RBI’s fresh questions on Microfinance

The business model of micro finance and its future has recently attracted many eyeballs. MFIs on one hand complain of excessive regulation and claim to help the system reach the unreachable at affordable costs. On other hand coercive action by some of them and subsequent suicides in select pockets prompted some state governments to act against the industry.

Is micro-finance the ultimate panacea for credit-deprived soceities of the third world? Public perception regarding micro-finance has undergone significant changes in recent years. Business model of microfinance and its future has recently attracted many eyeballs. MFIs on one hand complain of excessive regulation and claim to help the system reach the unreachable at affordable costs. On the other hand coercive action by some of them and subsequent suicides in select pockets prompted some state governments  to act against the industry. Now in the light of the newly proposed central legislation, Micro Finance Institutions (Development & Regulation) Bill 2011, the RBI has raised fresh questions about the future regulation of the sector. Here are excerpts from the RBI governor D .Subba Rao's speech at the annual function of Indian Overseas Bank in Chennai ……..

The SHG model was handicapped by inherent scalability issues, and thereby yielded the ‘last mile’ space to microfinance institutions (MFIs) which represent a more formal, structured and profit oriented approach. In some ways, the growth of the microfinance sector has been a remarkable success story of recent years; in some other ways, that very growth has also raised concerns about the quality of income generation support MFIs were offering. 

In particular, allegations about usurious interest rates, coercive recovery practices and multiple lending led the Government of Andhra Pradesh, a state that accounted for as much as 40 per cent of the total microfinance activity in the country, to promulgate an ordinance in October 2010. 

The ordinance, subsequently converted into an act, requires all MFIs operating in the state to register on an annual basis with the State Government. The law stipulates that the total interest cost cannot exceed the principal, and seeks to further protect borrowers from getting enticed into an unviable debt burden by restricting multiple lending by MFIs.

The Andhra Pradesh law brought the MFI activity in that state to a standstill; several other states began considering if they too should clamp down on the activities of the MFI sector. On the other side, both the MFIs and the banks that loaned funds to the MFIs were agitated about the security of the funds already lent, and more generally about the prospects for MFI activity in general.

In October 2010, the Central Board of the Reserve Bank discussed the policy impasse arising out of this situation and decided to constitute a sub-committee under the chairmanship of one of the Board members, Shri Y.H. Malegam, to study the issues and concerns in the MFI sector. The Malegam Committee submitted its report in January 2011; its important recommendations were:

• Creation of a separate category of NBFC-MFIs
• Continuation of priority sector status to bank loans to MFIs which comply with the regulation laid down for NBFC-MFIs
• A margin cap and an interest rate cap on individual loans;
• Transparency in interest charges
• Lending by not more than two MFIs to individual borrowers
• Creation of one or more credit information bureaus 
• Establishment of a proper system of grievance redressal by MFIs and 
• Creation of one or more “social capital funds”.

The Reserve Bank accepted the broad framework of recommendations by the Malegam Committee. A separate category of NBFCs - Non-Banking Financial Company - Micro Finance Institution (NBFC-MFI) - was created. Further, regulatory instructions were issued mandating the following. 

For an entity to qualify as a MFI, the aggregate amount of loan extended by it for income generating activity should not be less than 75 per cent of its total loans. Bank credit to micro finance institutions extended on or after April 1, 2011 for on-lending to individuals and also to members of SHGs/JLGs would be eligible for priority sector status only if not less than 85 per cent of total assets of MFI were in the nature of “qualifying assets”. 

To qualify as an asset under priority sector lending, banks should ensure that the interest rate charged by MFIs on final borrowers is capped. Further, to protect borrowers from usurious rates of interest, the interest rate that a MFI can charge a customer has been pegged at 12 per cent over the rate at which it borrows from the bank subject to a maximum of 26 per cent.

The more effective regulation imposed by the Reserve Bank - particularly by way of a cap on interest rate and transparency in MFI operations - has restored calm to the MFI sector. The sentiment of investors too has improved, and some MFIs are also reportedly attracting venture capital funds.

Nevertheless, the roll out of the new regulatory regime has run into some bottlenecks. Some MFIs are unable to comply with the qualifying asset criterion for registering as a NBFC-MFI, and therefore banks are reluctant to make fresh loans to them as such loans do not qualify as priority sector lending. 

Small MFIs are also not able to meet the 50 million entry point capital to be eligible to register as NBFC-MFI. In particular, the Andhra Pradesh based MFIs, saddled with huge losses, large NPAs and eroded capital, are facing an especially acute problem in complying with the capital and provisioning norms. The Reserve Bank is working on resolving these issues so that MFI operations can get back on track.

 Reflecting the lessons of the agitation in the microfinance sector, Government of India is considering a central legislation to comprehensively cover the regulation of the MFI sector. The important features of the Micro Finance Institutions (Development & Regulation) Bill 2011 are:

• The Reserve Bank will be the regulator of all MFIs irrespective of their size and organizational structure
• The minimum entry point capital for a MFI will be 500,000
• MFIs will be permitted to collect thrift
• Both Government of India and the Reserve Bank will enjoy concurrent power to frame rules; and
• There will be an ombudsman for the MFI sector.

Even as MFIs should be brought back on track, albeit under more effective regulation, there is another issue that banks need to ponder. By and large banks have largely outsourced the ‘last mile’ to intermediaries such as MFIs, SHGs etc. 

This is a model that has worked, and one that we should pursue, and refine. Nevertheless, the question is, “is there a business case for banks to do some of the last mile themselves?” 

Can banks rely entirely on outsourcing? Isn’t there valuable experience to be gained by banks by ‘dirtying their hands’ more and reoccupying the last mile?

(Excerpts from lecture by D Subba Rao, Governor,RBI  at IOB event in Chennai )