Lecture # 21 Role of Commercial Banks in Micro Finance Sector Micro Finance • Micro finance is the provision of financial services including Credit, Savings, Insurance etc, to those sectors of economy, which are not serviced by traditional formal financial institutions viz. commercial banks and non-banking financial institutions. • Microfinance caters to the financial services needs of the poor and micro enterprises and is normally collateral-free short term facility whereas the commercial banks generally deal with corporate clients, SMEs and individuals with • larger income levels and extend financing facilities primarily based on collaterals and borrowers capacity to repay. Microfinance in Pakistan Microfinance Providers Broadly there are two types of institutions in Pakistan providing micro credit/microfinance services to the poor households/micro enterprises • the Non Government-Micro finance Institutions (NGO-MFIs) /Rural Support Programs (RSPs) extending micro credit to the poor through sources other than public savings and • the formal microfinance banks providing a range of financial services to the poor and micro enterprises including micro credit, savings, payment transfers etc. • While the Microfinance Banks are eligible to mobilize public savings to finance their operations, the Government has established a wholesale window, the Pakistan Poverty Alleviation Fund (PPAF), • to provide wholesale funds/credit lines and grants to NGOs for on lending to the poor and capacity and infrastructure building. Law Implications • The formal microfinance banks are required to take license from State Bank of Pakistan under MFIs Ordinance 2001 to operate as microfinance bank and are under the regulatory ambit of the State Bank, • whereas the NGO-MFIs/RSPs are registered with Registrar NGOs/Provincial Cooperative Departments and are not under the regulatory ambit of State Bank. Suppliers of Microfinance • Category 1: Informal Sources • Category 2: Semiformal Sources • Category 3: Formal Sources Informal Sources Informal Reciprocal Arrangements Account for 83% of credit supply, Commercial creditors that liaison with marketing intermediaries, Land– based credit arrangements extended by landlords to farmers, Socially based arrangements of friends and family Semiformal Sources • Pakistan Poverty Alleviation Fund (PPAF) • NGOs –Multi- sectorial NGOs offers composite services: • education • Health • Infrastructure and community development • Offers Micro credit as a minor program –Few NGOs with microfinance as a core activity • Government sponsored programs NGOs in Microfinance • A number of NGOs are working in Pakistan, a few NGOs are doing their job with the contribution of international financial institutions. Formal • Commercial banks and licensed MFIs, by State Bank of Pakistan, Role of Commercial Banks in Microfinance Sector • Microfinance in its broadest terms can be defined as provision of a range of financial services such as deposits, loans, payment services, money transfers and insurance to poor and low income households, and their micro enterprises. • While a commercial bank is a financial institution that offers a broad range of deposit accounts, including checking, savings, and time deposits, and extends loans to individuals and businesses. • Primarily, the microfinance customers are large in number, scattered in far-flung areas with very minute transaction sizes. Only government or state bank alone cannot reach out to millions of potential Microfinance beneficiaries; • A whole well knitted network with almost doorstep reach is required, which is only possible when the commercial banks will be involved in microfinance. • In Pakistan it is estimated that as many as 5.6 million households need microfinance services but these services reach only to less than 1 percent, most probably because of the absence of commercial banks from the microfinance sector. • This way a poor person just need to visit his local commercial bank to get access to microfinance benefits, which will help reduce many economic problems. • One criticism over involving the commercial banks in microfinance is that commercial banks will charge higher interest rates, further lower the standard of living and will exploit the public. • The ground realities are totally different; empirical evidence has demonstrated that participants in microfinance programs have improved their living standards at both the individual and household level, and that this has provided increased educational opportunities for children. • For example, the clients of the Bangladesh Rural Advancement Committee increased household expenditures by 28% and assets by 112%. It was also demonstrated that Bangladeshi children were sent to school in larger numbers and stayed for a longer time – • almost all girls in Grameen Bank (A commercial bank!) client households had some schooling, compared with the rate of 60% in non-client households. • No doubt on the other hand the loans provided by the commercial banks to the microfinance beneficiaries are a bit expensive, its not to discourage the poor but there is a sound reason behind it; • Providing financial services to poor people is quite expensive, especially in relation to the size of the transactions involved. A $100 dollar loan, for example, requires the same personnel and resources as a $2,000 one thus increasing per unit transaction costs. • Loan officers must visit the client's home or place of work, evaluate creditworthiness on the basis of interviews with the client's family and references, and in many cases, follow through with visits to reinforce the repayment culture. • It can easily cost US$25 to make a micro loan. While that might not seem unreasonable in absolute terms, it might represent 25% of the value of the loan amount, and force the institution to charge a “high” rate of interest to cover its cost of loan administration. • If commercial banks are to be involved in the micro finance by no means it would be a wrong decision for them as regard to their primary aim, profitability. • Yes it can. Data from the Micro Banking Bulletin reports that 63 of the world's top MFIs had an average rate of return, after adjusting for inflation and after taking out subsidies programs might have received, of about 2.5% of total assets. • This compares favorably with returns in the commercial banking sector and gives credence to the hope of many that microfinance can be sufficiently attractive to mainstream into the retail banking sector. • Many feel that once microfinance becomes mainstreamed, massive growth in the numbers of clients can be achieved. According to a recent analysis conducted by the Consultative Group to Assist the Poor (CGAP), • the compound annual growth rate of the world’s leading microfinance providers over the last five years has been a whopping 15%. Micro-insurance • Micro insurance is the provision of insurance to low-income households. • Poor households are especially vulnerable to risk, both in the form of natural calamities as well as more regular occurrences of illness and accidents. Micro-insurance • Microfinance Institutions (MFIs) have played an active role in reducing or protecting against this vulnerability through providing credit for increasing income earning opportunities and through providing savings services to build up resources that can be drawn down in cases of emergencies. • However, some events still translate into crisis for many poor households and erode the economic gains they have made as clients of microfinance programs. Micro-insurance • Credit and savings services are inadequate when households are exposed to risks which cause losses that are beyond their means. • Insurance can serve as a promising response to such client needs. • Today micro insurers are providing different forms of insurance for life, health, property, disability, agriculture (crop), etc. • Poor households pay a small premium for limited coverage in the event of losses. Basic Insurance principles • Basic principles that should be observed by micro insurance providers are universal to insurance and risk management. They include: Basic Insurance principles 1) Similar units exposed to risk. 2) Limited policy holder control over the insured event. 3) Existence of insurable interest. 4) Losses are determinable and measurable. 5) Losses should not be catastrophic. 6) Chance of loss is calculable. 7) Premiums are economically affordable. State Bank of Pakistan & Micro Financing • The State Bank of Pakistan’ mission is to promote monetary and financial stability • Foster a sound and dynamic financial system • Its primary functions include: • issue of notes, • regulation of the financial system, • lender of the last resort, • And conduct of monetary policy SBP secondary functions include: • The management of public debt, • Management of foreign exchange, • Advising the Government on policy matters, • Anchoring payments system, and maintaining close relationships with international financial institutions. • Responsibilities of the State Bank of Pakistan go well beyond the conventional functions of a Central Bank, by including the economic growth objective in its statute and supporting the development of new financial institutions to promote financial intermediation. • SBP has also directed the use of credit according to development priorities, providing subsidized credit. • State Bank Pakistan support to microfinance commercialisation • The State Bank of Pakistan has encouraged the entry of private sector institutions into microfinance through an enabling environment. • As Pakistan's financial regulator, SBP has been entrusted by the MFIs ordinance 2001 with the licensing, regulation and supervision of Microfinance Banks (MFBs). • SBP is the implementing agency for strengthening supervision and regulation under the Rural Finance Sector Development Program (RFDP). • SBP is also incharge of special funds of more than US$70 million to lend support to the microfinance sector and provide risk mitigation mechanisms to poor depositors and borrowers of microfinance banks. Regulatory framework • The framework (MFIs Ordinance 2001) allows the establishment of three categories of formal microfinance banks, with minimum paid-up capital required: Nation wide MFBs: Rs. 500 million Province wide MFBs: Rs.250 million District wide MFBs: Rs.100 million • NGOs and other microfinance providers can bring their loan portfolio to contribute to up to 50% to the capital requirements.