Microfinance, Regulation, and MIMOSA

Recently, I was reading the Economist and came across Charles Keating's obituary. That name means little to most readers outside the US, but for me it reminded of an idea that's been percolating in my mind for quite some time now: while rich countries offer valuable lessons for microfinance regulation, those lessons alone won't be enough.

You see, Charles Keating was the poster-child of the Savings & Loan Crisis during the late-1980s, which saw the collapse of many of these small banks across the US, ending an unprecedented 50-year period of stability in the US banking sector. From today's vantage point, that period is also difficult to understand. After all, it took less than 20 years to go from the S&L crisis to the much larger collapse in 2008 (don't let the graph mislead – S&Ls were typically small banks, so while the failures were many, their impact on the broader economy was far smaller).

What was behind this period of stability? It wasn't the economy, which though growing nicely, still saw plenty of recessions, including some serious ones in the mid-70s and early 80s. It wasn't the Bretton Woods system, which was abandoned more than 15 years earlier. There is however, one factor that almost perfectly parallels this 50-year period: banking regulation.

The banking regulations in place as late as 1980 had not changed much since the 1933 Banking Act, which itself was introduced in response to a catastrophic bank failure during the Great Depression. Banks were constrained in both the type of loans they could make and the type of deposits they could offer. The system came to be encapsulated in the so-called 3-6-3 rule of banking: borrow at 3%, lend at 6%, be at the golf course by 3pm. As all jokes go, it's a gross oversimplification, but it's also a reflection of reality. After all, such a description would make no sense at all in today's banking system.

Starting in 1980, a series of laws started significantly eroding that process. These included loosening restrictions on the types of assets S&Ls could invest in. The resulting plunge into high-risk assets (real estate, junk bonds, and other mostly commercial investments) took only a few years to lead to a full-blown collapse of the industry.

So how is this historical episode relevant to microfinance? On the positive side, it demonstrates that despite recent experience, banking regulation can work. Because bank runs had been eliminated by the introduction of deposit guarantees, since 1933, there was really one way for banks to fail en masse: by making bad investments. In the S&L crisis these tended towards the commercial side, but in 2008, the fault lay very much with bad loans to consumers, particularly mortgages. And bad loans to consumers hurt the borrowers as much or more than the banks. So the regulations in place during the 50-year period of stability largely meant that people also weren't being overindebted through excessive lending by banks.

But there is a catch. The regulation in place at the time was highly repressive, offering little room for innovation in banking services. In the developed economy of the US, where access to finance was not a high concern, having a static banking sector was almost certainly a price worth paying in return for stability (needless to say, the economy certainly didn't suffer!).

But for developing countries, where access to finance is low, that tradeoff is much less clear. Repressive regulations in such a context might bring stability, but it would also maintain a status quo where the majority of the population continue to be excluded. That means continuing use of informal services that cost more and offer less, especially with respect to security. Shady operators and scammers offering "investments" or "deposits" will continue to bilk the most vulnerable out of their hard-earned money.

So where does that leave microfinance? Must we accept a volatile sector and the risk of overindebtedness as an unavoidable cost of greater financial inclusion? I don't believe so. The key lies in being able to recognize overheating markets and cool them before they crash. Over the past year, I've become convinced that this could be done with a tool like MIMOSA, which highlights markets that show signs of excessive credit and overheating. Its standardized system of scoring makes it more difficult to explain away signs of overheating, and make it easier for regulators to put in place controls to slow down the sector. And for that reason, my collaborators and I have been working hard to take MIMOSA to the next level, making it sufficiently reliable that it could become the technical guide for strategic decisions on a country's financial system.

Armed with such a tool, no longer would we have to choose between stability and financial inclusion. I hope we can get there.

author: Daniel Rozas