Regulation at Last for Indian MFIs

The lean season¹ monetary policy statement has finally signaled Reserve Bank of India’s (RBI) intent to engage in the regulation of Microfinance Companies from a customer protection perspective. These regulations would apply to 56 NBFCs (against a total of 264 MFIs that reported information to Sa-Shan² last year). But these 56 institutions account for an estimated 85% of clients and loan volumes.

Breaking down the regulation

This policy for MFIs is based on the considerable work done by the Malegam Committee and the sector wide consultations that followed. While the committee’s recommendations were positive in terms of intent and direction they were found wanting in pragmatism and enforceability. In a commendable effort, RBI had held wide consultations with several stakeholders and accommodated valid representations before finalizing its views. As a result the statement issued by the RBI starts with saying that it accepts the broad framework of regulations recommended by the Malegam Committee, implying that the practical aspects required rethink.

RBI has made the MFIs into a separate category of NBFCs in accordance with the recommendation made by the Malegam Committee. It has defined the features of loans that qualify as legitimate business of MFIs and tried to make use of priority sector lending as a means to enforce regulation.

If NBFCs fail to conform to the characteristics of ‘qualifying assets’ the loans given to them by banks cannot be classified as priority sector and hence their cost of borrowing would go up and availability would shrink. This economic disincentive is expected to keep MFIs disciplined – which is a realistic expectation as 85% of funding for MFIs in India flows from banking system. Ideally there should have been some more teeth to enforce discipline than the weak threat of disqualification from priority sector benefits.

The characteristics of ‘qualifying asset’ (that define microfinance) according to the announced regulations are:

a. The credit services should be offered to small income households (Rs 60,000 – USD1,350 per annum in Rural centers and Rs 120,000 – USD 2,700 in urban and semi-urban centers)

b. The loans amounts should be small (not exceeding Rs 35,000 – USD 790 in the first cycle of loans and Rs 50,000 – USD 1125 in the second and subsequent cycle of loans) and without collateral

c. MFIs should avoid excessive debt at the borrowers hands ( the absolute ceiling level of debt per borrower fixed at Rs 50,000 – USD 1125)

d. Loan service should be reasonably within the capacity of the borrower (with large loans exceeding Rs 15,000 having a minimum repayment period of 24 months)

e. Not less than 75% of the total amount of loans given should be for the purpose of income generation

f. Not less than 85% of total assets of the NBFC should be in the nature of qualifying assets and

g. The repayment intervals – weekly, fortnightly or monthly – would be at the choice of the borrower

The NBFC-MFIs have the following obligations to meet in respect of the qualifying assets:

1. Microfinance loans that have the characteristics described above should not be less than 85% of total assets
2. Ensure that loans are not priced above 26% and the margin does not exceed 12% (in addition a service charge of 1% is allowed).
3. Determine that the total indebtedness of the borrower does not exceed Rs 50,000.
4. Get their books and operations professionally audited for a certification that (i) 85% of total assets of the MFI are in the nature of “qualifying assets,’’ (ii) the aggregate amount of loan, extended for income generation activity, is not less than 75% of the total loans given by the MFIs, and (iii) pricing guidelines are followed.

If NBFC-MFIs conform to these guidelines, then the loans given to them by banks would be reckoned as part of priority sector lending.                                                                          

RBI has taken a pragmatic view of several recommendations of MC and has suitably modified the same while finalizing its policy. Some of these changes had to do with increasing the ceilings on income limits for borrowing households, increasing the ceiling on loans per borrower, raising the interest and margin caps and reducing the proportion of qualifying assets to total assets.

Advantages and Challenges of the Policy

The announced policy would not be unduly restrictive as household income range is sufficiently large for ongoing customer acquisition. The stipulation that 85% of total assets (not just loans) should be taken into account while qualifying assets provides some space for other lending, if the MFIs do not carry too much of non-loan assets in their books. The MFIs would be able to provide larger loans or collateralized loans to a maximum amount of 15% of total assets and cross subsidize their MF operations.

The interest ceiling (taken along with service charges) will require a number of NBFCs to reduce their interest rates. Based on information provided by Microfinance Transparency , on APR India benchmarks, 13 MFIs are below 27% on significant part of their portfolios, 13 are between 27 to 30% and another 14 are between 30 and 35%. The 14 MFIs that charge between 30% and 35 % are likely to be the hardest hit; many of these are medium and small MFIs. The largest MFIs are likely to be able to conform to interest caps, though with reduced profitability.

RBI has come out with interest rate restrictions on financial institutions after 15 years of working actively to dismantle interest controls through reforms of the country’s broad financial sector. The service charge will impede price transparency and introduce a tendency on the part of MFIs to offer very short term loans.

The interest cap in absolute terms is bound to introduce rigidities. Because the interest rates in the market for other financial instruments are free and change in response to demand, supply and relative risks, MFIs would be unable to pass on the increased finance costs to their borrowers. Remoter areas will suffer as MFIs might scale down operations in high-cost areas to meet interest rate caps. In fact, it might discourage smaller loans and encourage large debt-pushing – something that the policy wanted to mitigate in the first place. It should be admitted that it is difficult to design regulatory policy to meet all various and dynamic anagles. The MFIs should invest in observing the spirit of regulation.

Operational implications

• Rural household incomes are nebulous and require great skill and experience to estimate it. How these incomes will be certified by Chartered Accountants is yet to be seen. MFIs will find it difficult to assess indebtedness level because “over-indebtedness” is not defined. If loans from non-MFI sources are to be reckoned (as seems to be the requirement) it is likely to be a herculean task, given the prevalence of high levels of informal debt. NBFCs’ bulk-lending to MFIs will suffer as a result of the denial of priority sector benefits to banks for their loans to such NBFCs. Their cost of funds is likely to increase as a result. With a ceiling of 26% on their loans, MFIs are unlikely to borrow at high costs from bulk lenders.
• MFIs will consolidate their business around semi-urban and urban areas where greater client base acquisition at lower costs is feasible under the regulation. Deeper engagement with individual borrowers (in the form of larger loan size) is also a likely result as MFIs will seek to maximize revenue per customer to make the interest cap work. In some households with three adults an overall debt level of Rs 150,000 (USD 3375) could be reached – even when the current income is Rs 50,000 (USD1125) per annum. Lender’s liability for excessive debt could have been part of the regulation to ensure that compliance is substantive and not just technical, to avoid this situation.
• The enforcement and monitoring of compliance is left to the chartered accountants, who would certify three key aspects of loans provided by MFIs. But the detailed guidelines to follow would possibly outline the regulatory practice and reporting requirements. The detailed guidelines will be eagerly awaited to examine whether those aspects on which there is no comment in the monetary policy (such as social capital fund, grievance redressal mechanism, credit bureaus, net worth requirements and provisioning) have been dealt with. Moreover, these regulations would not be applicable to those MFIs (more than 200 of them) not in the company form. As they would continue to be unregulated, banks may not be interested to provide them funds that are part of priority sector lending.

The proposed guidelines introduce customer protection within regulatory framework of credit-only institutions for the first time. There is almost no prudential aspect of MFIs covered in the policy. The AP microfinance legislation compelled the RBI to accept the responsibility for customer protection based regulation of microfinance.

These guidelines are likely to be adopted by the proposed central legislation expected to be passed in parliament soon. Whether in the light of these regulations other state governments will refrain from introducing legislation to regulate MFIs is yet to be seen.

However, this piece of regulation is too late to salvage the microfinance sector in AP. With recoveries at around 10 to 15%; MFIs with significant exposures in in the state are unlikely to survive. With declining recovery rates from SHGs banks are now reluctant to expand microcredit exposure, the poor households of AP will take much longer to rediscover the easy access to credit that they enjoyed prior to October 2010. The learning curve thus far has been steep. The sector will continue to pay a price for both delayed appropriate regulation and precipitate inappropriate regulation. But the regulations offer a second chance for the sector: those MFIs with a clear objective and manageable problems from AP can put the past behind; and progress will be possible under more certain conditions and a neutral business environment.

–N.Srinivasan³

¹ RBI does a review of monetary policy and announces policy measures twice in a year. The period between April to September is known to be lean season or slack season as the economic activity is at a lower intensity on account of summer and monsoon activity.                                                                                                                                                            
² As per information as on 31 March 2010 reported in ‘A Quick Review 2010’- Sa-Dhan, New Delhi. ³ Author, State of the Sector – Microfinance India 2008,2009 and 2010 and independent consultant in development finance.