen-tive systems

• Others

• Owner characteristics• Strength of Board of

Directors• Accuracy of accounting • Others

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As the risk categories to be monitored by risk-based supervision for agri-cultural finance do not differ from general banking, supervisory toolsfor agricultural finance do also not differ from tools for other segmentsof financial markets. The contrast, again, lies in the evaluation of therisk categories and the different quantitative assessments obtained.

This section looks at two prominent supervisory tools, applied for exter-nal supervision of small financial entities involved in microfinance activ-ities. The first is the PEARLS system, developed by the World Councilof Credit Unions (WOCCU). It is currently used as a mechanism ofinternal regulation and supervision. The application of this tool forsupervisory purposes has been proposed in a few countries, often pro-moted by WOCCU.

While it is a valuable tool for the internal and self-regulation of savingsand credit cooperatives and for monitoring improvements in overall per-formance, the PEARLS system has several flaws affecting its use as asupervisory tool. A basic problem of rating systems is the assignment ofan overall rating to institutions, where weaknesses in some areas can beoffset by strengths in other areas. This upsets risk-based evaluation, ascritical issues can be hidden in subratings. Next, the PEARLS system

52Within various projects carried out with savings and credit cooperatives in LatinAmerica, the World Council of Credit Unions has developed a tool for financialanalysis of cooperatives. The PEARLS system comprises a variety of quantitativeindicators. The maximum version has 41 separate indicators. These are grouped intosix key areas: Protection, Effective financial structure, Asset quality, Rates of returnand cost, Liquidity and Signs of growth.

The objectives of the PEARLS monitoring system are to provide an executive man-agement tool in identifying probable causes of institutional shortcomings. Secondly,it is intended to standardize evaluation of ratios and formulas. It also intends to pro-vide an option for comparative rankings with objectivity. The fourth objective is toprovide an effective supervisory tool for national federations in evaluating creditunion performance. As opposed to the CAMEL rating system, it was primarilydesigned as a management tool.

Source: Richardson (2000)

Box 6WOCCU’s PEARLS

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only contains quantitative data, without any qualitative assessment.This makes PEARLS a static approach in this terminology. Overall riskmanagement is not evaluated.

The Bolivian Superintendency recently started developing an adjustedCAMEL tool for the supervision of the Private Financial Funds (PFFs)predominantly involved in urban and partially rural microfinance on thebasis of ACCION’s adoption. As this involves the distinct perspective ofa supervisor, whose interest is assessing risk, and not in identifying areasfor technical assistance, substantial restructuring efforts are anticipated.

On the part of ACCION as of 1998, the CAMEL tool already was sub-ject to revision in relevant areas for supervision. These were a) a moreprospectively oriented evaluation, b) taking into account competitiveenvironments as well as, c) addressing issues of governance. However, toserve the purpose of a supervisory tool it should also widen its focusmore specifically to the requirements of the provision of deposit facili-ties and analysis of asset quality that includes sectoral considerations. Itshould take into account that microfinance and agricultural loans maywell form only a part of the total portfolio of a financial institution.

53

CAMEL is an acronym for five measurements of a financial institution: CapitalAdequacy, Asset Quality, Management, Earnings and Liquidity Management. NorthAmerican bank regulators first created it in 1978 to evaluate financial and manager-ial soundness of US commercial banks. By 1992, ACCION had developed on thebasis of this CAMEL an assessment tool for its affiliate microfinance institutionsthroughout Latin America. The major purposes of this tool where to provide a mea-surement mechanisms for management purposes on the part of the affiliate as well asACCION, and to identify areas for technical assistance. ACCION’s CAMEL includesquantitative and qualitative indicators, which add up to an overall rating of the insti-tution.

Source: Saltzmann et al., (1998)

Box 7ACCION’s CAMEL

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2.5.4 Staff Capacity

Adequate supervision needs sufficiently trained and experienced super-visors. Frequently low qualification, inadequate staff training and non-competitive salaries prevail in bank supervision. Bank examiners areoften paid on government pay scales, which cannot compete with com-mercial banks. These offer more money for the same skills and amountof work. Therefore, there is a shortage of qualified personnel. Usingcomputers to generate and analyse bank information can potentiallycompensate somewhat for a lack of personnel, but MIS needs specialistsand appropriate infrastructure. It cannot substitute for supervisors’ on-site examinations. On-site examinations are especially crucial for thesupervision of agricultural finance institutions.

Even if staff qualification is improved, it is not ensured that supervisoryquality will increase as well. Staff turnover and reallocation of examin-ers to other departments of the supervisory agency may affect supervi-sory quality. The Bolivian banking superintendency’s department fornon-bank financial institutions has repeatedly experienced rapid staffturnover and reallocation despite repeated donor efforts towards specif-ically training bank examiners in microfinance issues. Once commercialbanks got into trouble, specialized staff was drawn to the more volumi-

54The West African Monetary Union established a savings and credit cooperative lawin 1993 to regulate the many grassroots financial institutions in the region. ThisProjet d’Appui à la Réglementation des Mutuelles d’Épargne et de Crédit (PARMEC)has been ratified by Benin, Burkina Faso, Côte d’Ivoire, Mali, Niger, Senegal andTogo. In each of the countries, the Ministry of Finance is responsible for the super-vision of the institutions covered by the PARMEC law. The West African CentralBank as well as international donors has focused on providing technical assistance,training, short term technical assistance, equipment and funding for the Ministries.They have set up separate units of one to five staff members to supervise these insti-tutions. Still, the sheer volume of work to be done to comply fully with all the super-vision responsibilities formulated in the PARMEC law would quickly overwhelm thecurrent capacity of the Ministries. Accordingly, enforcement of the regulations isweakened.

Source: Christen and Rosenberg (2000)

Box 8The West African PARMEC law: Limits to supervisory capacity

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nous and thus more important banking section. While allocating super-visory power to the more risky and endangered areas is a prudent deci-sion, it left on-going and preventive supervision of the Bolivian PrivateFinancial Funds (PFF) in a temporary void.

In the area of agricultural lending, with its specific risk profile asdescribed above, discrete agricultural sector knowledge combined withbanking experience is required for supervisors (as much as for loan offi-cers). While they should not aim at being better agricultural bankers,they should be able to identify high-risk areas and evaluate the institu-tion’s risk management techniques. This is a complex task, whichrequires real knowledge of the agricultural sector and preferably practi-cal experience in agricultural lending.

It may well be useful to employ former credit officers as supervisors. Therequirement of an academic background in agricultural economics andbanking may not be sufficient to ensure that supervisors can actuallyevaluate real-life situations in specific regions. Assessing the risks of anagricultural lender goes beyond pure agronomic analysis and involvesthe repercussions on the whole range of credit risks, liquidity risks, man-agement risks and other risks outlined.22 In addition, supervision ofagricultural lending also requires personnel willing to travel extensivelythroughout the country for on-site visits in rural areas. This is a seriouschallenge.

However, external supervisors are often not qualified to do appropriateon-site, qualitative and risk-oriented supervisory examinations. This is aproblem which may be addressed by offering specified courses and on-site training organized by bank training institutions, perhaps with gov-ernment and donor support. If retail capacity in the area of agriculturallending is short, due consideration should be given as to what extent thescarce resource of human resources of a given country should be divert-ed away from the actual business of agricultural lending.23

55

22 This is an experience, which has been stressed for the qualification requirements on thecredit officer level for the Salvadorian Financiera Calpiá and the Bolivian Caja LosAndes (cf. Buchenau, 1999).

23 This chapter remains unsatisfactory in proposing answers to these diverse challenges.In fact, lack of adequate staff may render specialized agricultural finance regulationand supervision impossible to implement. Again, it has to be reiterated that regulationwithout adequate supervision is a waste of time and resources.

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2.5.5 Costs of Supervision

Costs of supervision include examiner’s staff salaries, staff trainingcosts, administrative costs, off-site database set-up and maintenancecosts as well as the costs of on-site visits. As a general rule, supervisingrural financial institutions is more costly than supervising urban inter-mediaries. Costs are also relatively high if small financial entities arebeing supervised, because supervising these generally is not lessresource-intense than those involved in supervising a big commercialbank. While size matters for on-site examinations, nearly all superviso-ry costs are fixed. Thus, in a prudential manner, many supervisory insti-tutions with limited funds (and limited capacities) prefer to focus onthose financial institutions that form a potentially more dangerousthreat to the safety and soundness of the financial system. In addition tosize considerations of the institution, an extensive branch network inrural settings also increases costs. Transportation, accommodation andper diem costs of on-site inspections will further augment supervisioncosts.

Thus, supervising agricultural lending means cost increases in variousrelevant categories. On-site supervision is more important in agricultur-al lending than in traditional commercial bank lending, which impliesgreater expenses. Also, training costs of examiners are high. For anappropriate risk assessment of agricultural loan portfolios, specificknowledge in the agricultural sector and banking is needed. Finally,supervising agricultural lending and rural intermediaries may provecostly through the diversion of supervisory attendance away frompotentially riskier big banks.

Cost-benefit considerations on the side of external supervisors shouldconsider the number of institutions in place that would fall under spe-cific treatment. If only one or two rather small institutions actually fitthis category, benefits can be estimated to be rather small. It is impor-tant not to mix this argument with considerations on the benefits ofenabling financial institutions by regulatory means to carry out innova-tive lending to agricultural producers.

How can these challenges to rural and small entity supervision be over-come? As mechanisms for effective financial service delivery in rural

56

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57

areas have been developed with an emphasis on decentralization of deci-sion making and e.g. the introduction of mobile banking units, it followsthat supervision could develop cost-reducing mechanisms. In rural con-texts, an increased emphasis on ensuring adequate internal informationsystems to be established to manage the risks of rural financial interme-diation and ensuring appropriate information flow also to supervisors,may prove more important than in urban areas. An external supervisorin the city can check compliance with quantitative requirements morefrequently.

The primary funding source for external supervisors usually is the gov-ernment budget, as they are primarily providing public goods.Alternatively, they are completely or partially financed by the institu-tions that are being supervised. As an example, Arzbach and Durán(1999) points out for most of the countries in Latin America, the savingsand credit cooperatives themselves fund all or part of the supervisorycosts. These fees may be distributed on a per-institution-basis or on asize-oriented basis. However size does not relate directly to the costsinvolved, as expenses are not higher for bigger financial institutions.Fees correspond to their capacity to pay supervision costs.

In very small countries, it is an open question whether the additionalcosts exceed the benefits of creating a specialized supervisory super-structure and specific regulations for the whole financial system.24 Thisconsideration is specifically valid regarding a regulatory framework thatcomprises differentiated types of financial institutions.

2.5.6 Operational Independence, Credibility and Enforcement

“Known cancers in banking go untreated and spread whenbankers see others getting away with bad practices” (Long,1999)

The key to the effectiveness of regulation and supervision is the oppor-tunity of the supervisor to act upon deviation from the regulations.

24 As Long (1999) has pointed out in this context, three fourths of the world’s countries’financial systems comprise less than US$10 billion in assets, which is the size of a mod-erately sized regional bank in a developed country.

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Banking supervisors usually have a whole set of enforcement mecha-nisms, which include moral persuasion, fines, calls for change of seniormanagement, or capital injection from owners together with specificregulations regarding the closure of financial institutions.

These instruments, however, can only be put into place if the superviso-ry entity has the mandate and sufficient independence to act upon itsobservations. Independence of supervisory entities, however, in manycountries still is not in place and interferes with implementation of reg-ulation.

Some of the enforcement instruments usually applied by banking super-vision may prove difficult to apply for agricultural lenders. A transi-tional halt in lending can imply a credit crunch for the agricultural sec-tor in the regions served. An established trust-relationship betweenclients and financial institution may deteriorate substantially once wholeagricultural cycles are not serviced. It may prove very difficult for farm-ers to substitute their usual production credit from their own resourcesor other financial sources. On the other hand, in countries where theagricultural sector provides significant national income, political pres-sures of farmer organizations may render this instrument not, or not eas-ily applicable.25

One of the common complaints about bank supervisors is that theyintervene too late in problem banks. This observation has triggered sug-gestions, that interventions should be guided by rules (Hawkings andTurner, 1999). For example, different levels of capital adequacy ratiostrigger supervisory action in some countries. These rule-based interven-tion methods may be particularly helpful for supervisors operating in anenvironment of strong political pressure such as in agriculturalfinance.26

58

25 An example of governments discriminating between different classes of creditors incase of bankruptcy is provided by Hawkins and Turner (1999). They underline, thatwhen the bankrupt Japanese housing finance companies “jusen” were liquidated,banks lost all their loans, while agricultural cooperatives lost only a tenth of theirloans.

26 There are, however some drawbacks of such a rule-based approach. Firstly, definingrobust intervention rules may be difficult. Regulators may not know that a financialinstitution has crossed a threshold until long after the event. Also, strong political pres-sure will not stop at changing these rules for “very special cases” (see also Brownbridgeand Kirkpatrick, 2000).

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In bank supervision, the term “too big to fail” is used if supervisorsdecide to act differently if a very large financial institution has problems.For licensed rural financial institutions, this may turn into a “too smallto fail” problem. If only few financial institutions are licensed that grantaccess to financial services to an otherwise neglected target group, polit-ical pressure may escalate to keep these important institutions running –somehow. This hold also true for recently licensed institutions, wherethe licensing supervisor would be blamed for not foreseeing the prob-lems early enough in the licensing phase.

Other sanctioning mechanisms may as well prove difficult to apply foragricultural lenders. Calls for capital increases require potent owners asregards additional capital. Calls for a change in senior management maybe hampered by scarcity of staff qualified and experienced in agricul-tural lending. A related problem may occur once parts of the portfolioneed to be transferred to other intermediaries. Agricultural lending tech-nologies are highly dependent on a track record of experience with thecustomer as well as highly personalized services. These services mayprove complicated to transfer to other entities. Technical capacity andexperience in agriculture may not be possible to find in other financialinstitutions.

2.5.7 Delegation of Supervisory Tasks

A proposed alternative to centralized bank supervision has been the del-egation of specific supervisory tasks or specific types of financial insti-tutions. These delegated supervisors can be specialized auditing compa-nies, specifically designated consultancy firms as well as member-basedsecond-tier institutions. See Table 12 for a list of potential benefits andchallenges.

Some proponents of supervisory delegation have argued that delegationcan help reduce the costs of supervision and address the widespreadreluctance of banking supervisors to take on smaller financial institu-tions into their work agenda. However, it remains questionable whethera specialized supervisory agency can really carry out examinations andsanction wrongdoings in a less costly way than can specialized supervi-sory agencies. There is a particular danger of duplication. Centralizedsupervision may be able to exploit economies of scale. It may also help

59

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increase consistency in requirements throughout the sector, if supervi-sion is carried out by one institution. Also, the credibility lent to super-vised institutions in the eyes of depositors and commercial fundproviders may increase, if it is not a separate institution that issues theapproval for operations of these institutions.27

External auditors are used for on-site banking supervision and forreporting irregularities or internal control weaknesses to the superviso-ry authority in many countries (e.g. Chile, Mexico, India, Poland,Hungary, Czech Republic and Germany). These assignments usuallyinclude reports on whether specific ratios and other requirements havebeen accurately completed, licensing conditions have been compliedwith, bank transactions are in accordance to specific laws applicable tobanks, and the accounting and/or internal control systems are adequate.(cf. Hawkins and Turner, 1999; Snoek, 1990).

60

Table 12

Potential benefits and challenges of delegated supervision

• Payment of supervisors outsidecivil service conditions

• Supervisory process may be morecost-efficient

• Higher degree of technical special-ization

• Diversion of supervisory capacityless likely

• Danger of duplication (extent ofdelegation)

• Total costs may be higher• Delegation of enforcement? (time-

liness of action)• Possible conflicts of interest (self-

regulatory institutions and exter-nal auditors)

• Creation of second-class super-vised institutions

• Governance structure of delegatedsupervisor needs to be welldesigned

Potential benefits Challenges

27 Many West-European Cooperative Banks are supervised by delegated supervisoryagencies. The German cooperative banks in particular are audited and supervised bytheir own auditing federations, which act as agents of the Federal Bank SupervisoryAuthority. Recently the Supervisory Authority has started sending private auditingcompanies out to verify the information gathered and fowarded by the federations.Discussions have arisen as regards uniform quality and the timeliness of forwarding“bad news” to the Supervisory Authority.

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For external auditors, as well as other delegated supervisors the samequalifications and knowledge requirements apply as bank supervisors.Specialized agencies may face less potential of diversion to other super-visory tasks and ensure, by concentrating on one set of institutions, thatsupervision is carried out consistently and continuously.

A very critical issue in supervisory delegation has been highlighted bythe Costa Rican experience with an auxiliary institution carrying outsupervision for the Superintendency. Costs of supervision, in this case,were intended to be borne by the superintendency. Lately, this delegationhad been halted due to the non-payment of the institution by the state(cf. Arzbach and Durán, 1999). In the discussion of microfinance regu-lation, proposals have been put forward that microfinance institutionsthemselves can pay part or all of the costs of their specific supervision.As a public good is provided, full cost-recovery from individual finan-cial institutions may not be appropriate. Also, as supervisory costs usu-ally do not differ by institutional size, bearing the costs may prove pro-hibitive for smaller financial entities.

Often, civil service conditions of employment in specialized supervisoryagencies and central banks are not attractive enough to retain qualifiedsupervisors, sharply limiting the scope for regular and effective on-siteexaminations. This restriction may be lifted by involving separate insti-tutions that do not fall under this restriction.

As Berenbach and Churchill (1997) have pointed out, with the delega-tion of the supervision of specific product lines or specialized institu-tions, the bank supervision entity also loses the opportunity to build upsupervisory capacities and an in-depth knowledge of a new line of busi-ness. The assessment of the necessity to intervene may thus remain com-plicated. An alternative could be the combination of centralized super-visory authorities and delegated supervision, with the assignment of veryspecific tasks to the delegated supervisor. These solutions face challengesof potential duplication of effort, but could help address the questionsof limited capacities on the part of banking specialized supervisory agen-cies.

The most critical issue in delegating supervisory tasks to apex institu-tions is potential conflicts of interests. Member-based apex institutions

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often carry out training and advisory services for their members, andinvolve themselves in advocacy and promotional duties. Members maychose to stop accessing the apex services and, through the general assem-bly or seats on the board of the apex, exert pressure to certify compli-ance with external regulations. Financial apexes specifically face con-flicts of interests when they service their clients with concessionary fund-ing, while concurrently carrying out supervisory tasks.

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Internal Regulation and Supervision

“... The responsibility for risk management rests principally onvoluntary regulation through internal governance, rather thanon external supervision by regulatory authorities.” (VanGreuning et al., 1998)

Owners are the first line regarding regulation of a financial institution’saction. Owners that have capital at stake have a strong incentive toclosely supervise the financial institution. Risk management is imple-mented by senior management, which acts on the basis of internal infor-mation systems and mechanisms ensuring the accuracy, substance andtimeliness of these information systems.

Issues of owner control largely depend on the institutional type. NGOs,cooperatives, commercial banks and state development banks have sub-stantially different profiles as owners. Management issues, on the otherhand, are determined by the chosen organizational structure of a finan-cial institution. The requirements towards internal control, however,which agricultural lending poses, do not differ across institutional types.Sections 3.1and 3.2 will cover these issues before mechanisms to connectexternal with internal regulation to ensure strong owners and internalcontrol are elaborated in Section 3.3.

3.1 ISSUES OF OWNER CONTROL

The type of ownership defines the mission and objective of an organiza-tion and sets out the framework for management accountability. Fourtypes of financial institutions may be classified. First, shareholder-basedinstitutions are a very common form of ownership. Second, member-based institutions such as savings and credit cooperatives, credit unionsand village banks are owned by the same clients they serve. Third, nongovernmental organizations have no formal owner. There exists no equi-ty provided by individuals or institutions, which are held responsible inthe event of problems. Fourth, government-owned institutions such aspost office savings banks and development banks are formally owned bystate institutions.

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3 Internal Regulationand Supervision

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Different owners may have different capacities to monitor a financialinstitution while different types of institutions’ ownership generally trig-ger different capacities. In the case of NGOs, an ownership-drivenmechanism of accountability is lacking, as an owner with a financialstake does not exist. NGOs largely rely on the motivation and reputa-tion of their top management in ensuring mission fulfilment and finan-cial rigour. Board members often cannot provide the adequate oversightas they may lack the necessary financial skills or may pursue socialobjectives at the expense of financial considerations. Donor involvementoften contributes to vague responsibilities and dependence of NGOs.28

As a consequence, very few regulators consider NGOs acceptable forformal financial intermediation including deposit-taking.

Cooperatives, although by concept pure self-help organizations ruled bythe clientele they serve, face weaknesses in owner control as well.29 The“one man one vote” rule implicitly poses disincentives for strong ownercontrol, as criticism and monitoring rigor becomes a public good for sin-gle members. In addition, the usual practice of withdrawn shares beingpaid back at nominal value only additionally decreases members’ incen-tives to pressure for the institution’s profitability. Consequently, internalcontrol in cooperatives also remains mostly weak. Membership is main-ly seen as an access prerequisite for the services offered and not as pri-vate investment.

Agricultural development banks with obscure or inactive state ownersmay follow goals that impede the banks’ financial health. However, stateownership does not automatically suggest that owner control deter-mines goals beyond profitability to the degree financial sustainability isimpacted adversely. Public development banks such as BAAC Thailandand the BRI Unit Desa system have shown under government ownershipthat financial institutions can prosper while providing financial services

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28 Steege (1998) points out for the case of Finansol Columbia, that “the bad habit of hid-ing behind an NGO to avoid playing by the rules [...] kept Finansol from developingoperational standards with the required rigor. At the same time, the fact that Finansoldid not have to bear its own full operational costs [...] helped to camouflage Finansol’strue financial condition.”

29 The basic concept of cooperatives does not allow for strong donor involvement. Inmany countries, however, cooperatives have been used as channelling mechanisms fordonor and government funding, leading to the goal of membership to access thesefunds. This situation still prevails in some countries.

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to rural lower-income clientele. In both cases, government intrusion hasbeen minimal and apart from operational levels. Subsidized loan pro-grams have been kept in separate operations as in BRI’s Unit Desa sys-tem or at a manageable size (BAAC).

Shareholder-based commercial banks have private owners with theirown capital at stake, which bring in substantial equity investments.They provide the possibility to leverage these equity amounts on finan-cial markets. The capacity and willingness to provide oversight, howev-er, is at times hampered by problems of opportunities for insider lendingto shareholders and family-run businesses, that nurture other commer-cial businesses with access to credit. Private ownership, thus, does notnecessarily supply intense owner control. For external regulators andsupervisors this implies, that “fit and proper” tests should be extendedto shareholders to assess their capacity to monitor the institution’s well-being, provide oversight and “keeping on track” services as well as deeppockets in case of need.

In Latin America, the IDB FOMIN fund in addition to the CorporaciónAndina de Fomento (CAF) are involved in providing subordinated debtas equity strengthening contributions. While these provide significantequity investments which is needed to set up new intermediaries, the cri-teria of oversight and keeping a financial institution on track face thesame obstacles as other donor-owners. Donors generally are not verystrong owners. The responsible staff members of donors often changeand their attention is drawn to other activities. As their own capital isnot at risk, the incentive for rigorous oversight is thus reduced. Whiledonors mostly do have deep pockets for additional funding, the timelyemergency access to these resources face challenges of bureaucracy,lengthy application and appraisal procedures.

This may be different for international NGO networks, which havedeveloped a solid reputation for financially sound specialized financialinstitutions, such as ACCION International or FINCA International.These may have substantial reputation capital at stake, which does notallow them to give up weakened institutions. These networks may evenbe regarded as particularly strong owners in specific cases.30

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30 As examples, see Steege (1998) for an analysis of ACCION’s role in the Finansol case,and Fiebig (1999b) for the role of FINCA International in the case of FINCA Uganda.

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3.2 ISSUES OF INTERNAL CONTROL

Internal control refers to the whole set of institutional policies and pro-cedures in place to monitor and manage the risks inherent in the finan-cial intermediation process. It includes the outline and implementationof management information systems, internal auditing, fraud detectionand adequate enforcement of control. The Basle Committee summarizesthe key elements of internal control (see Table 13). In addition, positivecontrol incentives such as staff incentive systems that put more empha-sis on an internal framework conducive to the financial well-being andgrowth of an agricultural lender need to be in place.

Management oversight and control cultureBoard of Directors should decide on and monitor overall business strate-gies, organizational structure, policies, and major risks run by the bank.Financial intermediation, and especially intermediation involving agri-cultural lending does involve risk taking, which boards should recognizeand evaluate to define acceptable risk levels as well as risk managementpolicies. Boards should also control senior management and carry ulti-mate responsibility for the proper functioning of internal control sys-tems.

Senior management, in turn, has the main responsibility for implement-ing strategies and policies regarding agricultural lending. The boardshould approve these strategies. It should also develop a valid control

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Table 13

Elements of internal control

1. Management oversight and control culture

2. Risk recognition and assessment

3. Control activities and segregation of duties

4. Information and communication

5. Monitoring activities and correcting deficiencies

Source: Basle Committee on Banking Supervision (1998)

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process as well as maintain an organizational structure with clearresponsibilities, authority and reporting requirements between organi-zational levels. In rural intermediaries, the delegation of responsibilitiestogether with the setting of internal off-site and on-site control policiesis crucial.

Reform of the internal regulation of development banks has been a par-ticularly challenging part of development bank reform. But also in otherinstitutional types, such as for example NGOs, the change of attitudetowards enhanced internal control is often problematic throughout agrowth process. While small NGO-type institutions may well surviveand prosper without explicit focus on internal regulatory issues, a mid-sized NGO can be severely struck by fraud, lack of management over-sight and weak Board control.

To illustrate the importance of a ‘control culture’ within the financialinstitution, Box 9 presents a list of key institutional changes that led tothe success in reform of Bank Rakyat Indonesia’s (BRI) Unit Desa sys-tem of rural branch units.

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1. Major reorganization of BRI management at all levels from head office to theunit banks

2. High priority accorded at the head office to the management of the unit bankingsystem

3. Extensive reorganization and training of staff throughout the country4. Establishment of a system of promotion and development of promotion criteria

that reflect new expectations for performance5. Fundamental revision of bookkeeping, audit, and supervision systems, which

permitted the establishment of the unit banks as independent profit centre (ratherthan branch windows) and made accountability and a sustained anticorruptiondrive possible.

6. Opening of new unit banks and relocation of others to areas with high demand7. Attention to learning about rural financial markets and emphasis on using this

information to avoid potential problems with moral hazard and adverse selection8. Crucial improvements in communications and computerization facilities9. Overhaul of BRI’s public relations10. Implementation of an effective unit bank staff incentive system rewarding good

performance.

Source: Robinson (1994)

Box 9Substantial institutional changes that led to BRI Unit Desa’s success

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From this reform agenda, internal regulation issues have been core ele-ments to the turnaround of the BRI Unit Desa system of rural branchunits. Besides providing this list, Robinson stresses, even thoughimprovements were still needed and necessary in many of these areas,the new organizational culture and systems have given BRI managementan incentive to recognize and take action.

Risk recognition and assessmentMaterial risks need to be recognized and continually assessed as a basisfor an effective internal control system. It should cover all relevant riskcategories (e.g. credit, liquidity, operational and management risk).Management information systems in financial institutions involved inagricultural lending should provide the applicable data to manage theclient-specific and the external risks of the agricultural sector.Recognition of risks and their assessment needs to involve branch andcredit officer levels and cannot stop at headquarter/aggregate data lev-els. Policies for recognizing risks on-site, i.e. on the credit officer levelneed to be put in place.

Control activities and segregation of dutiesSystems of checks and balances between different organizational layersform basic control activities and need to be in place. In order to ensurea cross-checking of risk-relevant activities, segregation of duties e.g. inloan appraisal is essential. Control activities should be an integral partof daily business.

Internal auditors need to be operationally independent to carry out theirassigned tasks in a prudent manner. While being organizationally inde-pendent, they should have the opportunity to obtain on-site and off-siteinformation in the auditing, adequate resources need to be available interms of staffing, but also e.g. in terms of travelling costs.

Information and communicationAs the Basle Committee (1998) points out, “An effective internal con-trol system requires that there are adequate and comprehensive internalfinancial, operational and compliance data, as well as external marketinformation about events and conditions that are relevant to decisionmaking. Information should be reliable, timely, accessible, and providedin a consistent format.”

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Information generation and communication of information obtained isa severe problem in rural contexts. Rural infrastructure for informationsubmission is scarce due to lack of telephone lines, electric power, roadsand qualified staff. In decentralized institutional structures, managementinformation systems and internal control mechanisms need to bedesigned taking this into account. Box 10 provides another examplefrom Indonesia.

Monitoring activities and correcting deficienciesAs with external supervision, an integral part of internal regulation andsupervision is the timely recognition of deficiencies and immediate reme-dial action upon discovery. Management information systems that col-lect all risk relevant data are of little use as long as they are not used aspart of proactive management, which should range from fraud detectionto the active management of portfolio diversification.

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The BRI Unit Desa experience sheds some light on how a highly decentralized systemcan accomplish with internal control requirements. Firstly, every one of the morethan 3 500 units acts as a separate financial entity with their own balance sheets andprofit and loss account (profit centre approach). This has instilled accountability andhas created responsibility among unit chiefs and staff. Evaluation of Unit Desa per-formance is based on their profitability rather than on loans disbursed.As one of the crucial pillars of effective management of this diverse network, BRIUnit Desa has implemented a well-functioning management information system. Theprincipal components of this MIS have been:

• a sound, functional and transparent bookkeeping and accounting system;• a set of clear performance criteria and indicators, which resemble the major

CAMEL criteria; and• a simple and focused reporting system among management levels.

At the next organizational level, specific sections at BRI branches guide and super-vise the 10-15 units in their region. Branch and unit operations are overseen by theregional offices, which also carry out regular internal audits of branches and units.At head office, a separate division for Unit Desa Business monitors performance ofunits and consolidation reporting from the regions in a national management infor-mation system. While in the 1980s, the President Director of BRI had directly over-seen this division, today the Managing Director carries out this job.

Source: Maurer (1999)

Box 10Controlling Decentralized Institutional Structures:

The Bank Rakyat Indonesia (BRI) Unit Desa System

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To illustrate lessons on the importance of information generation andreaction on information obtained by senior management, Box 11describes the example of Finansol Columbia. Finansol has been a fastgrowing microfinance institution that has faced severe pitfalls through-out its rapid growth process. It only survived its institutional crises dueto heavy rescue measures taken by owners and donors (see Steege,1998).

While the information provided by management information systemsshould be directed towards and formatted according to different man-agement levels, internal auditing should also assign discrete responsibil-ities of action upon discovered problems. It should also set a timeframefor action and ensure reporting of task completion.

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Finansol Colombia, a licensed commercial finance company involved in microcreditprovision, had grown to a client base of 65 000 customers and a lending portfolio ofabout 35 million US$ by 1995 when it stumbled into a severe institutional crisis. Asa consequence, Finansol survived only due to a major refinancing and rescue planimplemented by a group of international donors. One of the major reasons for thebreakdown of Finansol performance was its extremely fast and uncontrolled growthprocess, which posed challenges to Finansol’s internal supervisory system, which itaddressed insufficiently.

The performance objectives defined for field staff induced risky lending behaviour.Also, rapid geographic extension from urban to suburban and rural markets did notconsider the profitability of each of the new markets sufficiently. Feasibility studiesfor new branches were not sufficient. Aggressive product diversification and market-ing to the similar clientele lead to reduced stability of the existing portfolio. Staffrecruitment boosted, while the hiring volume exceeded the training, mentoring andsupervisory capacity of experienced staff. Early success gave management confidenceto rely on quantitative performance indicators only, leaving supervisors unable totrack actual credit policies and practices. Changing scope of operations requireddevelopment of personnel qualification, which did not take place on a broad basis.Too many new and ambitious initiatives were launched without evaluation of costsand benefits. While strong executive leadership created initial charismatic momen-tum, concentration of powers limited organizational strength during the growthprocess. Inside (management, owners) and outside (stakeholders, public) communi-cation was rather based on a ‘rosy picture’ than on transparent performance dataprovision.

Source: Steege (1998)

Box 11Pitfalls of Institutional Growth – A Lesson From Finansol Colombia

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Incentive schemesPositive control incentives should complement the control mechanismsin the form of staff motivational and remuneration incentive systems.Incentive systems for staff are crucial for the well-being of a financialinstitution. Public development banks may face considerable difficultiesin motivating their staff to operate efficiently. Generally, if incentive sys-tems favour lending regardless of projected returns, or the financialinstitution is acting more like an employment agency than a bank, evena reformed regulatory environment may not change the behaviour of abank. The behaviour of state-owned banks is particularly difficult tochange as compensation is very rarely based on performance.31

3.3 CONNECTING INTERNAL REGULATION WITH EXTERNAL

REGULATION

“A major issue is whether regulation should proceed throughexternally imposed prescriptive and detailed rules, or by the reg-ulator creating incentives for appropriate behaviour”(Llewellyn, 1999)

Regarding “strong owners” and internal control there are the followingrecommendations for connecting internal with external regulation.

OwnersGenerally, the structure of a private shareholding company appears tobe the most appropriate institutional form for extensive outreach andfinancial profitability of agricultural lenders. Regulators and supervisorsare recommended to apply the same criteria to owners to ensure “strongownership” no matter what the legal status may be of the owners. Theseshould include a) bringing in substantial equity investments as fundingsource, b) providing the possibility to leverage these amounts throughaccess to other funding, c) providing intensive oversight and the serviceof keeping the institution on track, d) providing additional capital incase of need and emergency (deep pockets).

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31 For an introduction into various staff incentive systems see Churchill (1999).

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In countries such as Uganda and Kenya, ownership needs to be at leastpartially national. While interests may prevail to keep part of the own-ership within the respective country, a prudent approach from the super-visor’s point of view does not allow for a general distinction of nation-al and international owners considering their efficiency in ensuringappropriate internal regulation.

As a means to connect external regulation to internal regulation, Caprio(1997) emphasizes the need to put low limits on owner liability, intro-duce high capital requirements and reform existing deposit insurancesystems to put more capital of owners at risk. This, he assumes, willincrease motivation of owners to control a financial institution:“Aligning incentives for bank owners and managers to promote prudentrisktaking would lift the excessive burden placed on bank supervisors toguarantee safe banking. If owners have more at stake in terms of theirreputation, deposits, personal assets, or future expected profits, they canbe expected to take greater measures to safeguard their bank.” This canbe used as a general guideline for designing regulatory requirements forowners of financial institutions.

Internal controlThough the board of directors and senior management bear ultimateresponsibility for internal control systems, supervisory agencies shouldassess the appropriateness of the internal control systems as a key ele-ment of their on-site inspections. External regulation can and shoulddemand and connect to effective internal control systems. As the BasleCommittee on Banking Supervision puts it: “Supervisors should requirethat all banks, regardless of size, have an effective system of internalcontrols that is consistent with the nature, complexity, and risk inherentin their on-balance-sheet and off-balance-sheet activities and thatresponds to changes in the bank’s environment and conditions. [...]”(1998)

Acknowledging the prime role of management and owners in managingthe various risks faced by the financial institution results in external con-trol mechanisms emphasizing the well-functioning of these internalmechanisms. Supervisors should especially attend to high-risk areas ofinternal regulation and the systems in place to control these. Potentialhigh-risk areas include new personnel, new information systems,

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areas/activities experiencing rapid growth, new technology, along withnew products and activities. In agricultural lending, a well-developedmanagement information system needs to accommodate agriculturalsector developments as well as portfolio diversification on the portfoliolevel and on the client level. Qualitative external supervision will evalu-ate the internal mechanisms in place to monitor and control the risksinvolved in the agricultural lending business, as much as those of otherlines of business.

Internal auditingExternal supervisors should also focus on the quality and scope of inter-nal auditing. As an example, Indonesia has introduced a general require-ment for a separate internal audit unit in every financial institution thatreports directly to the Board of Directors. Requiring an independentlyworking internal auditing department that operates outside the influ-ence of the management of a financial institution can efficiently supportinternal control.

In many countries, external regulation requires a risk evaluation andportfolio classification unit, which is independent from the loan depart-ment. Separating the operational lending and follow-up process fromthe classification process is intended to limit the scope for “evergreen-ing” not reflected in the portfolio reports of a financial institution.32

The underlying concept resembles internal auditing departments, buthas a much more limited scope on loan portfolio quality.

Staff qualification requirementsRequiring extensive and specialized qualification in banking is a com-mon feature of regulatory requirements throughout the world. For topmanagement, a “fit and proper” requirement for general managers isdesigned to provide strong and qualified bank leadership. These require-ments are sometimes also extended to board members of banks. Forexample in the Indonesian rural banks, at least half of the board mem-bers are required to have more than one year of practical experience ina commercial bank. For the rural banks of the Philippines, as shown inBox 12, a more complex set of requirements is being set.

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32 The term “evergreening” refers to the process of hiding potential losses by giving outnew loans that refinance the repayment of the past due payments of previous loans tothe same loanee.

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One of the problems of requiring a satisfactory degree of qualificationand experience in the area of banking, specifically serving the marketsegments an intermediary has selected to target, is the scarcity of for-malized bank training in many developing countries. Authentic certifi-cates of rural, micro or even agricultural banking seldom exist, whichmake an evaluation of financial institutions’ staff qualification more dif-ficult for external supervisors. Possibly, external regulation could estab-lish an affiliation to training institutes of bankers providing certificationfor banking and specialized banking qualifications.

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A director of a rural bank must be a Filipino citizen who holds at least one votingstock in a rural bank. He/she has to be at least 25 years of age and be a college grad-uate or have at least five years experience in business or have undergone training inbanking provided by the Central Bank. The requirements for officers are similar,except that the minimum age is 21 and the majority of the key executive officers ofthe rural bank must be residents of the municipality where the rural bank is operat-ing.

Source: Wehnert (1999)

Box 12Stockholding, Age, Training and Residency:

Qualification Requirements in The Philippines

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Self-Regulation and Self-Supervision

Self-regulation has a long history for savings and credit cooperatives allover the world. It refers to the self-bonding of a group of financial insti-tutions to definite rules and regulations (Section 4.1). The most commonform of self-regulation is the contracting of an agency by a group offinancial institutions to evaluate the compliance of the group of institu-tions with self-set rules and regulations (Section 4.2). Generally, self-reg-ulation is a form of self-bonding to rules to certify to owners, fundingsources and clients the safety and soundness of an institution.

4.1 SETTING INDUSTRY STANDARDS

The overall aim in setting industry standards is the provision of uniforminformation to commercial fund providers, donors, depositors, andowners. Industry standards can also include target values of key perfor-mance indicators, which set a benchmark against which a financialindustry measures its own performance.

A drawback of setting industry standards, as with other self-regulatorymeasures is the general absence of strong enforcement mechanisms. Asopposed to pure self-regulation, other regulatory sources may providethe incentive to conform. This may be a commercial fund provider, whorecognizes the standards as indicators for the financial health of finan-cial institutions, or at least find the information given trustworthy anduseful for their investment decisions. The regulatory source may as wellbe donors that require the fulfilment of a custom reporting format or setof information. However, the standards developed can no longer be con-sidered self-regulatory measures, but rather are to be subsumed underregulation by market forces (see Chapter 5).

Important examples of setting industry standards are the PEARLS rat-ing system developed by the World Council of Credit Unions(WOCCU), which comprises six different areas of self-assessment,which summarized in one overall rating (see Richardson, 2000). Thetool is designed and is being used for self-assessment and signalling tofund providers. In certain instances, by publishing the results of the rat-ing publicly, it is also used to build trust with depositors.

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4 Self-Regulationand Self-Supervision

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Another example of self-regulation through industry standards isprovided by the Microbanking Bulletin published semi-annually by theCalmeadow Foundation, which assembles the supplied data from adiverse set of microfinance institutions, computes ratios and presentsthese data for comparison purposes to similar peer groups(Microbanking Bulletin, 2000). While these compilations do providevaluable management tools from a regulatory perspective, they remainweak due to a lack of qualitative assessments and prospective evalua-tions.

4.2 SELF-SUPERVISION

Once an agency is contracted by intermediaries in order to monitor com-pliance with self-set rules and regulations, the term self-supervisionapplies. This form of delegated internal control may complement inter-nal auditing and connect to external auditors. It can provide a basis formanagement decisions as part of internal control and especially makeavailable accurate and timely information on the status of a financialinstitutions to owners and depositors.

Membership in such schemes is voluntary. Thus, the entity that super-vises these self-set rules lacks legal backing and compliance enforcement.Enforcement is a cross-cutting weakness of self-regulatory approaches.In the end, it remains up to the financial institution whether it wants tocomply with set rules or not on a case-by-case basis. The example of acooperative agency in Honduras, as outlined in Box 13, highlights someof the key problems of self-supervision.

As supervisory powers are handed over on a contractual basis, enforce-ment powers usually remain rather weak. As denoted earlier, this is com-plemented by potential conflicts of interests for the self-supervisoryagency. Derived from the experience of savings and credit cooperativesin developing countries, the overall empirical record is negative. AsChristen and Rosenberg (2000) put it, “in poor countries, self-supervi-sion of financial intermediaries has been tried dozens of times and hasconsistently proven to be ineffective”.

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Self-Regulation and Self-Supervision

4.3 FROM SELF-REGULATION AND SELF-SUPERVISION TO DELEGATED

SUPERVISION

In some cases, self-regulatory mechanisms are considered to be the pre-decessor of delegated supervision. The Microfinance RegulatoryCouncil of South Africa (MFRC) and AIRAC of the DominicanRepublic both have started as industry associations that defined perfor-mance standards. They now evolved into delegated supervisors withfinancial functions that enable them to set positive and negative incen-tives for compliance. These incentives include better terms or services ortermination of funding. (see Valenzuela and Young, 1999).

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The Inspectora y Protectora de Cooperativas de Ahorro y Credito de Honduras(IPCA) is a self-regulatory body which oversees 46 of the approximately 105 savingsand credit cooperatives in Honduras since 1998. It is a member-based institution,which exists apart from the cooperative federation in order to offer "prudentialinspections service of private character". However, large parts of the current capitalstem from a terminated USAID/WOCCU Project of cooperative strengthening, andmost of the members had not paid up their required equity shares to IPCA as of April1999.

While IPCA has gained supervisory authority by delegation from the registrar, it isnot in a position to directly intervene in the cooperatives following audits. Instead,the only enforcement mechanism of recommendations is moral persuasion and for-warding the information acquired to the boards of the cooperatives. In the end,enforcement relies on the decision of the owners of the cooperatives. Even thoughIPCA by statue is entitled to liquidate and merge cooperatives, in practice this seemsunfeasible, as cooperatives would rather leave IPCA than let itself be liquidated ormerged.

The fee structure for the audits is depressed in favour of the cooperatives to attractnew members. IPCA’s activities are mainly funded from a seed capital injection fromthe USAID/WOCCU project. In addition, IPCA pay the member cooperatives a 10%interest per annum on their equity shares to maintain real value. IPCA in turnreceives a small fee from member cooperatives, which does not cover costs. It is inten-tionally kept low to attract additional members. Overall, it appears questionablewhether full cost-coverage can be achieved and whether the incentives for IPCA aredefined in a way to adhere to objectives.

Source: Fiebig (1999a)

Box 13Cooperative Self-Regulation in Honduras: The Case of IPCA

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The most critical issues for self-regulation evolving into delegated super-vision are the governance structure of the supervisor. For member-basedinstitutions, possible conflicts of interest exist in acting as delegatedsupervisors. Especially if the institutions to be supervised are the ownersor quasi-owners of the delegated supervisor, prompt and strict correctivesanctioning may not evolve. If a transformation for example of a secondtier cooperative institution is intended, a change of governance structureto ensure neutrality, independence and sanctioning potential is essential.The case of IPCA Honduras presented above provides a representativeexample of this problem. Self-regulatory institutions will need to satisfyall the standards laid out for delegated supervision in Section 2.5.7.

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Regulation and Supervision by Funding Sources

Funding sources have a large impact on governance and performance offinancial institutions. This chapter refers to this source of regulation. Itis a diverse set of regulation sources with all those powers and incentivesstemming from the liability side of a financial institution except equitycovered in internal regulation. Earlier in this series, costs, risks andimpacts of various funding sources have been analysed in detail (cf.Giehler, 1999). Here the regulatory forces exerted by different fundproviders is highlighted.

Generally, funding sources can be divided into those provided at com-mercial terms and those provided at concessionary terms. Concessionscan be made for diverse characteristics of the funds, e.g. interest, butalso for terms, repayment structures and collateralization. The chapterwill first concentrate on funding sources that in most cases providefunds at concessionary terms (governments, donors and financial apex-es), before turning to commercial fund providers and to the subgroup ofdepositors. But before analysing the explicit characteristics of these,common requirements for funding of the first three regulation sourceswill be examined. Finally, there will be a look at opportunities for con-necting funding sources’ regulatory effects with external regulation.

5.1 INDUSTRY STANDARDS REQUIRED BY FUNDING AND RATING

AGENCIES

Usually, donors, apexes, and commercial fund providers, but also depos-itors require a minimum standard of performance from financial insti-tutions with which they entrust their money. Standardized informationprovided to the public forms the basis for this investment decision, com-plemented with specific assessments and evaluation efforts carried outby donors, apexes and commercial fund providers, mostly on-site. Thestandardized information format can be decided upon and required byexternal regulation. It can be enforced by owners, result from a self-reg-ulatory mechanism, but it can also be directly requested and required bydonors, apexes and commercial sources of funds.

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5 Regulation and Supervisionby Funding Sources

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Initiatives to develop standard performance indicators and industrystandards as regards benchmarks abound within the microfinance dis-cussion. Examples are the minimum reporting formats established in1996 by the Donor’s Working Group followed by the detailed assess-ment tool for microfinance institutions developed and published byCGAP.33 Use of these standards, however, is still rather slight.

Rating agencies may provide an assurance that the developed standardsare applied, and can possibly put a quality seal on the figures and qual-itative information provided. The contracting of rating agencies by own-ers is a comprehensive issue of self-regulation and regulation by marketforces. Owners of financial institutions can use these ratings in order toassess performance of the institution and expressly of the managementin place. It can also be a tool for management staff, complementary tointernal control and management information systems. In most of thecases, however, it is a tool of fund providers to assess the creditworthi-ness of a financial institution.

Box 14 offers an example of a rating agency of the Private SectorInitiatives Corp., which puts a seal of approval under the data provided.

5.2 GOVERNMENTS AND DONORS

GovernmentsMany agricultural development banks almost exclusively rely on con-cessionary public funds. Even when government representatives are noton the board of directors, this usually implies a high degree of interven-tion opportunities in the financial institution’s management.

The degree of distortion can vary. Sometimes large-scale governmentfunds may provide little distorting incentives to an intermediary. As anexample, some financial institutions might be chosen to act as a clearingcentre for governments to pay salaries and pensions to civil servants.Institutions with a widespread network of branches in rural areas maybe especially interesting partners for governments. Such transfer pay-

80

33 See Donor’s Working Group (1995), CGAP (1999).

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ment functions however do not deliver funds for on-lending purposes,as they provide only illusory liquidity as long as part of the transferredamount is kept with the intermediary (Wisniwski, 1999b).34

DonorsWhile extensive efforts have been made to develop uniform reportingstandards, sets of indicators and ratios including benchmarks, donorsstill use a wide diversity of reporting formats and requirements.Satisfying dissimilar formats for reporting to different donors canbecome a significant cost and expertise issue for financial institutions.

At the same time, earmarking of funds for the provision of types of ser-vices (e.g. group loans) to a very precisely defined target group (e.g.potato growers in a specific region) may prove infeasible for the client-orientation of the financial institution and for its mid-term sustainabili-ty. Klein et al., (1999) have identified portfolio diversification for agri-

81

34 Monthly reports to external supervisors timed at month-end sometimes overestimatethe liquidity position of an intermediary.

MicroRate is a credit rating agency that specializes in microfinance, which is basedin Washington DC and, since 1997 has evaluated 24 MFIs in Latin America. Asaccelerated growth of successful Latin American MFIs is expected to create bottle-necks in funding, access to domestic and international capital markets has been iden-tified as being a crucial issue for their future development. Microrate aims at pro-viding up-to-date and reliable information to these potential fund providers as a basisfor funding decisions.

The MicroRate evaluations take place at least once a year, with semi-annual dataupdates. They provide a detailed analysis of operational performance, including anevaluation of lending operations, portfolio quality, organizational issues (such asmanagement information systems and internal controls), financial position (adjustedfor possible subsidies) as well as the market environment. On a summary sheet,major strengths, risk factor, summary data on the loan portfolio and overall perfor-mance, operational efficiency, asset quality and sources of funding are provided.

Currently, the ratings are predominantly used by the MFIs themselves as a means ofself-assessment and quality control. In addition, donors have started using them as abasis for funding decisions. As commercial funding sources are still scarce,MicroRate is currently financed primarily from donor sources.

Source: Von Stauffenberg (1999)

Box 14MicroRate : A Rating Agency for Microfinance Institutions

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cultural products and variance of income sources as one of the majorlending strategies to cope with critical agricultural risks. Efforts to applythis risk management strategy may be obstructed by restrictive targeting.

The Philippine Microfinance Standards initiative (Box 15) shows howdonors supported the development of industry standards.

Many donors and governments promote a graduation of microfinanceinstitutions into commercial financial markets. One of the proposedinstruments for achieving this goal has been apex institutions. Otheroptions include venture capital funds, stand-by letters of credit fromprime international financial institutions and other guarantee mecha-nisms. Donors implementing these strategies are acknowledging the vig-orous regulation forces that exposure to commercial financing developsin financial institutions.

Many donors may use external auditing firms to check the fulfilment oftheir requirements on a regular basis. Currently however, many donorsview the necessity to include audits into their project agreements as aside issue rather than as a powerful tool of exerting regulatory controlon their partners (cf. CGAP 1999). The establishment of uniformaccounting and auditing standards and active reference of donors tothese in a given country may lead to more clarity for all regulatorysources involved and may help attract more commercial funding.

Apex financial institutions are an attractive option for placing donor aswell as government funds. These are expected to select and finance suc-cessful and robust financial institutions.

5.3 WHOLESALE FINANCIAL INSTITUTIONS

“... The accomplishment of efficient and sustainable microfi-nance retailing capacity is usually promoted when privateinvestors, commercial lenders, and/or depositors become holderof the MFO’s [microfinance organization, M.F.] liabilities. [...]This positive effect may be dampened by access to funds from anapex organization in terms softer than those of commercialfunds [...].” (Gonzalez-Vega, 1998)

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Apex institutions provide one or more of a range of services to financialinstitutions, from the wholesaling of loanable funds; disbursement ofgrants and subsidies on behalf of donors and government; operation ofloan guarantee facilities; supply of guarantees for financial institutionsraising funds in capital markets; institution-building support in the formof technical assistance and/or training of the staff of financial institu-tions; provision of services and inputs for financial institutions; genera-tion of public goods (e.g. lobbying, forum for information exchange) toa role in the prudential regulation and supervision of financial institu-tions (Gonzalez-Vega, 1998). Because of the variety of services offeredby apexes, it is difficult to clearly identify their regulatory impact onfinancial institutions.

Apexes that combine different functions and types of services offered arelikely to also provide mixed and contradicting incentives to the institu-tions. Conflicts of interests are likely to occur between promotionalroles, such as advocacy, technical assistance and grant provision andfinancial roles, such as the provision of guarantees and funding sources.Funding decisions based on a perspective of promoting agriculturallending may incur intensive and costly investment monitoring, whichputs more emphasis on the provision of credit to a selected clientele than

83

The Philippine Microfinance Standards initiative is a USAID funded project whichencompasses microfinance institutions, donors and other local supporters in aMicrofinance Coalition. It has developed performance standards for microfinanceNGOs in the Philippines, which were launched in 1998. The Coalition does not haveany mandate to enforce the use of the standards. A number of leading NGOs in theMicrofinance Coalition have adopted the standards due to Board decisions for self-assessment as well as to provide information to donors.

Financial apexes such as the People’s Credit and Finance Corporation and CAREPhilippines use the standards as an evaluation tool for loan fund applicant NGOs.The Asian Development Bank also advocates the use of the performance standards intheir member countries for long term financing applications. Apart from these firstapplications, the Coalition expects usage of the standards to become more prevalentamong financial institutions together with fund providers once donor funds formicrofinance become more rare than they are currently in the Philippines.

Source: Garcia (1999)

Box 15The Philippine Microfinance Standards for NGO’s

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on profitability. Especially once donor funds are involved as fundingsources for the financial apex, disbursement pressures may additionallyprovide an incentive to lower the standards for access to financing. Apexinstitutions, which provide subsidized funding to agricultural lenders,are likely to have crowding out effects for deposit mobilization and theaccessing of other commercial funds by agricultural lenders.

When analysing the backgrounds of expressed desire of financial insti-tutions to become part of the external regulatory framework in a spe-cific country, it is important to bear in mind, that hidden agendas mayexist. In some countries, the prime motivation for non-conventionalfinancial institutions such as NGOs or savings and credit cooperativesto become regulated and supervised entities, may be access to financialapexes and government credit lines. For Central American countries,this has been recently emphasized as the prime motivation for becominga licensed institution (FOLADE, 1999). The desire stems from restric-tions of financial apexes to work with non-regulated financial entities.It remains questionable whether this interest can be sufficient to promptthe costly endeavour of external regulation and supervision.

Box 16 provides an example from Bolivia, where the overall frameworkof the financial sector has contributed to a widescale movement ofNGOs to become regulated entities.

5.4 COMMERCIAL FUND PROVIDERS

Commercial fund providers use the most powerful enforcement mecha-nism, which may have a domino effect on other commercial fundproviders once one of the providers pulls out This is the enforcementmechanism of withdrawing or cutting off access to new funds. However,the degree of utilization of this mechanism differs between socially moti-vated commercial funding (e.g. social investment funds) and purely prof-it-oriented commercial funding. Measured according to the effectivenessof regulatory force there are strong fund providers (commercial sources,depositors, good apexes) and weak/possibly distorting ones (donors,governments, bad apexes).

84

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External regulation may be called for to ease the process of obtaininginformation necessary for investment decisions. However, the primeconsideration for external regulation is the protection of small deposits.Commercial fund providers usually are expected to evaluate their owninvestment opportunities. Many commercial fund providers and apexfinance institutions require a formal status of the financial institution tobe financed. This is a means to ensure to some extent, that an externalregulator and some sort of supervision are in place that ensures safety ofthe investment.

Quasi-private commercial fund providers are those, who are searchingfor viable investment options while maintaining a social mission to theirinvestments. Examples in the world of microfinance in Latin Americaare ACCION’s Bridge Fund (guarantees) and Gateway Fund (equityinvestments). Both funds require a very detailed information, most ofwhich is gained through a personal on-site visit. While guarantee fundswill specifically focus on an institution’s relations to local commercialbanks, an equity fund will put importance on projected performance

85

Since the beginning of 1999, the role of the wholesale financial institution institutionsFONDESIF (Fondo de Desarollo del Sistema Financiero) and NAFIBO (NacionalFinanciera Boliviana) has been defined by a decree. These two institutions are nowthe only second tier institutions that channel funds from government and donors tothe financial sector. NAFIBO is confined to work with regulated institutions only,and FONDESIF is allowed to finance the portfolio of non-regulated institutions onetime before the hypothetical transformation into a regulated institution. The primeinstitutions to turn to for funding today are NAFIBO and FONDESIF. This providesa potent incentive for providers of microcredit to convert into the form of a PrivateFinancial Fund.

As Navajas and Schreiner (1998) put it, “the irony is that while supervision enablesan organization to take deposits [...], the link between supervision and open accessto cheap funds from an apex may relieve an MFO [microfinance organization, M.F.]from the need to push itself to make the effort to vigorously attract deposits in themarket.” At the same time, while the regulations imposed by the Superintendencyallow for deposit-taking, many of the institutions do not plan or at least do not placestrong emphasis on attracting depositors as major future funding source.

Sources: Fiebig (1999b), Navajas and Schreiner (1998)

Box 16Wholesale Financial Institutions and the Rush to Become Regulated in Bolivia

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and perspectives to investor participation in strategic decision-mak-ing.35

Generally, depositors’ inability to intensely monitor the performance ofthe financial institution they entrust their savings with is the mostimportant trigger for external regulation. However, capacity to super-vise differs across depositors, as larger, possibly institutional depositorsmay well be in a position to be well informed. Generally, public disclo-sure of audited, certified financial information is an important tool toenable depositors to make savings decisions on the basis of securedinformation. Accurate external audits together with disclosure require-ments constitute a necessary condition for strong depositor control.

Likewise, rating agencies may be used to provide depositors with moredetailed information. One recent example of this concept is theGuatemalan plans to introduce a specialized rating agency for selectedsavings and credit cooperatives. See Box 17.

5.5 RELATIONS BETWEEN MARKET AND EXTERNAL REGULATION AND

SUPERVISION

As with internal regulation, external regulators can use the incentiveeffects of certain funding sources to assure that proper control of thebusiness conduct of agricultural lenders is in place. Information disclo-sure plays a vital role in connecting regulation by funding sources withexternal regulation. Public information disclosure can help marketactors support their decisions to provide funds to financial institutionson solid information. Regular publication of key performance data, bal-ance sheets and financial statements form a good basis. While manycountries provide updated performance information of financial institu-tions, a number of nations still do not even review balance sheets ofcommercial banks required to be published. Transparency requirementscan enhance commercial market forces’ roles in the intermediary andthereby also lighten the workload of external supervisors. Rating agen-

86

35 Saltzmann et al., (1998) stress, that while ACCION’s CAMEL instrument does provideuseful information for investment decisions of ACCION’s fund managers, it lacks thespecific in-depth assessments needed in the context of equity investments.

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cies may form an additional tool to provide this transparency, thoughexperiences remain limited in a developing country context.

Also, in the ongoing external supervision, emphasis should be put onevaluating the extent and the form, in which funding sources affect afinancial institution’s business conduct. External supervision shouldmonitor and analyse the different funding sources of an agriculturallender for liquidity implications, interest rate sensitivity, impact on thefinancial institution’s governance, its profitability as well as conse-quences of possible concentration on only a few funding sources.Potential access to funding sources in cases of liquidity crunches is a keyaspect of liquidity risk analysis and needs to take into account the insti-tutions’ rating on the relevant financial markets.

87The federation of savings and credit cooperatives (FENACOAC) in Guatemala todaycomprises 39 out of 130 existing cooperatives. These are the institutions that haveopted for a WOCCU/USAID project in 1987, and today comply with most of thePEARLS system indicators. Out of these, 13 cooperatives have been selected to par-ticipate in a regulatory experiment. These will be regularly assessed by an indepen-dent rating agency. An adoption of the PEARLS system is expected to provide the off-site information, and regular on-site examination with a specific focus on the loanportfolio will complement this. Contractual agreements between the rating agencyand the cooperatives will include a range of sanctioning mechanisms.

The key information that will be provided to the depositors of the savings and cred-it cooperatives will either be a seal/no seal, or a more differentiated rating. This ishoped to provide a soundness signal to depositors, which so far demand an addi-tional “insecurity” premium of 2 percent on deposit rates as compared to banks’rates.

Source: CGAP Investment Proposal

Box 17The Guatemalan Rating System Project

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Findings: A Regulatory and Supervisory Perspective on Agricultural Finance

89

This study has shown, that the question of whether the provision offinancial services to rural farm households requires specific regulatoryand supervisory structure to prosper is not easy to resolve. A compre-hensive analytical framework has been introduced that embraces all pos-sible forms of regulation and supervision. The focus is on the role ofexternal, state-rule based regulation and supervision, the effects of inter-nal and self-regulation as well as regulation by funding sources. Whenconsidering adjustments necessary from either approach it is necessaryto take into account the others.

Which one of the regulatory sources defined is the most important onefor facilitation of financial services to farmers? The primary source ofinfluence on financial institutions’ action are owners and management.Only if owners and managers are willing and capable of venturing intoagricultural finance will it take place continuously. This recommenda-tion assumes only market-oriented financial institutions will be in theposition to provide financial services from credit, savings, insurance andpayment systems to the rural farmers. Government can provide incen-tives to support agricultural finance, but should not be involved in theactual provision of loans, as has been the case via development banks ina variety of countries in the past.36

Clearly the role of government through prudential regulation and super-vision is to provide a fair and competitive marketplace framework.Nothing more and nothing less is required. This means that specifica-tions and adjustments of regulatory and supervisory requirementsshould not go further than ensuring that different client groups in dif-ferent sectors are only treated differently once they have a different riskand cost profile for financial service provision.

Regulators should ensure a competitive level playing field in rural areas.Specific regulations, which impede agricultural lending to rural small-holders, should be modified to reduce undue discrimination. This studystressed several regulations, which often are the source of actual dis-crimination against agricultural lending. This refers to loan collateral

6 Findings: A Regulatoryand Supervisory Perspective

on Agricultural Finance

36 Efficient and effective development banks remain the exception from the rule, such asfor example (after substantial reform efforts) BAAC Thailand or BRI Unit Desa,Indonesia.

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requirements, which cannot be met by farmers, strict provisioningrequirements for “non-collateralized loans” and very strict and rule-based systems for the provisioning of possibly longer-term agriculturalloans. Branching regulations and reporting requirements also need to beadjusted so that they do not overburden rural financial institutions withcosts. Every additional regulatory rule implies costs for financial institu-tions. Rural finance is already a costly endeavour.

External regulation, however, should also not be more lenient with agri-cultural finance than with other sectors. All too often, when inadequa-cy of regulatory regimes is claimed, a relaxation to allow for financialflows to move to the agricultural sector is sought. Instead, it is proposedto require a higher capital coverage for agricultural loan portfolios thanother loan types. The capital adequacy ratio for these parts of the port-folio should be set substantially above the Basle Committee’s recom-mended 8%. Liquidity management requirements also need to take intoaccount seasonal and covariant risks in rural financial intermediation.Guidelines should also be stricter.

Agricultural finance is a risky and expensive business. However, theproblem does not lie with the unchangeable risks and costs which canbe avoided by not providing access to rural smallholders, but with theaccurate management of the risks and costs. External supervision shouldaccordingly zero in on the appropriateness of risk management systemswithin rural financial institutions. This implies a strong emphasis onqualitative, and not only quantitative measures. It also implies a focuson forward-looking, rather difficult to standardize assessment tools. Italso implies a stronger role of on-site supervision for agricultural financeproviders. Recent discussants have summarized the overall adjustmentrequirements for bank supervision in general banking as a risk-basedapproach to supervision. Examples of the adjustments of supervisorytools necessary have been presented in this text. So far implementationof such approaches has occurred in only a few countries worldwide.

A risk-based approach to supervision again implies high supervisorycosts on the part of the supervisory institution. Not only are large por-tions of on-going supervisory costs fixed, but moreover the geographicisolation of rural branches contributes to higher costs for appropriatesupervision. Requirements referring to control of strong internal controlsystems may help lower these costs.

90

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Apart from costs, supervisory capacity is a major issue in many devel-oping countries. It is clear, that a sophisticated supervisory system foragricultural finance will not work within a politically dependent, tech-nically inadequate bank supervision system. In many countries, there issubstantial scope for donor and government support to help tackle thisproblem.

Delegation of supervisory tasks is sometimes proposed as an alternativeto heal supervisory capacity and cost problems. However, it is oftenquestionable whether these arrangements provide better technical ade-quacy of supervision, and whether the delegation process introducesadditional control costs on the part of the delegating institution.

Self-regulation can complement external regulation and supervision. Asself-regulation per definition refers to self-imposed rules, conflicts ofinterest on the part of the self-supervisory institution are likely to pre-vail. Especially once deposit-taking from non-members/owners of finan-cial institutions is involved, self-regulation cannot suffice.

Regulation and supervision by funding providers is a difficult issue inagricultural finance. Concessionary fund providers, such as govern-ments and donors tend to have good intentions with funding agricultur-al loan portfolios or the expansion of savings services to remote ruralareas. Long-term, they may provide disincentives for the building of sus-tainable financial institutions. It is advised to use subsidy resources toincrease the management capacity of rural financial institutions ratherthan to fund agricultural loans.

Commercial fund providers, such as savers often fear institutions thatinvest substantial parts of their depositors’ money in the agricultural sec-tor. Agricultural lending is perceived as a high risk, high cost endeavour.Transparency, which is created by ensuring adequate internal and exter-nal auditing and additional information disclosure requirements, willsupport the establishment of trust between the saver and rural financialinstitution.

The circle closes with the adjustments or specific requirements neededfor internal regulation and supervision. The study has emphasized thatappropriate risk and cost recognition forms the basis for prudent riskand cost management in agricultural finance. Technical capacity and

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decision-making based on economic and agronomic evaluations of agri-cultural loans needs to be bolstered. Owners of financial institutionsneed to balance possible social objectives with profit objectives. Theyalso need to be in a position to be adequately informed about what risks,costs and liquidity challenges are involved in rural finance.

External regulation and supervision can support the well-functioning ofthese internal control mechanisms by requiring information disclosure,evaluating owners and managers qualitatively and prescribing appropri-ate internal control measures to be taken. Ensuring that only “healthy”rural financial institutions enter the market in the first place remains amajor challenge for external regulation.37

Table 14 provides a generic overview of the roles and the interplay ofdifferent regulatory and supervisory levels in a complex reform agenda.

Opportunity costs will have to be reviewed when determining whatinstitutions merit primary attention within the design of a reformprocess. Donor and government coordination in this policy fieldbecomes, as in many other fields, a fundamental prerequisite for a suc-cessful reform program.

92

37 It is important to reiterate that this recommendation refers to deposit taking financialinstitutions, which mobilize savings from non-member/owners and supercede a certainminimum size only.

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93

Table 14

Framework for the interplay of the different regulatory and supervisory levels

External Regulation andSupervision

Legal and RegulatoryAuthories

Bank Supervisors

Internal Regulation andSupervision

Shareholders

Board of Directors

Executive Management

Internal Auditor

External Auditors

Self-regulation andsupervision

Self-supervisoryinstitution

Critical

Indirect (monitoring)

Indirect

Critical

Critical (implementation)

Indirect(compliance)

Indirect(evaluation)

Indirect

None

Indirect

Indirect

Indirect

Critical

Critical

Indirect

Indirect

Set optimisedframework

Monitor

Appoint key players

Set policy

Implement policy

Test compliance

Evaluate andexpress opinion

Set policyframework

Monitor compliance

Key Players Responsibilityin Risk Management

Importanceon the Policy Level

Importance on theOperational level

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Glossary of Terms

95

External regulation and supervision

External regulation acts by legislative power. Usually involves special-ized public institutions, such as central banks, superintendencies andcourts, as external supervisors to ensure that the norms set are followedby the financial institutions.

Internal regulation and supervision

Internal regulation is a set of rules established by the owners of a finan-cial institution. Internal supervision is carried out by the owners them-selves, delegated to specialized boards, internal auditors and other enti-ties within the organizational set-up of a financial institution.

Prudential regulation and supervision

The process of structuring of financial institutions’ actions according toa set of rules and norms that ensures the protection of depositors’money, a safe and sound financial system and a competitive financialmarket structure.

Regulation

A specific set of rules that structures actions of market participantsaccording to certain principles. Regulation requires the existence of anenforcement mechanism.

Regulation by funding sources

The diverse funding sources impose certain requirements on financialinstitutions. Owners, as one of the sources of funds impose rules that arereferred to as internal regulation. The rules, to which a financial institu-tion voluntarily subscribes in order to gain access to funding, arereferred to as regulation by funding sources. Sources either monitorcompliance themselves or delegate part or all of the supervisory work toother supervisory institutions.

Glossary of Terms

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Regulator/Regulatory institution

A regulatory institution sets regulatory rules for financial institutions.Typical regulators are governments, ministries, central banks, banksuperintendencies; but are also owners, boards of directors, commercialand subsidized fund providers, as well as self-regulatory bodies.

Self-regulation and -supervision

Self-regulation refers to rules set voluntarily by financial institutionsthemselves. The decision to commit the institution to the fulfilment ofthese rules is taken either by the owners or by top-management. Self-reg-ulation can also be called delegated internal regulation, as the primarysource of regulation remains with the owners. Self-supervision is carriedout by institutions outside the organizational set-up of a financial insti-tution in order to ensure the fulfilment of the self-set rules.

Supervision

The process of collecting data, analysing the data and acting upon theanalytical outcomes of the data in order to ensure the application of reg-ulation.

Supervisor/Supervisory institution

A supervisory institution is entitled by the regulator to carry out theprocess of supervision of the set rules.

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