The microfinance industry specifically caters to the low-income section, mainly self-employed individuals and consumers. Keeping in mind that the target client base lacks access and the knowledge to properly use financial tools, laws, and policies regulating, operations within the microfinance industry should strive to protect client interests. This can help avoid over-indebtedness that ultimately adversely affects the entire market. The laws should ensure that microfinance institutes are ethical in conducting their businesses.
Microfinance in the Developing Countries
The major difference between developed and developing economies is that the developed countries have a more structured, legally-bound framework for financial management that is available for most if not all, members of the country. In developing countries, the prevalence of self-funded and community savings organizations is at par with developed countries.
Still, due to lack of laws protecting the interest of both the financial institutions and the clients result in poor success in this industry. For instance, microfinance regulation for consumer protection in Kenya is quite poor. Looking towards the future, one must incorporate the lessons acquired from the past.
The History of Microfinance
Microfinance came into popularity when Muhammad Yunus, the pioneer of microfinance, started to shape the microfinance industry with the development of the Grameen Bank in Bangladesh in the 1970s. In his paper titled “History matters in microfinance”, Prof. Dr. Hans Dieter Siebel highlights the rich history of microfinance institutions across the globe. He warns against ignoring the lessons learned from these practices through trial and error. Studying the history of microfinance gives us an insight into what works and what does not work.
The history of microfinance in Europe gives prominence to the importance of regulatory policies in the growth and sometimes even the downfall of community-based microfinance institutes. The legal or formal control over the operations of small financial institutions was necessary as discrimination and credit underwriting affected the marginal community immensely. The following case studies will help better understand the idea.
- The Rise and Fall of the Microfinance Movement in Ireland Between 1720 and 1950:
In the 16th century, Europe faced an unprecedented increase in poverty. This necessitated the birth of financial institutions that loaned credit to the poor, looking to improve their living status. The first of these institutions emerged in Ireland in the 1720s – peer-monitored loan funds that provided funds to the poor interest-free and allowed for weekly repayments of loans. The growth of this industry was slow until regulations were in place allowing loan funds to charge interest on loans and even offer interest on deposits.
Thus, facilitated by the regulation and supervision of the Loan Fund Board (established in 1836), the loan funds evolved to become self-reliant, accruing profits from interests and improving their establishments, all while providing funds to the poor section of the community. They became so popular because of a lack of an upper limit on the interest rate on deposits that they started invading the client base for commercial banks. The commercial banks in the country were unable to compete and were losing customers helter-skelter. They fought back and demanded a cap on the interest rates of loan funds.
Through financial repression, the Loan Funds lost their competitive edge and ultimately disappeared in the 1950s. This case study highlights the importance of regulations that are sustainable in the long run and maintains a balance between growing microfinance institutions and commercial banks.
- The Positive Role of Regulatory Practices in the Growth of the Microfinance Industry in Germany Since 1778:
Microfinancing in Germany began with community-based savings funds and movements of savings and credit cooperatives established in rural and urban setups. They did not repeat the mistake the Irish made by starting with charities. Instead, they established the first thrift society in Hamburg in 1778, which led to the birth of the first communal savings funds in 1801. As the movement grew, so did the influx of savings, which allowed the savings fund to expand its credit business.
The success of savings funds in Germany was mainly attributed to the fact that they gave importance to self-reliance and built their model around the effective mobilization of savings. The intervention of legal processes for regulatory and safety purposes at an early stage of the development of microfinance in Germany was instrumental in the success of savings funds in Germany. It was also facilitated by promoting their facilities among various local groups and maintaining loyalty among participating members.
Ways in which Microfinance Helped Alleviate Poverty
The number one goal listed under Sustainable Development Goals given by the United Nations Department of Economic and Social Affairs is to reduce world poverty. The bulk of the population suffering from poverty belongs to developing countries, and as such, their efforts in reaching the goal are crucial. The effects of a developing microfinance industry in developing countries are manifold.
But with the implementation of financial strategies, it is extremely important for microfinance regulation for consumer protection in Kenya, Ghana, Tanzania, and other developing countries to be an absolute necessity to further the benefits of microfinance institutions. Some of these benefits are:
Availability of Funds for Emergency
Everyone has specific expenditures on a weekly, monthly, or yearly basis. These expenditures, along with savings, dig into their source of income. The remaining amount after the necessary disbursement is what is known as disposable income. Further, the disposable income is utilized for emergencies, investments, growing assets, etc. However, for the poor community, very little amount of disposable income remains. Through microfinancing, they can receive funds immediately in case of emergencies.
Providing Credit for the Unbanked
Commercial banks do not operate with small amounts of capital, but that is just the requirement of the lower-income section. Similarly, individuals without assets or unclear documents, as is prevalent in the case of women, are refused loans from banks, deeming it to be an unprofitable investment. The microfinance industry is specially built with such clientele in mind. They provide small capital to the poor to use for investments, asset growth, and reducing poverty.
Improved Rates for Loan Repayment
Microfinance institutions have fared better in terms of the rate of loan repayment. The community targeted by these institutes is honest and punctual regarding repayments. Thus, the institutes see value in such investments and poorer communities also benefit from access to credits.
Reaching Every Section of the Community
Using better outreach and targeting marginally vulnerable sections of society, microfinance institutes ensure that the needy who are overlooked by for-profit organizations have a fair opportunity to access financial services. Primarily they have access to bank accounts and realize money management what bank account for.
Education Rates are Increased
As children belonging to low-income families get inducted to work at an earlier age to support the family financially, their education gets hampered and even stopped. But with the financial needs of such families being taken care of, children can continue their education thereby increasing their chance of a successful future.
Targeting Poverty to Improve Overall Economy
The poor get poorer as a consequence of the unfair distribution of wealth, inaccessibility to proper financial tools, and ignorance about efficient financial management techniques. They lack sufficient funds to improve their status and are excluded from the general market. However, the economy of a country improves with greater financial inclusion. Hence, as more capital is available to individuals, there are higher chances of future investments.
Creating Job Opportunities
Small business owners also have a hard time gathering funding for their businesses via traditional methods. Microfinance institutions help them establish their business by providing access to funds which in the long run creates jobs and improves the overall social status.
Significant Economic Gains
As the overall wealth becomes evenly distributed throughout society, more and more individuals have larger disposable income and make active participation in economic development. Not only that, individuals are encouraged to increase their savings. This step is important because of savings are key to merchant payments in developing countries.
Client Protection Regulations in Developing Countries
The benefits of a microfinance strategy in improving the living standards of clients and growing an economy so far are not of any value if the clients are extorted in the process. Unfortunately, the present condition of the microfinance industry is replete with unethical practices that defy the whole purpose of these industries. Let us look at the different Client Protection Regulations in some developing countries to understand the situation better.
Kenya: A Case Study in Microfinance Malpractices
In order to improve the total standing of seven developing countries in Africa, several non-commercial funders committed around 50% of their total funds to developing Microfinance Institutes in sub-Saharan Africa. More than $75 million of which was dedicated to Kenya. Yet, political instability and lack of intervention by the government have resulted in prevalent malpractice, that ignores the client’s concerns, about microfinance institutions.
The growth of Microfinance Institutions in Kenya came about in the 1980s and 1990s when newer policies were introduced to liberalize the financial markets. As the success of these Microfinance Institutes increased, their contribution to the Gross Domestic Product (GDP) of Kenya increased to 14%. Still, the contributions to GDP from commercial banks surpassed that of Microfinance Institutes.
In 2006, the Central Bank of Kenya took the responsibility to formally license and regulate Microfinance Institutes within the country. Until 2009, Savings and Credit Cooperative Organizations (SACCO) were not under the regulations of formal financial institutions.
The SACCO Act of 2009 initiated the conversion of SACCOs into formally established institutions that are controlled by the regulations provided by the Central Bank of Kenya. Followed by this development, in 2010, mobile financial services started to gain popularity in the country. The most popular among those services is M-PESA owned by Safaricom and Vodafone. Although the Central Bank of Kenya introduced guidelines for microfinance regulation for consumer protection in Kenya, they are unable to reduce corruption due to improper execution and lack of supervision.
|Other Informal Institutions||32%||36%||28%||41%|
|Mobile Financial Institutions||N/A||28%||62%||71%|
Table 1: Customer’s usage of different financial institutions (source: Central Bank of Kenya, 2016)
The need for client protection policies is evident from the amount of trust the population puts in financial institutions. The Central Bank of Kenya conducted a survey to understand the level of trust their citizens have in the available financial service providers. This survey showed that both the rural and urban populations had the most faith in commercial banks, followed by mobile financial services.
Although, neither the rural nor the urban population trusted the services of a mobile bank account. Furthermore, the rural population was twice as skeptical about any financial service providers and the urban population seemed to trust financial institutions more.
To improve the conditions of microfinance institutes, the Central Bank of Kenya has focussed on three aspects:
Monitoring functions of financial institutions, both banks (including commercial banks) and non-banking financial service providers. This is done by collecting data and information on the various operations of the institutions directly from the financial service provider. Unfortunately, as there are no guidelines in place, financial institutions can manipulate the data in their favor before submitting it.
The Central Bank of Kenya is inefficient in its handling of disputes. They lack proper rules to resolve the conflicts that arise between several competing financial service providers and are unequipped to handle large amounts of conflicts at the same time.
Controlling False Advertising
Misleading advertising campaigns are used by financial service providers to increase their client base, but this harms the customer’s interests, and they ultimately lose faith in the entire system. Regulations placed by the Central Bank of Kenya aim toward limiting such ad campaigns.
The above steps taken to improve the microfinance regulation for consumer protection in Kenya will hopefully succeed in protecting client interests and safeguarding their investments.
Tanzania: A Case Study of Efficient Microfinance Regulation
The Tanzanian government privatized commercial banks and reduced barriers to entry to increase the growth of private sectors during the 1980s and 1990s. This propelled the rapid evolution of the financial sector in Tanzania.
In addition to the boost to private sectors, the regulatory power of the Bank of Tanzania over microfinance institutes was increased. The government has made efforts to license and regulate all operating financial institutions by formalizing rural and community microfinance institutes, SACCOs, and NGOs. The number of informal institutions compared to formal institutions is quite high, yet the customer base for formal institutions is higher. The Bank of Tanzania has taken many positive steps toward client protection. They include:
- In order to safeguard clients’ interests, every service provider is required to draft a contract between them and the clients beforehand, which includes interest rates, repayment conditions, etc. The information mentioned in the contract cannot be altered by the financial institute without first discussing it with the client.
- The Bank of Tanzania organized a credit reporting system to help financial institutions to decide on clients based on their creditworthiness. This is also beneficial to clients in the long run as it prevents them from continuously taking loans that they cannot repay.
- The Fair Competition Act enforced by the Bank of Tanzania ensures that monopolies are not formed.
Association for Social Advancement (ASA) International has laid down 7 core principles to ensure the protection of microfinance clients. They are:
- The product or services should be designed to answer the client’s needs, and the marketing of such products should be honest.
- Making the effort to prevent over-indebtedness.
- All interactions between the financial service providers and clients should be transparent so that everything is on board.
- The policies should see to it that no single financial institute can monopolize the market and charge exorbitant prices for their services.
- The clients are in the foreground, and they should be treated with respect.
- All client data should be confidential to prevent unethical use of data or any discrimination.
- The client’s complaints and grievances should be taken seriously, and steps taken for the resolution of those complaints.
Governments of developing countries are reliant on field experts to develop effective policies for client protection. The Africa board fellows deliberate on such matters as client protection in the microfinance economy, conflict resolution, managing sustainable growth, navigating competitive environments, etc. to determine strategies and policies to improve the overall health of the economy.
Importance of Financial Education in the Execution of Client Protection Laws
The regulations and laws guiding the operations of financial institutions and, by extension, the micro financial economy is put in place to ensure the ethical functioning of such institutes keeping the customer’s well-being in mind. The organizations in the microfinance industry providing financial services to customers have a huge responsibility toward their client base to safeguard their savings.
On the other hand, since the microfinance industry often deals with the poorer sections of society, they are either at risk of losing their investment or are unable to grow enough to be able to cater to a larger community. So, proper regulatory systems are absolutely essential to protect the interests of both the customers and the financial service providers.
All the policies put in place become ineffective if the customers are unaware of their rights. Microfinance industries are instrumental in providing financial services to the uneducated section of society. But, as marginalized communities are allowed to engage with the market, they should be educated on the proper usage of financial tools available to them to prevent them from incurring a debt they cannot repay. Financial education for them should include:
- Usage of Financial Tools to control their savings, investments, etc.
- Policies to protect their deposits and be aware of fraudulent behavior on the part of the financial service provider.
- Managing and growing investments to increase the overall income.
Financial Inclusion and Client Protection Policies
Client Protection Policies also play an important part in promoting financial inclusion. Financial inclusion refers to the appropriate involvement of every section of the community. Historically, due to the prevalence of prejudice, members of certain communities were kept from availing of credits from established financial institutions. Such practices have been mostly controlled with appropriate policies that regulate such behaviors.
Nowadays, due to the involvement of an ever-growing population, financial service providers need to be efficient in risk prediction. They use information from every possible source, even the customer’s digital presence, to assess the risk involved. In fact, Financial Inclusion Week dedicated all its discussions in 2022 to “Inclusive Growth in a Digital Era”. In the financial inclusion week final recap, it comes to light that social media has an unprecedented effect on credit scoring, but it is still a gray area on whether that is a good thing or not.
In order to reconcile client protection and financial inclusion, the economy of any nation needs to be flexible and strong. The developed countries have a better standing in this regard. But the economic strength of these countries is now being challenged by the problem of including immigrants into their system without upsetting the economy or reducing consumer protection. Immigration poses a problem for financial inclusion as identity norms hinder immigrants from getting involved in the market. It becomes a problem for financial inclusion and immigration in Europe disrupting identity norms.
Q1. Who is the client in the microfinance industry?
The microfinance industry specifically provides financial services to the poverty-stricken section of the population and those who are unable to avail of traditional banking services. Together they make up the client base for the microfinance industry.
Q2. Why is client protection important?
Client protection is important to prevent financial service providers from taking advantage of the poorer sector or excluding members of certain communities. The decisions and operations of financial service providers are responsible for the growth of the entire economy, and their actions should be under strict regulation to keep clients from losing money, causing the entire economy to go into debt.
Q3. What are Client Protection Principles (CPPs)?
Client Protection Principles are principles that are followed to protect clients’ interests, ensure fair and respectful treatment of clients, prevent misuse of clients’ confidential information, and address any grievances. These principles were outlined by ASA International.
The microfinance industry is absolutely crucial for economic development and alleviation of poverty, but the industry should focus on the client’s needs and complaints to improve their services. Government and other organizations’ interventions are important in executing and regulating the operations of the microfinance industry to ensure the continued loyalty of the customer.
- Jonas Taylor is a financial expert and experienced writer with a focus on finance news, accounting software, and related topics. He has a talent for explaining complex financial concepts in an accessible way and has published high-quality content in various publications. He is dedicated to delivering valuable information to readers, staying up-to-date with financial news and trends, and sharing his expertise with others.
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