In order to promote microfinance or the provision of a broad range of financial services to poor and low-income households for their microenterprises and small business endeavors, several financial sector reforms were initiated by the government beginning in the 1990s. Notwithstanding the considerably improved policy environment for microfinance to flourish, however, banks still face a number of constraints in expanding their financial services to the above target beneficiaries. What are these constraints? This Policy Notes outlines some of them and recommends measures to address them.microfinance, poverty, small and medium enterprises, microenterprises

Lamberte, Mario B.

English

Research Papers in Economics

No. 2001-17 December 2001
Mario B. Lamberte*
Policy Notes
Addressing Constraints in
the Provision of Financial
Services to MicSMEs
and Poor Households
__________
*The author is President of the Philippine Institute for Development
Studies (PIDS).
1Some 90 percent of the total number of manufacturing establish-
ments are small, i.e., those with average total employment of less than 10
workers. As of 2000, 31.3 million people had income below the poverty
line.
M M
PHILIPPINE INSTITUTE
FOR DEVELOPMENT STUDIES
Surian sa mga Pag-aaral
Pangkaunlaran ng Pilipinas
PIDS Policy Notes are observations/analyses written by PIDS
researchers on certain policy issues. The treatise is holistic in approach
and aims to provide useful inputs for decisionmaking.
This Notes is based on PIDS Discussion Paper Series No. 2001-
24 entitled "Expanding banking services to micro, small and medium
enterprises and poor households in the Philippines" by the same au-
thor. The views expressed are those of the author and do not neces-
sarily reflect those of PIDS or any of the study's sponsors.
icrofinance seems to be the flavor of the day.
Understandably, then, almost everybody wants
to get a piece of its action. A lot of stories have
in fact been told on how several nonbank entities, which
have been receiving funding support from local or foreign
donors, have been able to provide small loans to
microenterprises and poor households.
This is well and good. At the end of the day, however,
we have to ask ourselves how to make a much wider array
of financial services, other than credit, easily accessible to
a large number of micro, small and medium enterprises
(MicSMEs) and poor households in a more sustainable
manner.1
This is a role banks can very well play provided the
policy environment is right. This is the main issue being
addressed in this Notes.
Microfinance-friendly policy
and banking regulation
The financial sector reforms initiated by the govern-
ment in the 1990s, e.g., bank entry and branching liberal-
ization, have laid the ground for promoting microfinance in
the country. This was further boosted by the recent pas-
sage of the General Banking Law of 2000, which includes 3
provisions that set a much clearer policy framework for pro-
moting microfinance. In 2001, the Bangko Sentral ng
Pilipinas (BSP) issued several circulars to implement said
policy, one of which was Circular No. 272 which came out
on 30 January 2001.
In this circular, the BSP defines microfinance as “the
provision of a broad range of financial services such as
deposits, loans, payment services, money transfers and in-
surance products to the poor and low-income households,
for their microenterprises and small businesses, to enable
them to raise their income levels and improve their living2 December 2001
Policy Notes
standards.”2 This is important in that it conveys to the gen-
eral public the kind of microfinance the government is pro-
moting.
There are four important paragraphs in Circular 272.
One indicates that “microfinance loans may be amortized
on a daily, weekly, bi-monthly or monthly basis, depending
on the cash flow conditions of the borrowers.” This is in-
tended to give small borrowers flexibility in choosing their
amortization schedule that would reflect the timing of their
cash flow. Two is a statement on interest rate policy which
says that “interest rate shall not be lower than the prevail-
ing market rates to enable the lending institution to recover
the financial and operational costs incidental to this type of
microfinance lending.” The statement is meant to send a
clear signal to the public that the government intends to
promote viable, self-sustaining microfinance institutions. This
runs counter to the previous policy of promoting below-mar-
ket interest rate for loans to MicSMEs and poor households,
making it difficult for microfinance institutions to operate in
a sustainable manner. Three refers to a guideline to do
away with requirements that are not appropriate for or raise
the cost of microfinance loans. Thus, it states that for
microfinance loans, “a bank may not require from its credit
applicants a statement of assets and liabilities and of their
income and expenditures and such information as may be
prescribed by law or by rules and regulations of the Mon-
etary Board….” Obviously, small borrowers cannot present
to a bank audited financial statements which are required
of big borrowers. And four is the paragraph that encourages
banks to lend to small borrowers not on the basis of a
collateral but on the basis of borrowers’ cash flows. This is
to address the problem that small borrowers cannot borrow
from banks to finance viable economic projects because
they cannot present hard collateral to banks.
There are already signs that small banks are favor-
ably responding to the new policy environment. For instance,
the number of offices of thrift and rural banks combined
increased from 2,685 in 1996 to 3,285 in June 2001. Un-
fortunately, many of these also failed during the same pe-
riod. With cheap funds provided by the government drying
up, banks, particularly rural and cooperative banks, have
increasingly relied on deposits to finance their loans. The
recent decision of the BSP to exempt microfinance-oriented
banks such as thrift and rural banks from the moratorium
on the licensing of new banks supports the effort of ex-
panding financial services to MicSMEs and poor households.3
Recently, a microfinance-oriented bank was established by
a thrift bank jointly with foreign partners in the southern
part of the Philippines. Based on the criteria formulated by
the BSP for giving a license to microfinance-oriented banks,
these banks are not like a regular rural or thrift bank.4 The
BSP also provides liquidity assistance to support and pro-
mote microfinance programs.5
Constraints to be addressed
Notwithstanding this considerably improved policy en-
vironment for microfinance to flourish, banks still face some
constraints in expanding their financial services to MicSMEs
and poor households.
Below is a discussion of these constraints and the
recommended measures to address them.
Macroeconomic instability. Lending to MicSMEs and
poor households is a very risky venture, especially if lend-
ers base their decisions solely on the strength of the cash
flow position and character of borrowers. Instability of the
economy can make those loans much riskier because cash
flows can easily dry up during a sudden downturn of the
economy. This can lead to the collapse of banks, especially
small ones, and ultimately undermine the public’s confidence
in the banking system. Such confidence is not easy to re-
store especially if a large number of small savers lose their
money and otherwise good borrowers suddenly become
delinquent borrowers. The experience of the Philippines in
the last 25 years clearly demonstrates this point. From 1998
__________
2This can be found in the Notes to Microfinance, an annex to Circu-
lar 272.
3See BSP Circular No. 273, 27 February 2001.
4For example, Section 1.4 of the BSP Circular No. 273 states that
organizers must have the capacity to engage in microfinancing which
may be indicated by the following: (a) at least 20 percent of the paid-in
capital of the proposed bank must be owned by persons or entities with
track record in microfinancing; (b) majority of the members of the board
of directors have experience in microfinancing, with at least one member
having actual banking experience; and (c) the proposed bank must have,
as a minimum, an adequate loan tracking system that allows daily moni-
toring of loan releases, collection and arrearages, and any restructuring
and refinancing.
5See Circular No. 282, 19 April 2001.3 No. 2001-17
Policy Notes
to 2000 alone, 12 thrift banks and 83 rural banks were
closed by the Philippine Deposit Insurance Corporation
(PDIC), thereby reducing the number of potential providers
of financial services to MicSMEs and poor households. In-
deed, a stable macroeconomic environment is conducive to
the expansion of financial services to these sectors of the
society.
Inadequate infrastructure. Poor infrastructure in-
creases the cost of providing financial services to MicSMEs
and poor households. Aside from good roads and sturdy
bridges, cheap and reliable electricity and telecommunica-
tion system are important in improving the efficiency of
microfinance institutions. Indeed, some thrift and rural banks
are prevented from computerizing their operations because
of inadequate and unreliable supply of electricity in their
area. They badly need to computerize their system to be
able to accurately process numerous small deposits and
loans in a very short time. The government’s thrust to give
high priority to the improvement of the infrastructure sys-
tem in rural areas is a step in the right direction. The gov-
ernment budget should reflect this.
Regulation on deposit mobilization. The key to ex-
panding financial services to MicSMEs and poor households
is for banks to mobilize more deposits. Several studies have
shown that even poor households save, and if properly com-
pensated, they place their savings in banks. Many of them
reside in areas quite far from where banks are located and
transport cost is very high. Microfinance-oriented banks can
therefore mobilize more deposits at lesser cost only if they
are allowed to make house-to-house visits to pick up depos-
its. Thus, the BSP has to rethink the circular it issued in
1999 prohibiting banks from doing so (Llanto 2000).
Shortage of capital. Although small banks can mobi-
lize more deposits, as many of them have already demon-
strated, their limited capital sets a ceiling as to how much
they can mobilize.6 There are ways of dealing with this prob-
lem. One is to encourage large commercial banks to infuse
equity into small banks such as rural banks by including
such investment as an alternative instrument for complying
with the existing loan portfolio regulation. They have to re-
main, however, as minority stakeholders.7 Such arrangement
can pave the way for a correspondent banking relationship
between small and large banks in the country. This is a
better option than compelling large commercial banks to
lend to small enterprises or to buy eligible government se-
curities.
In the case of cooperative rural banks, the expansion
of their capital is constrained by the limited number of coop-
eratives that have the financial capability to invest in coop-
erative banks.8 The Rural Banking Act must therefore be
amended to allow cooperative rural banks to accept indi-
vidual members as preferred shareholders.
The recent establishment of a microfinance-oriented
bank is a welcome development. The BSP should, however,
also look into possibilities of encouraging other commercial
and thrift banks to venture into microfinance business. Per-
haps, it can organize training programs for banks to expose
them to microfinance lending technologies.
Competition with government banks. It has been the
policy of the government to give private financial institutions
a bigger role in the provision of financial services, espe-
cially to small farm and nonfarm enterprises. The govern-
ment financial institution’s role, therefore, is only to fill up
some gaps left out by private financial institutions and pro-
vide support to them in areas where they have comparative
advantage. However, the number of offices of government
banks has increased from less than 100 before 1990 to
about 400 today. Because of the policy of the government
to make these banks self-sufficient, they are currently in-
tensely competing with private banks in mobilizing depos-
its. For instance, although the two government banks are
engaged in wholesaling, they also do retail lending which
directly competes with private banks. Unless the orienta-
tion of government banks is therefore changed, private banks
will always find their (government banks) presence a seri-
ous constraint to the expansion of their (private banks) ser-
vices in view of the undue competition.9
__________
6This pertains to the capital adequacy ratio.
7Commercial banks seem to prefer to have a wholly-owned thrift
bank.
8Under the existing law, only cooperatives can own shares in coop-
erative rural banks.
9Government banks are also designated depository banks of all gov-
ernment agencies and corporations. Hence, they maintain a large pool of
cheap deposits. See Lamberte (2000) for a proposal to re-orient the LBP.4 December 2001
Policy Notes
Aside from government banks, government-owned
nonbank financial institutions such as the Small Business
Credit and Guarantee Corporation, the People’s Credit and
Finance Corporation (PCFC), and a host of special credit
programs for MicSMEs and poor households implemented
by nonfinancial government agencies also provide competi-
tion to private banks. Many of these special credit programs
have performed badly. If continued, they could even under-
mine the discipline needed to promote market-based
microfinance institutions.10 Another immediate task is to
privatize LBP's subsidiary, the PCFC, and convert it into a
bank so that it can operate as a truly market-based
microfinance bank.
Inadequate supervision. While the BSP encourages
private banks to engage in microfinance, it must ensure
that banks that do so remain safe and sound at all times so
that financial services to MicSMEs and poor households
will not be disrupted due to massive bank failure. Indeed,
some banks are hesitant to venture into microfinance be-
cause of the fear that the failure of poorly managed, ill-
supervised microfinance-oriented banks can undermine oth-
erwise soundly managed microfinance- oriented banks.11 In
this regard, the BSP must adopt a risk-based supervision
approach for microfinance and upgrade the capability of its
staff to effectively utilize such approach.12 It must also con-
stantly finetune its regulatory system to discourage banks
from doing regulatory arbitrage.
Loan portfolio regulations. Most rural banks and some
thrift banks are not able to meet the requirement to allo-
cate at least 2 percent of their total loan portfolio to me-
dium enterprises. They can, however, easily meet the re-
quirement to allocate at least 6 percent of their loan portfo-
lio to small enterprises because of the nature and size of
their operation.13 The government should therefore review
this law to give small banks such as rural banks and small
thrift banks more flexibility in selecting their own clients.
Concluding remarks
This Notes has tried to emphasize the point that the
policy environment matters a lot in expanding financial ser-
vices to MicSMEs and poor households. Indeed, the policy
environment has improved considerably since the early
1990s and banks have responded positively to it. Nonethe-
less, banks still face some constraints in expanding their
services to the abovementioned clientele. The government
must therefore address these constraints to promote mar-
ket-based microfinance in the country.  4 4
References
Fitzgerald, Thomas and Robert C. Vogel. 2000. Moving towards risk-
based supervision in developing economies. CAER II Discussion
Paper No. 66.
Lamberte, Mario B. 2000. Transforming Land Bank into a microfinance
development institution. PIDS Discussion Paper Series No. 2000-
34. Makati City: Philippine Institute for Development Studies.
———. 2001. Expanding banking services to micro, small and me-
dium enterprises and poor households in the Philippines. PIDS
Discussion Paper Series No. 2001-24. Makati City: Philippine In-
stitute for Development Studies.
———, Magdalena S. Casuga and Doreen Carla E. Erfe. 1997. Assess-
ment of the role and performance of government nonfinancial agen-
cies in implementing directed credit programs. Working Paper No.
6. Manila: Credit Policy Improvement Program.
———. 1998. Assessment of the performance of GFIs and GOCCs/
NBFIs in implementing directed credit programs. Manila: Credit
Policy Improvement Program. Mimeographed.
Llanto, Gilberto M. 2000. The Philippines. In The Role of Central Banks
in Microfinance in Asia and the Pacific. Manila: Asian Develop-
ment Bank.
———. 2001. Risk-based supervision of banks involved in microfinance.
PIDS Policy Notes No. 2001-01. Makati City: Philippine Institute
for Development Studies.
__________
10See Lamberte et al. (1997, 1998).
11This is part of the information asymmetry problem wherein bank
depositors and other creditors are not able to distinguish between good
and bad banks in times of severe financial distress.
12See Fitzgerald and Vogel (2000), and Llanto (2001).
13Medium enterprises are currently defined as firms with assets of
between PhP15,000,01 and PhP100,000,000. The Small and Medium
Enterprise Development Council periodically reviews this definition and,
if necessary, adjusts it, taking into account inflation and other economic
indicators.
For further information, please contact
The Research Information Staff
Philippine Institute for Development Studies
NEDA sa Makati Building, 106 Amorsolo Street
Legaspi Village, Makati City
Telephone Nos: 8924059 and 8935705;
Fax Nos: 8939589 and 8161091
E-mail: mlamberte@pidsnet.pids.gov.ph
jliguton@pidsnet.pids.gov.ph
The Policy Notes series is available online at
http://www.pids.gov.ph

Assessment of the performance of GFIs and GOCCs/ NBFIs in implementing directed credit programs. Manila: Credit Policy Improvement Program.

Assessment of the role and performance of government nonfinancial agencies in implementing directed credit programs. Working Paper No. 6. Manila: Credit Policy Improvement Program.

Expanding banking services to micro, small and medium enterprises and poor households in the Philippines.

Makati City: Philippine Institute for Development Studies. __________ 10See Lamberte

Moving towards riskbased supervision in developing economies.

Risk-based supervision of banks involved in microfinance.

The Philippines.

Transforming Land Bank into a microfinance development institution.

Addressing Constraints in the Provision of Financial Services to MicSMEs and Poor Households

http://dirp4.pids.gov.ph/ris/pdf/pidspn0117.pdf

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