A new FAI paper asks: So how exactly do we regulate microfinance?

That is indeed the question when regulators so often find themselves playing catch up – trying to figure out if and how something that’s already happening should be supervised. When it comes to prudential regulation – or, safeguarding deposits – the stakes are particularly high.

In microfinance, most MFIs aren’t big enough to threaten the health of the financial systems they’re part of if they run into trouble. However, if prudential regulation of microfinance is inadequate – or when it fails – poor customers stand to lose their savings entirely. And the stakes really don’t get much higher than that.

As with other forms of regulation, the basic dilemma is that regulators of microfinance want to ensure the health of financial institutions without creating undue burdens on the institutions, or on themselves. Striking the balance is tricky when experience with regulating financial access and evidence to support hypothetical costs and benefits are so thin.

In his third Policy Framing Note for FAI, David Porteous sheds some light on why these challenges are so, well, challenging, and describes early experiences with prudential regulation of microfinance in India, Nigeria, the Philippines and Nigeria.

According to the paper, there are two basic ways to integrate microfinance into regulatory frameworks. One is to amend existing regulations; the other is to write new laws that open special “windows” for microfinance. The window approach is appealing, since microfinance is a rather unique animal in the world of financial services. But, as CGAP points out in its 2003 “good practice” guidelines, for the sake of consistency and efficiency, financial regulation really works best when it focuses on activities or functions, not on types of institutions.

In the end, there’s no such thing as off-the-rack regulatory policy, and amending existing regulation to incorporate microfinance just isn’t always doable. Some activities, like mobile banking, are so distinct, they simply demand their own sets of rules. What’s more, regulation should always be considered on a country-by-country basis. But paying close attention to early experiences with prudential regulation of microfinance will certainly help policymakers start to make smart choices.