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Regulatory Impact Assessment in Microfinance: A Theoretical Framework and Its Application to Uganda Stefan Staschen Development Studies Institute London School of Economics and Political Science Submitted in Candidacy for the Degree of Doctor of Philosophy 2010 2 Declaration I certify that the thesis I have presented for examination for the MPhil/PhD degree of the London School of Economics and Political Science is solely my own work other than where I have clearly indicated that it is the work of others (in which case the extent of any work carried out jointly by me and any other person is clearly identified in it). The copyright of this thesis rests with the author. Quotation from it is permitted, provided that full acknowledgement is made. This thesis may not be reproduced without the prior written consent of the author. I warrant that this authorisation does not, to the best of my belief, infringe the rights of any third party. 3 Abstract This thesis develops a public interest methodology for assessing the impact of regulatory reforms in microfinance, applies this methodology to the case study of Uganda and explains the results by analysing the political economy of policy change. It thus combines public and private interest approaches in assessing mi- crofinance regulation. Firstly, the study develops a methodology for regulatory impact assessment based on the public interest theory of regulation. The first step is an analysis of market failures as the main rationale for regulation. Regulatory objectives are then de- fined with reference to these market failures. Finally, a variety of quantitative and qualitative impact indicators are identified to measure the benefits of regulation with reference to the achievement of the regulatory objectives while also consider- ing the costs. Secondly, the thesis applies this rationale-objectives-indicators ap- proach to the new legal framework for microfinance deposit-taking institutions (MDIs) in Uganda using similar, but unregulated microfinance institutions as a control group. The results show that the MDI regime‘s generally positive impact was only achieved at substantial cost to the regulator and regulated institutions and is skewed towards safety and soundness and systemic stability without ade- quate consideration of other objectives such as consumer protection and access. Thirdly, the thesis explains the degree to which public interest objectives were achieved by analysing the political economy of regulatory change. It shows that the three stakeholder groups with the best knowledge of microfinance regulation and whose interests were most closely aligned with the public interest objectives – the Central Bank (Bank of Uganda), the MDI candidates, and donor agencies – were also those who had the strongest influence on the policy change process. The thesis concludes that its unique contribution is to develop a thorough method- ology for assessing regulatory impact in microfinance. The methodology is used to measure the strengths and weaknesses of the MDI regime in Uganda, while the political economy analysis explains why these strengths and weaknesses arose. 4 Acknowledgements This thesis has occupied me and people close to me with varying intensity over many years, first in London and later in Nairobi. I would like to thank Anja König, who was my girlfriend when I started on this journey, and is now my wife and mother of my daughter. Her continual role as a sounding board for my ideas significantly shaped my thoughts, she encouraged me to continue working on it in times when my life as a consultant seemed so much more attractive, and believed in me even when I did not. I also want to thank our daughter Alina for not disturb- ing me while studying, and my parents for never doubting that I would eventually finish this project. Many people contributed in one way or the other to this thesis, among them Theresa Kaleja, Kate Lauer, David Porteous, Richard Rosenberg, and Dieter Zinnbauer, who commented on draft chapters; Giulia Ferrari, Felix Naschold, and Alejandro Ponce, who introduced me to Stata; Biff Steel, who left me with a treasure of documents about the early regulatory debate in Uganda; CGAP and GTZ, who gave me consultancy assignments that supported me financially (and also the chance to blame any delay in finishing on them); FinMark Trust for commissioning further research on the FinScope Uganda survey on my behalf; and Elizabeth Gardiner, Tillmann Lenz, and Niraj Shah for providing me with a place to sleep on my visits to London. Also, I gratefully acknowledge the valuable input and feedback given by my main supervisor, Jonathan Leape, and the helpful support by Ken Shadlen in mastering any challenges on the way. Sue Redgrave did a wonderful job in proofreading the final text. Finally, my biggest thank you goes to all persons interviewed and consulted dur- ing the course of my visits to Uganda for sacrificing their time and for sharing their insights. This study would not have been possible without their input. 5 TABLE OF CONTENTS List of Figures and Tables 8 List of Abbreviations 10 Chapter 1 – Introduction 12 1.1. Relevance and Related Research 13 1.2. Choice of Uganda as the Single Case Study 18 1.3. Empirical Methodology 22 1.4. Data Collection Methods 27 1.5. Structure of the Argument 33 Chapter 2 – Developing the Public Interest Theory of Regulation into a RIA Methodology for Microfinance 37 2.1. Market Failures in Banking as Economic Rationale 38 2.2. Market Failures in Microfinance 44 2.3. Public Interest Objectives 54 2.4. Impact Indicators 65 Chapter 3 – The Main Characteristics of the MDI Regime and its Expected Impact on the Regulatory Objectives 83 3.1. Overview of Uganda‘s Banking and Microfinance Sector 83 3.2. The Regulatory Approach for MDIs 92 6 3.3. Main Provisions of the Legal Framework for MDIs 104 Chapter 4 – Quantitative Analysis of the Regulatory Impact: Changes in Market Outcomes 119 4.1. Choice, Preparation, and Use of Data from Ugandan MFIs 120 4.2. Results from Analysis of Performance Indicators 131 Chapter 5 – Qualitative Analysis of Regulatory Impact: Process Tracing 164 5.1. Safety and Soundness 165 5.2. Systemic Risk 170 5.3. Competition 175 5.4. Consumer Protection 182 5.5. Access 188 Chapter 6 – The Cost of Regulation 198 6.1. Measurement Methods and Cost Elements 198 6.2. Cost Analysis of the MDI Regime 210 6.3. Towards a Cost-Benefit Analysis 218 Chapter 7 – The Impact Explained: The Political Economy of Regulatory Change 227 7.1. Methodology for the Political Economy Analysis 228 7.2. The Role of the Legislature and Executive 235 7.3. The Role of the Regulator and Regulated Institutions 248 7 7.4. The Role of Other Stakeholders 258 7.5. Private Interest Explanations for Having a Separate Law 266 Chapter 8 – Conclusion 272 8.1. Results from the Application of the RIA Approach in Uganda 272 8.2. Concluding Comments on the RIA Methodology 280 Appendices 288 Appendix 1: Coding of Unpublished Documents 289 Appendix 2: Indicators for Measuring Regulatory Impact 296 Appendix 3: Main Regulatory Provisions of the Legal Framework for MDIs 304 Appendix 4: Difference-in-Differences Analysis 310 Appendix 5: Performance Indicators Used for Quantitative Analysis 311 Appendix 6: Results from Analysis of Performance Indicators 313 Appendix 7: Analysis of Impact Indicators for the MDI Regime 319 Appendix 8: Cost of MDI Regime 322 Bibliography 327 8 LIST OF FIGURES AND TABLES Tables Table 2.1: Market Failures in Conventional Banking and in Microfinance 53 Table 2.2: Regulatory Objectives for Microfinance 64 Table 2.3: Trade-offs/Supportive Relationships among Regulatory Objectives 67 Table 2.4: Regulatory Impact Indicators 73 Table 3.1: Number of MFIs in Different Tiers 89 Table 3.2: Loan Classification and Provisioning 113 Table 3.3: Reporting Requirements 115 Table 4.1: Problems of Bias in Research Design 125 Table 4.2: Impact of the MDI Regime on Performance Indicators 162 Table 5.1: Development of Bank of Uganda Ratings of MDIs 165 Table 5.2: Frequency of MDI Examinations 169 Table 5.3: Perceptions of Practitioners About Competition 181 Table 5.4: Perceptions of Various Types of Financial Institutions (2006) 187 Table 5.5: Interview Responses on Access (Interviews in July 2008) 192 Table 6.1: Transformation Funding (in US$ at the time costs were incurred) 215 Table 6.2: Estimated Costs of MDI Regime (in US$ and 2008 prices) 218 Table 7.1: Stakeholder Analysis of the Policy Change Process in Uganda 266 9 Figures Figure 1.1: Coding System for Unpublished Documents 29 Figure 1.2: Coding System for Interviews 30 Figure 1.3: Structure of Thesis 34 Figure 3.1: Access Strands in Sub-Saharan Africa 86 Figure 4.1: Impact Channels for Return on Assets 134 Figure 4.2: Return on Assets for Treatment Group 135 Figure 4.3: Capital to Assets Ratio for Treatment Group 137 Figure 4.4: Portfolio at Risk > 30 Days for Treatment Group 141 Figure 4.5: Write-off Ratio for Treatment Group 142 Figure 4.6: Number of Borrowers for Treatment Group, FAULU and BRAC 144 Figure 4.7: Average Loan Size for Treatment Group and FAULU 146 Figure 4.8: Share of Individual Borrowers versus Average Loan Size 148 Figure 4.9: Average Loan Size versus Portfolio Yield for TG 152 Figure 4.10: Total Savings for Treatment Group 154 Figure 4.11: Number of Savers for Treatment Group and FAULU 156 Figure 4.12: Cost per Borrower for Treatment Group 159 Figure 5.1: Market Share Centenary Bank 179 10 LIST OF ABBREVIATIONS AMFIU Association of Microfinance Institutions of Uganda AML/CFT Anti-money laundering and combating financing of terrorism BCBS Basel Committee on Banking Supervision BoU Bank of Uganda CAMELS Capital, asset quality, management, earnings, liquidity and market sensitivity CBA Cost-benefit analysis CG Control group CGAP Consultative Group to Assist the Poor CMF Commercial Microfinance Ltd.

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