Regulating Microfinance in India
The Malegam Committee’s (referred to hereinafter as the “Committee”) recommendations to increase the supervisory capacity of the RBI, to make MFI regulation consistent at the national level, to promote good corporate governance and to increase bank lending to MFIs are welcome.
At the same time, many of the tactical and operational prescriptions made by the Committee require to be examined in the context of (a) broadening the RBI’s financial inclusion agenda, (b) regulatory approaches to pursuing this agenda (c) operationalising the recommendations in an effective and inclusive manner and (d) ensuring sustainable development and orderly growth of the industry by limiting externalities and developing a series of best practices.
Definition of the Sector
1. Under 2.1 of the Committee’s report, the Committee has defined microfinance as “an economic development tool whose objective is to assist the poor to work their way out of poverty. It covers a range of services which include, in addition to the provision of credit, many other services such as savings, insurance, money transfers, counselling, etc.”
2. At the same time, the Committee has confined itself to “micro-credit” for the purpose of the report.
3. The Committee has subsequently defined a separate category – NBFC-MFIs – for NBFCs operating in the microfinance sector, and stated that, in such firms, over 90% of assets must comprise of “qualifying assets”. At the same time, the Committee suggests that NBFCs should either allocate over 90% of assets to “qualifying assets” or less than 10%
4. We suggest that it is counter-productive to limit micro-credit or the supervision of micro-credit to NBFCs in the fashion as described above for the following reasons:
a) These recommendations, if accepted, would prevent the transformation of microfinance into full service finance for rural customers.
a. One of the main reasons for becoming an NBFC is that the entity is then able move beyond traditional JLG lending, and gradually start to offer larger loans, individual loans, enterprise loans, crop loans, equipment loans, etc. while continuing to offer the original JLG product.
b. This allows the entity to meet completely the requirements of those borrowers that need larger amounts as well as use the wider product-scope to spread its cost structures over a much larger pool of assets and bring its lending rates down, eventually well below even the caps specified by the Committee for the traditional JLG product.
c. Entities operating in this space would have to grapple with low value of transaction and still remain viable. Multiple sources of revenue would provide such viability to such entities.
b) The 90/10 recommendations (Clause Numbers 5.9 and 5.10), if accepted, would essentially freeze the sector to permanently stay in its current form since nobody else would even be allowed to address the needs of this sector and no other business models would evolve.
a. And for this reason, there would also then be no impetus for interest rates to come down further below the caps specified by the Committee. Costs of operations, using new technologies and economies of scope and scale can be brought down to as much lower levels relatively quickly.
b. This would also take away the entities’ incentive to invest effort in working in a challenging environment.
c) The recommendations would leave out significant microfinance providers from the regulatory framework
a. It is quite possible that Banks may emerge as substantial providers of micro-credit and other forms of microfinance, but microcredit (as defined by the committee) may not form 10% of their assets. This will leave out a significant institution-type from the regulatory ambit. The proposed regulation must cover all microfinance providers
i. However, it may be argued that microfinance, at present, is being provided by multiple non-profit entities that are not within the regulatory ambit of the RBI. Recognising this, we propose that microfinance regulation must cover at least all existing forms of entities regulated by the RBI, i.e. Banks and NBFCs
ii. The microfinance operations of such entities, be in micro-credit, micro-savings, distribution of micro-insurance etc., must be reported separately as an SBU to the RBI, to permit efficient information dissemination, transparency and effective regulation
iii. For entities outside RBI’s regulatory ambit, regulation could make the principals (in case of business correspondents) and lenders (in case of microcredit) to the providers aware of the importance adherence to client protection standards by the providers. These principals and lenders should be actively encouraged to broaden their due diligence and monitoring processes to ensure that the providers are not just maintaining financial discipline but also adhering to ethical standards of client protection.RBI must also actively use such measures to enforce covenants on entities not regulated by RBI to create a level playing field and uniform standards.
a. If entities were forced to concentrate over 90% of their assets in the microfinance sector, lack of diversification within their asset portfolios could emerge as a significant systemic risk.
b. In India, portfolio protection for institutions providing services to low income rural households against the vagaries of systemic and catastrophic losses, i.e. rainfall reduction, weather variations, crop losses, floods and other events etc. are still not available on a large scale
5. Hence, we recommend that the definition of microfinance be applied at a functional level, rather than at the entity level. This would imply that entities providing microfinance would be required to create separate business units, tailor internal policies to provide efficient service delivery and at the same time be able to leverage internal financial, technology and process strengths in this regard.
6. Ensuring complete access to finance for every individual and every enterprise in India will require continuous innovations in financial products, delivery channels, and human resource management by a wide array of strong firms competing with each other to do business with the low-income household in a responsible manner. By opening up the sector to multiple institutions will enhance competition and meet the regulator’s objectives
Capital adequacy requirement
7. The committee has not offered any rationale for the Rs. 15 crore minimum capital requirements even for pure non-deposit taking NBFCs despite recommending very conservative loan limits and being aware of the very low default rates that have been observed for this sector in India for over a decade.
8. Such a requirement clearly favours the established large microfinance providers, which making it even more difficult for smaller, locally focused entities to emerge.
The issue of “Qualifying Assets”
9. The Committee has defined a low income household as one with annual household income less than Rs 50,000
10. IFMR Trust’s experience is that though a large number of microfinance clients belong to households with less than Rs. 50,000 annual household income, there are also a very large number of households with higher incomes who can and do benefit from microfinance mechanisms.
a) This happens mainly because of limitations of the credit appraisal methods of traditional financial providers. Many rural and urban low income households cannot access credit through these mechanisms – their assets cannot be easily collateralised; their incomes are hard to estimate; and their past repayment records are not recorded in accessible databases.
b) So, though most poor are financially excluded, many financially excluded households have household incomes exceeding Rs 50,000. Much of urban microfinance caters to such clients. Restricting microfinance to the poor will make the financially excluded non-poor more vulnerable.
11. We believe that it would be detrimental to the interests of a large section of the population to define low income households in the manner as recommended by the Committee. Further, this definition implies that originators (and perhaps their lenders) have the wherewithal to collect information regarding household income, which is unlikely and expensive
12. The Committee has also stated that credit to individual clients be limited to Rs 25,000 per member
13. This is not clear and raises the following questions
a) What are such households to do when their credit needs outstrip Rs 25,000 per individual member?
b) Shouldn’t the committee focus on “regulating the lender” rather than “regulating the household’s debt needs”?
c) Is it not wasteful for such a household to approach multiple lenders, rather than avail of a single “one-stop shop” solution for financial needs?
d) Effect of inflation on household credit requirements are not factored in
14. Given the above negative effects on a household’s credit access, we find it difficult to believe this is the Committee’s intention. We suggest that it is up to the household to determine its own debt needs and requirements, and for the provider to determine the creditworthiness.
15. Given that the objective is to regulate the originators, we suggest the following approach
a) The Committee has opined that multiple loans given to a single household may increase the risk of non-repayment and amplifies systemic risk
b) At the same time, it is the objective of the committee to ensure that the maximum number of households come under the coverage of financial inclusion
c) Therefore, to incentivise organisations to enhance coverage and limit multiple lending to a single household it is proposed that a higher capital charge be levied upon institutions providing the third or further loan to a single household (at the time of providing the loan)
a. Therefore, the first loan to a household could attract a capital charge of 75%, the second loan 100%, the third loan 125% and so on
b. This could be tracked by stipulating the use of biometric authentication, and a credit bureau
Read the rest on the IFMR Trust Blog