Capital Square Advisors’s on the Malegam Committee Report on Microfinance Sector

Capital Square Advisors , an investment banking firm closely associated with the MFI sector in India, has released it’s observations about the Malegam Committee Report, which is given below.

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Our Observations / suggestion on Malegam Committee recommendation on MFI sector

The recently released Malegam Committee report on the Micro Finance Industry has cleared many doubts but it has still left some questions unanswered. The committee has addressed some important concerns in the industry related to regulation, transparency, coercive method of recovery, funding etc whereas on the other hand the recommendation limits the growth of the sector by proposing the interest rate cap of 24% with maximum loan of Rs 25000 to an individual.

Comments on the recommendation of Malegam Committee report

1. Separate category for NBFCs operating in Microfinance sector such as NBFC-MFI.

This is an important step towards formulating uniformity to the companies operating in the Microfinance space. It also provides the distinct identity for them

2. Priority Sector Status to continue

This will help MFIs to raise fund from banks, since under banking norms banks are under compulsion to meet targets of priority sector lending. This ensures flow of funds to MFIs.

3. NBFC-MFI should have a minimum Net worth of Rs 15 Crore

Currently an MFI being a NBFC is required to have a minimum capital of Rs.2 crores. Increasing the Net worth will restrict the new entrants in MFI Sector to serious players. While at the same time, how the MFIs will meet this criterion is a concern. Most of the upcoming MFIs have grown out of Non profit oriented Societies/Trusts etc, who would not have the long pockets to increase the capital base. On the other hand, capping the interest rate/profit margins is bound to drive away a lot of PE funds, who had just developed a liking for the sector.

4. Funding of MFIs- Creation of one or more “Domestic Social Capital Funds”

This can be considered as new source of finance for the MFIs and will also help the small and upcoming MFIs to start the micro finance operation. This may also create distinct identity for Social Oriented MFIs. Though it sounds good on paper, how this will actually fructify remains to be seen. The broad intent of the committee seems to be fairly clear – High profit seeking PE funds need not dabble in the sector, whereas Social capital (who will typically have lower return expectations and more emphasis on the noble objective of poverty alleviation) be channelized on a larger scale.

5. Restriction on individual lending upto Rs 25000 and interest rate cap of 24%

The committee has suggested limit on the loan provided to the individual upto Rs 25000 and also that the total indebtedness of the individual borrower should not exceed Rs 25000. This limit will not only restrict the access or availability of credit facility to individual microfinance customer but will also curtail his economic development. Till now, the cap on individual loan was Rs 50000, which can be considered reasonable. There was no harm is maintain status quo in this regard.

Further the cap of 24% interest rate will hit hard to those MFIs who are working in very remote area and where the cost of operation is on a higher side. The Micro Finance business is extremely region specific. The cost of operation may vary across different states as well as geographical conditions. Generally, the cost of operations is much higher in hilly and inaccessible regions. Not coincidentally, the need for micro finance in these areas is most urgent and intense.

The committee has laid stress on putting the interest rate cap of 24%. It would have been preferable is this was accompanied with an assurance of subsidized interest rate. The committed has backed up the priority sector status and also hoped for lower interest rates without firmly prescribing the same. Special concessions to Micro Finance sector (apart from the priority sector status) would have reassured the sector that the Government does consider it as a powerful means of poverty alleviation.

6.  Transparency In interest Charges- Only three components in pricing of loan a) Processing fees not exceeding 1% of the gross loan amount b) interest charges c) insurance premium

This will ensure uniformity among all microfinance providers and also restricts those MFIs who unnecessarily charge high processing fees and administrative charges.

7. Malegam panel suggests limiting margins cap at 10% for MFIs with a loan portfolio of Rs.100 crore and at 12% for smaller MFIs.

This recommendation is strongly questioned on the point as the committee member has made no difference in the operating cost of MFIs across the states in India. There are MFIs who work in the hilly and remote area and for them the cost of operation is pretty high. Considering the example of North Eastern India where the cost of operation for MFIs is on higher side due to socio-economic situation in the states especially in remote areas, where there is inadequate infrastructure, poor connectivity and diverse population spread. Such initiative will restrict the upcoming and existing MFI to enter or expand into these areas.

Few questions where the focus is still required by the Malegam committee

The interest rate cap of 24%.

Will be sustainable for different MFIs operating in a diverse location which may not be homogenous?

The loan limit of Rs 25000 and household income limit of Rs 50000.

Setting an upper limit for household income is logical and desirable, yet can prove to be quite if not adequately nuanced. Lets say, A person X had annual income of Rs. 49,000 last year. So he would be eligible for an income generating loan of Rs. 25,000. After getting the loan, his annual income rises to Rs. 55,000, which makes him ineligible for further loan (probable even for the existing loan going by the strict interpretation). However, if one has to deduct the repayment of Rs. 25,000 loan, his net savings might be well below Rs.50,000. What this implies is that the definition of household income must necessarily mean income net of the total debt servicing made during the year. Moreover, it should be made clear that once a Micro Finance loan is given, the person should remain eligible to at least that amount or upto Rs. 25,000, till he reaches the next level of income, say Rs. 1,00,000. This is because in many cases, the MF loan may be required to sustain the income.

Further, one of the reasons for high recovery rate of MF loans is that the borrowers have to repay the loan for getting further loans in the future. From the MFIs point of view, it is safer to lend to a 3rd cycle borrower with a proven track record than a first time borrower. With the limit of annual income, many of the second and third cycle borrowers may get disqualified and still require loan funds to sustain their business. No one gains MFIs lose some of these ‘good customers’ drop out without reaching the next level.

Setting a cap on income is necessary. So it will be better if the limit is Rs. 1,00,000 instead of Rs. 50,000. More people and more MFIs will gain.

In India the entire priority sector lending is backed up by a systematic refinance facility from the respective apex banks. The recommendation has not touched upon such a possibility. Such backup finance, if available, will strengthen the growth of MFI’s sector further.

About Capital Square Advisors Pvt Ltd

CapitalSquare Advisors Pvt Ltd (CSAPL) is an emerging Investment Banking company, based out of Mumbai. In the past 3 years, it has been active in the areas of Debt Syndication, Private Equity, Mergers & Acquisitions and Structured Finance. It also has a Microfinance desk where it is actively involved in debt syndication for it’s MFI clients.

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