Regulating to establish systemic trust

June 26, 2015

By Agathe L’Homme

Camilla Nestor, Grameen Foundation’s Senior Vice President for Global Solutions, teaches a financial inclusion course at Columbia University’s School of International and Public Affairs. As part of her course, students submitted blog posts that were evaluated by professors and Grameen Foundation’s communications staff. The winning post is featured here.

I don’t trust my bank. There, I said it. I am a highly educated female from the global north and financially literate. Though I have been using financial services since I was first able to open a current and savings accounts at 14, my relationship with the banking industry has been of measured enthusiasm and persistent suspicion. There is no denial that my daily life, as well as my life goals, has been well served by the financial products I have received, from international transactions during my travels to accessing a loan to pay for graduate school. But this personal experience has been regularly strained by customer relations issues, distrust and diverging interests. 

Judging from my highly biased sample of relatives and friends, I am not the only one in this situation. And this type of relationship is not particular either to the banking industry. However this anecdotal story takes on another dimension as financial services, through microfinance, can be profitable and also benefit the poorest. One of the recurring mottos for microfinance providers is trust. It goes both ways as lending to the poor was at first perceived as a very risky move, but it was challenging as well to convince lower-income people to entrust some institution with their very modest but crucial resources. There are many ways this important and necessary goal can be achieved with, for instance, the use of an established and recognized actor, like a bank or a mobile operator, as well as successful and ethical business practices. 

The issue of trust in microfinance is particularly relevant as the tension between innovation and regulation has major consequences. The need for consumer protection is extremely strong, as the target population of these services is extremely vulnerable. However, in the case of microfinance, practice and innovation have often preceded legislation. The design and implementation of national legislation on microfinance is an important first step to set up client protection and sound regulation. An overview of the situation can be found with the report of Ernst & Young on “Client Protection in Microfinance- The current state of law and regulation”. One of its findings is that the legal and regulatory landscape of microfinance is still developing. But more importantly it highlights that while there is a focus on financial requirements for microfinance institutions, existing measures often rarely include provisions on client protection. 

Going back to my personal experience as an average Western consumer of financial services, I have to admit that my understanding of the products is far below what I would like it to be, which probably fosters part of my distrust. On the other hand, I have the insurance of relying on several mechanisms for support such as a public guarantee scheme for deposits, a legal framework on lending practices, regulated interest rates, consumer protection agencies and supervision authorities. 

Although this type of sophisticated and comprehensive system is still far from perfect, it mitigates the asymmetry of power between the financial providers and individual clients. Those are essential mechanisms, enabling by proxy trust in an overall system that is also needed for the beneficiaries of microfinance services. 

Faced with both criticisms on the basis of their economic development claims as well as with bankruptcies and cases of predatory behaviors, the microfinance industry has come up with common and agreed on principles and guidelines such as the Guide to Regulation and Supervision of Microfinance published by CGAP in October 2012. There are efforts for self-regulation as well with initiatives like the Smart Campaign or Truelift. NGOs are also working towards increased transparency on core issues such as the actual interest rates charged by microfinance institutions published by MFTransparency

However, apart from self-regulation initiatives and financial literacy efforts, adequate legislation is still much needed for customer protection, in particular, over-indebtedness. Of the 12 countries surveyed in the Ernst & Young study, only five have specific regulations to prevent over-indebtedness. This issue is related to the fact that many microfinance institutions are non-deposit-taking and therefore not included within the regulatory framework on commercial banking. Trust is hard earned, and microfinance institutions are working towards deserving it like many other businesses. However the imperative of an enabling regulatory environment to balance interests is all the more vital for the microfinance industry if it wants to live up to its developing goals.