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PART A 

RATIONALE FOR CREATING CONDUCIVE POLICY ENVIRONMENT FOR MICROFINANCE INSTITUTIONS

History Of Rural/Micro Finance  

 Pakistan is an agrarian country with about 64% of the population still living in rural areas despite large-scale migration from rural to urban areas since independence in 1947. Agriculture presently contributes 25% to the GDP, employs about 50% of the labour force and most of the industrial and services concerns depends largely on the performance of agriculture. To cater to the financial needs of this huge sector Government established a specialized institution, the Agricultural Development Bank of Pakistan (ADBP) in 1960 and since then it has been a major supplier of credit to the rural population. The Commercial Banks after nationalization in 1974 expanded their branch network to rural and far flung areas and have been extending financial services, savings and credits in the rural areas, their contribution in the overall rural finance however has been unimpressive. To further enhance the level of rural credit and to promote the cooperative societies and cooperative movement in the country the Government established Federal Bank for Cooperatives (FBC) and Provincial Cooperative Banks (PCBs) in late 1970s. 

Institutions Failure In Fulfillment Of The Financial Needs Of Rural Areas

The FBC along with PCBs played some positive role in development of cooperatives and extension of rural credit in the initial years, it however, could not sustain despite development of 66,000 primary societies, primarily due to misuse of subsidized funds and incapacity of FBC to effectively monitor and regulate the activities of PCBs and the Societies. The Government has recently liquidated the FBC. The PCBs except the Punjab Provincial Cooperative Bank are also not in a good financial shape and might meet a similar fate. The Punjab Provincial Cooperative Bank, the only scheduled cooperative bank will however, continue its operations and may be converted into an MFB. 

The Agricultural Development Bank though a major supplier of the rural credit, is also ailing with huge portfolio of non-performing loans (NPLs), low loan recovery rates and consequently, low profitability. The institutional efficiency in terms of quality of service to the customers and positive impact on the sector is also not very satisfactory. The ADBP (ZTBL) lending is however, collateral based and as such could not cater to the financial needs of the poor except through special program, the outreach of which is limited.    

The NGOs though have done a lot by extending Microfinance Services to the poor through effective targeting, participatory approaches, capacity building and gender sensitivity. Yet, their Microfinance operations are unlikely to attain financial self-sufficiency. The outreach of all these sources of rural/microfinance is very low at about 5% of the total target market consisting of 6.5 million poor households. As these NGOs are solely dependent on donor funding and credit lines, therefore they lack a stable/sustainable stream of funds available to them which in turn restricts their outreach capacity.     

Government's Initiatives for the Development of MF Sector in Pakistan: 

The Government learning from success of microfinance programs around the World and recognizing it as an important poverty reduction tool has taken some key steps during last few years to provide an enabling environment to MFIs so that provision of MF services to the poor on sustainable basis could be ensured. These include: 

·        Establishment of Pakistan Poverty Alleviation Fund with the assistance of World Bank

·        Establishment of Khushhali Bank with a capital Base of USD 30 Million

·        Incentive based Policy to encourage private investment in the sector

·        Creation of Microfinance Sector Development Funds

·        Restructuring of Agricultural Development Bank of Pakistan 

The Pakistan Poverty Alleviation Fund 

The PPAF has recently been one of the most significant developments in the MF sector. The PPAF has been modeled on the Palli Karma-Sahayak Foundation (PKSF) of Bangladesh, which functions as an apex financing institutions for MFIs. Like the PKSF, the PPAF has been registered as a private, autonomous company and has a Board of Directors, 8 of the 11 board members are representative of civil society. The PPAF has been established with a clear commitment to alleviating poverty and focuses on improving the access of communities to financial services and enhancing investments in productive infrastructure projects. Keeping these broad objectives in view, the PPAF aims to strengthen the microfinance sector in the following manner: 

• To provide a permanent source of funds to credible and reputable NGOs and to foster long-term relationships with such partners.
• To nurture intellectual debate within the sector on issues relating in particular to enhancing the outreach of financial services to the poor and at the same time gauging its link to poverty alleviation.
• To inculcate and promote standards and to encourage new innovative methods to improve the quality of services being offered.

The PPAF plans to disburse a total of US$ 100 million within a period of five years and this is earmarked as follows: US$55 million for micro credit, US$20 million for capacity development and US$25 million for infrastructure investments. It has so far disbursed more than 20% of the resources through partner NGOs. The Capacity building component of the fund is being used to build the capacity of NGOs to enable them to deliver MF services on sustainable basis and ultimately graduate into MFIs having the capacity to extend MF services on sustainable basis.

Establishment of Khushhali Bank (KB)- The Microfinance Bank 

The Khushhali Bank (KB) has been established to institutionalize the Microfinance policy with a paid-up capital equivalent to USD 30 million contributed by 16 Commercial banks operating in the country. The organization and operations of KB have been designed for a sustainable community-based service delivery system. The KB business model/framework requires structural integration and partnership with the NGOs.  It has an outstanding disbursement of around Rs.450 million to about 50,000 borrowers and during next five years it will reach to another about 450,000/- borrowers and almost similar number of savers. Khushhali Bank has been able to develop its portfolio and credibility in the market and it may lead the way for financial integration and overcome the reluctance of money markets in investing in Microfinance. In partnership with KB, the NGOs are expected to nurture and mature themselves in terms of systems, procedures, documentation and banking products to graduate into MFIs. 

Incentive based Policy to Attract Private Investment in MFIs

With the objective to attract private sector investment in MF sector, Government has allocated funds equivalent to USD10 million to extend grants to licensed MFIs to finance their initial establishment expenses, infrastructure development and branch net work expansion. The size of the grant funds is likely to be increased in the near future once funding arrangements with different sources are finalized.  Additionally MSDP funds, discussed in the next section, have been created to finance the social mobilization cost of MFIs, provided the function is outsourced to NGOs. 

Microfinance Sector Development Program Funds

The Government showing full commitment and resolve to promote the MF sector on sustainable basis has created special funds valuing more than USD 70 million. The Microfinance Social Development Fund (MSDF), an endowment fund valuing USD 40 million has been created to finance the social mobilization and community capacity building expenses of licensed MFIs provided the functions are outsourced to NGOs having expertise in this very field. The Community Investment Fund another endowment fund valuing USD 20 million has been created to provide matching grants to Community based Organizations to develop projects of mutual interest. This fund is also being utilized by MFIs in collaboration with NGOs. Then there are Deposit Protection Fund (DPF) and Risk Mitigation Fund (RMF) valuing USD 5 million each has been created to mitigate the risk of MFIs depositors and borrowers respectively. The mechanism is being developed to transform these funds into actuarial based risk mitigation instruments. 

The MSDF, the largest of the four MSDP funds, does not only finance some of the operational cost of licensed MFIs but also provides an opportunity to the NGOs to work in partnership with MFIs and gradually develop their capacity to apply for an MFIs license. 

Restructuring of Agricultural Development Bank

The restructuring of ADBP commenced with its portfolio audit and preparation of Restructuring and reorganization Plan by KPMG. The restructuring of the institution started with its corporatization and conversion into Zarai Taraqiati Bank Limited (ZTBL), and incorporated as limited company owned by the government of Pakistan with an enhanced paid up capital and a clean balance sheet with a leaner structure. The restructuring includes its process, system and product reengineering, with major emphasis being laid on reorientation of existing employees with specific focus on their capacity building, induction of a professionals and strengthening its management team. ZTBL restructuring is part of the reform agenda of the proposed ADB-funded Rural Finance Sector Development Program for $250 million. 

The reorganization of ADBP will increase its efficiency and outreach, enabling ZTBL formerly ADBP to cater to much larger segment of Rural population, giving room to MFBs / MFIs to concentrate on its lower segment / poor customers.

PART B 

POLICY & REGULATORY AND SUPERVISORY FRAMEWORK FOR MICROFINANCE BANKS / INSTITUTIONS.

POLICY & LEGAL FRAMEWORK

The government has adopted a Microfinance policy that mainstreams the concept of sustainable Microfinance, recognizes the need to enhance social capital, and considers risk mitigation as a necessary safety net measure for the poor. It also recognizes the need for and encourages private sector, especially NGOs, in poverty reduction and their entry into banking with the poor to ensure innovation and flexibility. It has enacted a legal framework for establishment of MFIs in private sector, known as MFIs Ordinance 2001. 

The MFIs Ordinance 2001 inter alia stipulates the functions, capital requirements, ownership structure, terms and conditions for establishing Microfinance Banks/Institutions in the country, audit and disclosure requirements and winding up procedure. It allows establishment of three categories of MFIs i.e. the MFIs having operations on national level, MFIs operating in a Province and the MFIs operating in a specified District with minimum capital requirements of Rs.500 million, Rs.250 million and Rs.100 million respectively for nation, province and district based MFI. The prospective MFIs are required to be incorporated as Limited Liability Company under the company law before applying to State Bank of Pakistan (SBP), the Central Bank, for an MFI license. The SBP being the only regulatory and supervisory agency for all deposit taking institutions has been entrusted with responsibility for regulation and supervision of MFIs as well. It will use both off-site and on-site surveillance techniques for the purpose. It will ensure good corporate governance and introduction of prudent business policies and practices in MFIs. The framework provides the scope for NGOs to become regulated MFIs provided they meet the requisite criteria.  The First Microfinance Bank Limited co-sponsored by a renowned NGO AKRSP has already been issued a MFI license. It is expected that a number of matured NGOs and Rural Support Programs presently operating in Pakistan will be licensed as MFIs.  

The legal and regulatory systems have been designed for financial intermediaries with substantive long-term interest in microfinance. NGO microfinance providers are subject to these provisions only when they seek a depository MFI status. Thus, the NGOs have the flexibility to either maintain their institutional orientation or to transform into MFIs. The microfinance sector thus now consists of new licensed depository MFIs, NGO microfinance providers, and partnership arrangements between MFIs and NGOs that provide social services.  

REGULATORY AND SUPERVISORY FRAMEWORK FOR  MICROFINANCE BANKS / INSTITUTIONS. 

The regulatory framework for the MFBs/MFIs has been developed through consultative process with a perception of relatively lenient regulations to enable the MFIs to grow. Being in the initial phase presently most of the supervision is off-site relying on the returns and data being/to be received from the MFIs with occasional on-site visits to have a feel of overall systems and control in place in the MFIs.  

Regulatory / Supervisory Framework consists of the following: 

   a) Criteria and Conditions for Grant of License for Establishing Microfinance Banks/Institutions.

   b)   Prudential Regulations for Microfinance Banks / Institutions.   

In order to maintain transparency in the process of granting of License for establishing an Microfinance Institution, SBP developed the criteria and conditions that was refined with the input of some international MF experts. This Criteria has been made public going through the consultative process and with the consensus of MF stakeholders. The criteria is readily available at SBP Website (www.sbp.org.pk). 

The Criteria requires that the MFB/MFI shall be a public limited company incorporated in Pakistan, whose Memorandum and Articles of Associations shall be reviewed and cleared by State Bank of Pakistan, the number of sponsor Directors shall not be less than seven. MFB/MFI shall have a minimum paid up capital of Rs. 500 million, Rs.250 million and Rs.100 million respectively for countrywide, specific province-wide and specific District-wide operations. However, NGOs/Projects having exposure and understanding of the dynamics of the MF Sector may apply for a license under MFIs Ordinance and they may contribute up to 50 percent of their capital in form of their existing portfolio of micro-credit and other assets (net of losses) after due diligence by a reputed Chartered Accountancy firm on the SBP's panel of auditors. 

The promoters or sponsor members shall subscribe at least 51% of the total paid up capital, these shares shall remain in safe custody of SBP and shall not be transferable nor encumbrance of any kind shall be created thereon without prior permission in writing from SBP. The amount proposed to be subscribed by each sponsor Director is required to be indicated separately. Sponsor Directors should have declared/Certified personal Net Worth, which should not be less than the amount to be subscribed by them personally. They shall furnish names of the banks/DFIs along with the names of the branches with which they have had dealings alongwith reports from these Banks or DFIs. The Sponsor Directors and Chief Executive shall submit commitment letters to serve against their respective positions. 

However, Institutional sponsors shall submit a resolution of their respective Boards/Governing Bodies for i) sponsoring the MFB/MFIs either individually or in collaboration with other persons ii) the amount to be subscribed and iii) the nomination of Directors representing the institution on the MFB/ MFI Board. It shall also submit latest years audited financial statements along with the auditors' opinion on the financial repute and capacity of the institution to make the proposed investment in the MFB/MFI. 

Foreign investment shall be allowed in accordance with the Govt. Foreign Investment Policy. While dividends may be repatriated with SBP approval, the repatriation of principal will be allowed at inter-bank exchange rate in case of sale of shareholding to sponsors acceptable to SBP. 

Applications may be disqualified if any of the sponsor Directors or their spouses has been convicted by a court of law in Pakistan or abroad for a criminal offence, associated with any illegal activity especially in contravention of banking and corporate laws, is a defaulter of banks and other financial institutions or tax authorities. 

The applicant shall also submit following documents with the application, which shall be used for analysis:

     Feasibility Study for setting up the Microfinance Bank/Institution in the specified area i.e. the specific district, province or the whole country;

     The organizational structure alongwith detailed CVs of the Chief Executive and the Senior Management team.

     The microfinance model(s), which the proposed MFB/MFI would be using for extending MF Services

     Short term and long term business plans 

The MFIs must commence operation within six months of the grant of license by the SBP. The Microfinance Banks / Institutions, which may be permitted to be established, shall bound to comply with the provisions of Microfinance Institutions Ordinance 2001, Rules Regulations framed under it and SBP directives to be issued from time to time. 

PRUDENTIAL REGULATIONS FOR MICROFINANCE BANKS/INSTITUTIONS:  

The basic Philosophy and theme of the regulatory framework is that it should be responsive to the peculiar characteristic of MFIs activities and should address the risks associated with the functions/activities of MFIs without stifling their growth. Considering limited capacity of SBP in MF regulation and supervision, international MF experts was hired as a consultant to give input for the regulatory framework for MFIs in consultation with domestic MF practitioners/stakeholders and keeping in view the international best practices adaptable to our local conditions. 

Prudential Regulations for MFBs/MFIs prescribes guidelines on capital requirements, creation of reserves, loan & Investment classification and provisioning requirements, exposure limits, code of conducts, on procedural issues, management and its conduct, reporting requirements and punitive measures on non compliance of instructions. A brief Highlights of different PRs are as follows: 

Minimum Capital Requirements-

MFB/MFI shall have minimum paid-up capital as prescribed in MFIs Ordinance 2001 and it shall also maintain equity equivalent to at least 15% of its risk-weighted assets, risk weights of various assets have been defined. The reason of assigning 15% Capital Adequacy Requirement is due to high risk associated with unsecured lending. 

Exposure against Contingent Liabilities-

The Contingent liabilities of the MFB/MFI for the first three years of its operations shall not exceed three times of its equity and there after shall not exceed 5 times of the MFB/MFI's equity.  

Cash Reserves & Liquidity Requirements-

MFB/MFI are required to maintain 5 % of its Time & Demand Liabilities as Cash Reserves and additional 10% as Liquidity in liquid assets i.e. gold and approved securities. 

Statutory Reserve-

MFB/MFI shall create a reserve fund to which shall be credited an amount at least 20% of its annual profits after taxes till it reserve fund equals the paid-up capital of the MFB/MFI and after that 5% of its annual profit after taxes.

Depositors' Protection Fund-

MFB/MFI is required to establish and maintain a Depositors' Protection Fund or scheme for the purpose of mitigating risk of its depositors, to which MFB/MFI shall credit not less than 5% of its annual profit after taxes. 

Restriction on certain types of transactions-

The MFB/MFI shall not allow any facility for speculative purposes;      allow financing facilities and other Microfinance Services to any of its sponsors, directors or employees including their spouses, parents, and children. The rule shall not apply on loans given to employees under staff loan policy of the MFB/MFI; without the prior approval in writing of the State Bank, enter into leasing, renting and sale / purchase of any kind with its directors, officers, employees or persons who either individually or in concert with their family members,  beneficially own 5% or more of the equity of the MFB/MFI & hold, deal or trade in real estate except for use of MFB/MFI itself. 

Maximum Loan Size-

The MFB/MFI shall not extend loans exceeding Rs.100,000/- to a single borrower. However, the MFB/MFI shall ensure that the loan amount is commensurate with the business requirements and repaying capacity of the borrower 

Maximum Exposure of a borrower from MFBs/MFIs/Other Financial Institutions / NGOs-

 MFI/MFB shall ensure that total exposure of its clients from banks/ MFIs/MFBs/Other Financial Institutions/NGOs etc. does not exceed Rs.100,000/- in aggregate. For this purpose, they will obtain a certificate from the clients regarding borrowings from banks and other MFIs/MFBs/NGOs. 

Classification of Assets And Provisioning Requirements-

(a)  Loans & Advances-

     i.      OAEM: loans in arrears (payments/installments overdue) for 30 days or more but less than 90 days

     ii.     Substandard: loans in arrears (payments/installments overdue) for 90 days or more but less than 180 days   

     iii.     Doubtful: loans in arrears (payments/installments overdue) for 180 days or more but less than 365 days

     iv.     Loss: loans in arrears (payments/installments overdue) for 365 days or more 

Provisioning Requirements-

A General Provision equivalent to 2% of the net outstanding advances (advances net of specific provisions) will be maintained by the MFB/MFI and in addition to the general provision, the MFB/MFI shall make specific provisions against NPLs on OAEM, Substandard, Doubtful and Loss 0%, 20%, 50% & 100% of outstanding principal net of cash collaterals respectively.        

(b)   Investments And Other Assets-

The MFB/MFI shall value its investments on mark-to market basis. However, in case of investments & other assets where active market does not exist, the MFB/MFI shall make subjective evaluation of such investments and other assets to determine their quality, category of classification and provisions required, keeping in view the risk involved and the requirements of international accounting standards. 

Rescheduling / Restructuring of loans-

MFB/MFI shall reschedule / restructure the NPLs as per the policy approved by their BOD. The rescheduled/restructured loans shall, however, remain classified unless serviced regularly for 6 months. 

Writing-off Non-Performing Loans (NPLs)-

All NPLs shall be written off, one year after the default in performance. This shall, however, not extinguish the MFI's/MFB's right of recovery of such written off loans. 

Pricing of MF Products and Services-

The MFB/MFI shall implement appropriate pricing policies, which ensure access of affordable financial services to the poor as well as operational and financial self-sustainability of MFIs. 

Investment in Shares Of Any Body Corporate-

The MFB/MFI may acquire or hold shares of any body corporate, the objective of which is to provide microfinance services to poor. The maximum investment in such a company, however, shall not exceed 15% of paid-up share capital of that company or 15% of MFIs' own equity free of losses, whichever is less. For making investment in excess of the 15% limit, prior permission from SBP shall be obtained. 

Prevention of Criminal Use of MFB/MFI Channels for the Purposes of Money Laundering and other unlawful trade

While considering proposals for extending Microfinance facilities, the MFB/MFI shall make all reasonable efforts to determine the true identity of its clients and shall develop and implement effective procedures and methods for the purpose. It shall interalia obtain copies of National Identity Card or Passport or Driving license etc. from the client which shall be stamped as original seen by the MFB/MFI officer. In far-flung and remote areas where people, particularly women, don't have identity cards, the MFB/MFI may extend micro-credit by establishing identity through other appropriate means. For Corporate clients, the MFB/MFI shall obtain by-laws, Memorandum & Articles of Association and Board Resolution etc. before extending services. 

Removal of Records-

The MFB/MFI shall not remove from specified area, to a place outside that specified area, any of its records and documents either physically or electronically relating to its business without the prior permission in writing of the State Bank of Pakistan. 

Management-

No member of the Board of Directors of an MFB/MFI holding 5% or more of the paid-up capital of the MFB/MFI either individually or in concert with his/her family members or concerns / companies in which he / she has the controlling interest, shall be appointed in the MFB/MFI in any capacity save as the Chief Executive of the MFB/MFI and that no payment shall be made or perquisites provided to the non-executive directors other than travelling and daily allowances for attending meetings of the Board of Directors or its Committees. Provided further that not more than 25% of the total directors can be paid executives of the MFB/MFI. 

Places of business-

The MFB/MFI shall not open new places of business without prior permission in writing of the State Bank. The approval/permission for opening of new branches/places of business shall be granted in accordance with the MFIs Branch Licensing Policy. 

Undertaking of cash payments outside the MFB's/MFI's authorized place of business-

The MFB/MFI shall not undertake any business of cash payments at any place other than the authorized place of business. However, this rule will not apply in case of Mobile Banking where permission has been obtained from the State Bank. 

Reconciliation of inter-branch accounts and settlement of suspense account entries-

The Entries booked in the Inter-Branch Accounts and/or Suspense Account must be reconciled/cleared and taken to the proper heads of accounts within a period of 30 days from the date entry is made in the above-named accounts. 

Audit and submission of accounts-

The MFB/MFI shall get its books of accounts audited in line with the provisions of section 16 of Microfinance Institutions Ordinance, 2001 and submit three copies of the annual audited accounts along with the auditors' opinion to the State Bank within three months of the close of the accounting year. 

Internal Audit-

The MFB/MFI shall have an Internal Audit Department manned preferably by professionals/persons having prior audit experience in banks/Financial Institutions. The Head of the Department shall report directly to the Board of Directors or to an Audit Committee of the Board. 

Operational Policies -

The MFB/MFI to formulate operational policies for all areas of operations including micro-credit, investments, internal audit, human resource and rescheduling/restructuring/write-off of loans/advances etc. 

Restriction on Election and Appointment of Directors-

Enumerates the disqualification conditions for election and appointment of directors. A person convicted in an offence involving frauds, breach of trust or moral turpitude, or has been adjudged as insolvent or has suspended payment of his debts or has compounded with his creditors or is a defaulter of any bank or financial institution or has been debarred from holding such office under Companies Ordinance 1984 or Banking Companies Ordinance 1962 or has been declared to be lacking fiduciary behavior by the Court under section 217 of Companies Ordinance 1984 at any time during preceding five years or is an office bearer of a political party or a member of Senate, National and Provincial Assembly. 

Submission of Statistical Returns-

prescribes the formats of statistical return and stipulates the periodicity of submission of these returns to SBP.