Capital Requirement and Financing Provision Regulation in
Islamic Microfinance Institutions (IMFIs):
Single and Double Mandate (s)
Suhal Kusairi
Nur Azura Sanusi
School of Social and Economic Development
Universiti Malaysia Terengganu
suhal@umt.edu.my
Introduction
• Microfinance institutions have a very important role in providing
financing for microenterprises.
• Have a major problem since they usually fail to get financing from standard
financial institutions such as commercial banks.
• This type of business cannot meet the requirements needed by the
commercial bank, such as collateral, proper documentation, and financial
statements.
• MFIs also have an important role in reducing the poverty rate by
helping low-income households increase their capacity and synchronize
cash flow.
• Microfinance institutions are complements of government programs, for
instance by providing subsidies, free assistance, or funds.
• Empirical evidence using world data from 2005-2010 shows that
microfinance institutions grew to comprise about 35% of the total
establishments in the world. The number of active borrowers
increased about 108%.
• Academic studies have found that microfinance institutions have
an important role in equitability of income distribution, either
through financing microenterprise or low income households
(Ahmed, 2002) and (Churcil & Coster, 2001).
• Gallardo (2001) and Hoxhaj (2010) supported previous studies in
finding that among microfinance institutions focused on financing,
total assets, lending and the number of microfinance institutions
always experienced a significant increase.
• Several studies have shown that a major problem is the position
of microfinance institutions, since the service users do not have
supporting financial data or collateral, and they are startup
businesses.
• In addition, the asset structure of microfinance institutions is weak,
since it is normally very dependent on the government budget,
financial institution and internal or external donors.
• Microfinance institutions are in a poor position in regards to raising
funds from the third party.
• If problems cannot be solved, it is expected that microfinance
industries will not achieve stability and sustainability.
• Unfortunately, the legal and regulatory infrastructures for both
activities are weak, and the regulatory process is too simple, with a
possibility of overlap between departments within a country.
• In any case, the development of microfinance institutions is very
important for the industry, since it can increase people's capacity,
reduce poverty, and develop new entrepreneurial businesses by a
selection process and fair competition.
• The efficiency of the industry is a golden goal which is desired by
all parties involved.
• The development of regulations and laws will ensure that
microfinance institution operations and activities are succeeding and
can be controlled to ensure the interest of all parties.
• Unfortunately, the rapid development of Islamic microfinance
institutions has not been supported by proper regulations and
supervisions in all activities and operations.
• This is very important in order that Islamic microfinance institutions
be efficient and effective.
Objective of study
• Objective of this paper is to explore the existing rules and
regulation for microfinance institutions and how to better supervise
them.
• This study will analyse the specific regulations and laws in
financing provision and asset requirement, as well as the best
practices on how to conduct supervision.
• These two issues are very important, since these factors will
ensure the return and cost operational status of microfinance
institutions and risk management.
• In addition, the stakeholder interest of both sides will be protected;
the investor or depositor and the creditor or partner will be shielded
from excessive risk.
Structure and Behavior of Islamic Microfinance
Industry
Five types of microfinance institutions:1.
Commercial Banks: • Provide microcredit as an integral part of the services provided to customers
• A microfinance unit is a substitute and it needs to meet the needs of regulators.
• Part of the credit must be extended to microenterprise industries.
2.
3.
Non-banking institutions.
A cooperative:• An economic institution formed by members of groups that have a specific
purpose, whether in production, marketing, or finance.
4.
Non Government Organizations:• An organization established by a group of citizens with a specific objective;
normally they are involved in social issues.
5.
Government Agencies
• Is established by the government to help government programs.
• Each Islamic microfinance institution has a different focus on
activities. Some focus heavily on financing/lending activity, some are
balanced, but few are heavy on fund raising alone.
• Ilanto (2006) stated that microfinance activities are divided into two
activities; collection of deposits and lending.
• Collection of deposits and lending can be divided into regulated and
non-regulated microfinance.
• In addition, the central bank or microfinance development institution
itself is the regulatory agency for microfinance activity.
• Table 1 shows the features of microfinance institutions in selected
Asian countries.
Table 1: MFIs Structure in Asian Countries
Regulated MFIs
Legal basis
Non Regulated MFIs
Bank R/S
Non Bank R/S
Cooperative Rules
Microfinance Rules
Central Bank
MF Division
Cooperative Dev
Traditional/Risk Based
Loan
Deposit from public
-
-
Required
Not specific
Bank
Non Bank Institution
Cooperation
-
Not required
-
NGO
Gov. Agency
Community
-
Traditional
Group guarantees
Joint guarantees
Personal guarantor
Market determined + subsidies
Fixed by government
-
Group guarantees
Joint guarantees
Personal guarantor
-
Market determined + subsidies
Fixed by government
CAR
-
Required
-
Not Required
Financial report to regulator
External audit
Loan loss provisioning
Yes
Yes
-
Regulatory agency
Supervisory approach
Activity
Minimum capital
Institution provider
Collateral
Interest rate / Ujr
Required not specific
Required 5%-10%, 5%-20%, 5%-50% and
100%
Source: Modified from Regulatory Architecture for Microfinance in Asia.
Bank R/S
Non Bank R/S
Cooperative Rules
Microfinance Rules
Traditional
Loan / as conduit of government loans
Deposit from members
Regulatory and Supervisory Framework in Financial
System
The financial system consists of three components:1. Financial institutions:• Act as financial intermediaries for fund surplus and deficit
sectors.
• There are various financial institutions: commercial banks,
insurance companies, mutual funds, finance companies, and
deposit and savings companies.
• The types of institutions can be separated into two: banking and
non-bank institutions.
2. Financial market:•
Can be divided into the money and capital market.
3. Financial assets:•
Is a product that is traded in the financial market. It shows the claim to
real assets of the issuer.
• The existences of strong, competent and effective regulatory and
supervisory frameworks are a priority for each financial system of a
country and the responsibility of the central bank.
• A central bank is responsible for the financial system’s stability, a
reliable payment system, and high confidence of savers and investors.
• Currently, principle based regulations frameworks get a lot of attention
in development, as they maintain prudential regulation in the financial
system.
• Under this framework, principle based regulation and bank regulation
have progressively shifted to the development of a high level of
principle based standards and contain more details of bank regulation
expectations related to the soundness of banks and businesses.
Regulation and Supervisory Framework in Islamic
Microfinance Institutions
• Islamic microfinance institutions comprise a new industry that is
growing very quickly. IMFIs give a high expectation of economic
development and reducing the poverty rate.
• This is in line with the two main roles of Islamic microfinance
institutions, to provide financing services to microenterprise and to help
low-income households synchronize their cash flow.
• La Porta, et al. (1998) found that the legal and regulatory framework
will greatly determine the performance of the industry.
•The majority of researchers favor activity regulation, as opposed to
institutional regulation. They argued that regulation based on institution
is very difficult since there is a lot of variability in the types of institutions
and characteristics of IMFIs. It is more reasonable and simpler to
regulate based on the activity of IMFIs than to regulate institutionally.
• Most academics suggest that microfinance should follow the standard
banking industry model in terms of prudential regulation and hierarchy
regulation internationally, regionally, and nationally.
• However, Macchiavello, et al. (2011) did not agree with these
conclusions since most microfinance activities are not related to the
international environment in terms of financing assets or resources.
• The major activities of Islamic microfinance institutions include collecting
funds from internal and external depositors or investors.
• It is very important to financial institutions that their assets are derived
from external parties through deposits or financial investment instruments.
In the Islamic finance industry, financial instruments can be created
through Sadaqah, Waqf, Wadiah, Mudharabah, or Musharakah contracts.
• Another microfinance institution activity is financing, which is the main
activity with the possibility of hampering management priorities.
• Most microfinance institutions are the kind of government agencies,
NGOs, and cooperatives who remain silent for implementing programs
for social reasons, such as to help low-income households or to help
increase the capacity and outreach of microenterprise.
• In addition, many creditors and partners of Islamic microfinance
institutions have poor documentation, financial positions, and collateral.
• The diversity of the types of microfinance institutions causes difficulty in
forming regulations and supervisory frameworks on what they should do
or be prohibited from doing in their activities.
• The possibility of microfinance institutions becoming involved in a new
transmission of monetary policy is very important in the future, given the
enormous opportunities in microenterprise financing as their average
market share is up to 30-40 percent of the country's financial assets and
the majority of the population is involved in microenterprise financing.
Proposed Asset Requirement and Financing
Provision Regulation in IMFIs
• The characteristics of microfinance institutions are very specific. Differ
from standard commercial banks in terms of asset quality.
• Normally, the asset portfolio of a microfinance institution consists of
microcredit, micro investments, and fixed assets.
• Microcredit portfolios frequently show lower delinquency than normal
commercial bank portfolios (CGAP, 1996).
• However, MFIs normally have higher volatility due to the type of client
and the characteristic of the business, especially if management becomes
frustrated from a consistent focus on repayment performance.
• IMFIs have similarities in terms of asset quality with conventional
institutions, but they have special characteristics and philosophies in
terms of their basic ideas and behaviors (Shariah compliant).
• Minimum asset requirements and capital adequacy ratio of IMFIs are
factors that can be considered when looking at the current and future
expectations that IMFIs become more independent financial
intermediaries in terms of the collection and usage of funds.
• There is a strong argument for allowing IMFIs to use more aggressive
strategies as the bank's equity business. This is due to the huge
demand that is unmet by existing IMFIs.
• Since most IMFIs are not a complete financial intermediary, they
have financial costs high enough to be exposed to bankruptcy more
rapidly than normal commercial banks. In consideration, IMFIs should
be charged a CAR (capital adequacy ratio) higher than the existing
BIS (Bank International Settlement), which is at 8%.
• The standard rate of financing provision can be proposed into the
measurement and weighted based on certain portfolio policies that are
reviewed periodically. The general financing provision is recommended
to be higher than for normal financial institutions, at about 2.5 percent
• Table 2 shows a simulation of the financing portfolio provision, the
weighted for sale and lease contract, fee based contract, and the profit
loss sharing contract.
Table 2: Simulation of Financing Portfolio Provision
NPL Categories
Contract
Weighed
Standard
Substandard
Doubtful
Loss
2 cycles
3 cycles
4 cycles
5 cycles
Sales and Lease
30%
3%
16%
30%
100%
Fee Based
50%
4%
18%
40%
100%
20%
5%
20%
50%
100%
Profit
and
Sharing
Loss
• For simplicity’s sake, IMFI activities are divided into single mandate,
which focuses on financing activities only, and double mandate, which
focuses on both financing and collecting of deposits from public.
• Table 3 shows that single mandate IMFIs are required to fulfill the
minimum capital, financing and liquidity provision regulations.
• Double mandate IMFIs are required to fulfill the minimum capital,
capital adequacy ratio, financing, and liquidity provisions.
Table 3: Application of Prudential Regulation in IMFIs
Regulation Items
Single Mandate
Double Mandates
Minimum Capital Requirement
V
V
Capital Adequacy Ratio
-
V
Financing Provision
V
V
Liquidity Provision
V
V
• Llanto (2006) noted that different regulatory frameworks will have
varying impacts on MFIs and depositors.
• For microfinance regulation to be considered effective, it must show
several characteristics, according to Vogel (2000).
• Therefore, the argument is that strong existing regulation should be
based on the activities of microfinance institutions.
• Supervisory framework should be appropriate and in accordance with
current requirements of the risk based supervisory framework.
• Figure 1 shows a risk based supervisory framework, starting with
identifying the significant activities of financial institutions: lending and
investment, and deposit and investment collection.
Conclusion
• The efficiency of the industry is a golden goal which is desired by all
parties involved. Industry and the microfinance market describe the
distribution of economic resources; industry utilized it in a more
transparent, efficient, and equitable manner.
• The development of regulations and supervisions will ensure that
microfinance operations and activities are succeeding and can be
controlled to ensure the interest of all parties.
• The characteristics of microfinance institutions are very specific.
Normally, the asset portfolio of a microfinance institution consists of
microcredit, micro investments, and current and fixed assets.
• However, MFIs normally have higher volatility due to the type of client
and the characteristic of the business, especially if management
becomes frustrated from a consistent focus on repayment performance.
• There is a strong argument for allowing IMFIs to use more aggressive
strategies as the bank's equity business. As previously mentioned, risk
factors should be considered in determining the assets.
• In consideration, IMFIs should be charged a CAR (capital adequacy
ratio) higher than the existing BIS (Bank International Settlement),
which is at 8 percent.
• The consequences of IMFI features are that IMFIs should monitor,
analyse, and measure their financing portfolios on a regular basis.
Financing portfolio can be categorized as standard, sub-standard,
doubtful, and loss for every type of contract.
• In accordance with the characteristics of IMFIs exposed to higher
risk. The financing provision is recommended to be higher than for
normal financial institutions, at about 2.5 percent.
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