Column

The developments involving multiple lending and coercive collection practices in the microfinance sector in Andhra Pradesh (AP) in 2010 emphasised the need for sound regulatory arrangements which permit the sector to grow, while addressing the needs of its members and other stakeholders.

The Reserve Bank of India (RBI) directive issued on May 3, 2011, however illustrates the ad-hoc manner in which such regulation is being pursued, neglecting transaction costs; regulatory capacities; and the distortions and inequities created among different participants in the sector.

It may be useful to provide some background on the efforts to develop regulation for the sector. In 2007, a bill was introduced in Parliament, which subsequently lapsed without being passed. In February 2010, the bill was reframed as a draft document and feedback was sought from stakeholders. Contrary to good governance practices, it suggested appointment of NABARD, a participant in the microfinance sector, as the sector regulator; and permitted microfinance institutions (MFIs) to accept savings without adequate safeguards. It excluded from its purview non-banking financial companies (NBFCs), which account for more than 70% of microfinance loans by value. No consensus emerged on the draft document.

The Andhra Pradesh government’s response to the 2010 developments was in the form of an Ordinance, which became an Act in January 2011. The Act’s onerous provisions for MFIs included branch registration requirements, restrictions on frequency and place for MFI repayments and requirement of prior approval for granting loans to self-help group (SHG) members.

The Act resulted in MFI loan repayments in AP dropping considerably to around 10 to 15% by May 2011.

In October 2010, the RBI appointed the Malegam Committee “…to study issues and concerns in the microfinance sector”.The committee, which gave its report in January 2011, focussed on NBFCs and proposed various restrictive measures, some of which, such as caps on incomes and loan sizes, did not take into account sector needs and practices.

The RBI directive specified conditions for MFI loans to be eligible for priority sector loans. These include a cap on the borrower’s income of Rs60,000 in rural areas and Rs1,20,000 in other areas; a cap on the loan amount of Rs35,000 in the first loan cycle and Rs50,000 thereafter; a cap on the total indebtedness of a borrower of Rs50,000; minimum loan tenure of 24 months for loans in excess of Rs15,000; no collateral for loans and finally minimum 75% of the MFI’s loans to be for income generation. In addition, banks are required to ensure that MFIs maintain a margin (difference between lending rate and cost of funds) cap of 12% and interest cap of 26% for MFI loans (interest cap excludes 1% processing fee). The directive offers flexibility to MFIs on periodicity of repayment of the loan and the lending model.The RBI directive has taken into account feedback and has fine-tuned the numerical value of the caps proposed by the Malegam Committee, but left the micro-management spirit behind the committee’s report intact.

MFIs are expected to adhere to the conditions stipulated by the RBI as those that do not meet the requirements will not be eligible to avail of priority sector loans from banks. Hence, they may face lower availability of bank funds and higher interest costs. In effect, the RBI has passed on the responsibility of implementing its many restrictive provisions on the bankers. The bankers in turn are advised to insist on certification by chartered accountants regarding compliance with the norms, necessitating payment of substantial audit and certification fees by MFIs. The higher transaction costs will particularly affect small and medium sized MFIs as the fixed costs involved are likely to be a larger proportion of their turnover and profits.

While mitigating regulatory and political risks are important objectives of microfinance regulation, minimising transaction costs in complying with them are also relevant. It appears that no empirical study has been undertaken to ascertain the transaction costs of following the provisions of the directive on MFIs of different sizes, and the resulting impact on customers. Such a study should not only be undertaken but also made public.

Even without these provisions, MFIs should consciously explore ways to reduce costs, for example by greater use of technology, and experimentation with new business models such as fortnightly repayment.

MFIs may resort to other tactics to improve their profitability such as encouraging customers to prepay loans (for which the RBI directive specifies that there is no penalty). Such a strategy may enable provision of higher loan amounts within the same time period, enabling MFIs to receive a processing fee of 1% each time. It is important that customers of MFIs have the necessary financial education to be able to make more informed decisions on these matters. There is a strong case for mandating financial education by independent entities though the costs involved will need to be shared among stakeholders, including the regulator(s).

For addressing multiple lending, a functional credit bureau is likely to be more useful than arbitrary limits on borrower indebtedness. While NBFCs are in the process of setting up a credit bureau through their association, a sector-wide credit bureau is necessary to help MFIs make better credit decisions.Increased availability of savings products for MFI members may assist in reducing over-borrowing.

The RBI directive does not over-rule the AP Act. Such state specific regulation is counterproductive for developing the microfinance sector. Regulatory architecture encompassing the whole country is needed.

According to the RBI directive, further regulations based on the Malegam Committee recommendations are to follow. Media reports had indicated that a new Microfinance Bill may be introduced in the monsoon session of Parliament. While introducing such regulation, the economic costs of the regulation for MFIs and members based on rigorous analytical and empirical research should be provided to the Parliament and the public.

The RBI directive suggests that those MFIs choosing to generate funding without priority sector classification will not be required to follow its provisions. While their funding costs are likely to be higher, they would be free to charge even higher rates of interest and would also save on the costs of extensive reporting and auditing that priority sector classification will entail.

The objective of microfinance regulation should not be merely
to restrict priority sector classification but to protect MFI customers. The RBI directive implies high transaction costs and discriminates against small and medium MFIs. A more rigorous and comprehensive approach to regulating the microfinance sector is needed.

— Mukul Asher (sppasher@nus.edu.sg) is a professor of public policy and Savita Shankar (savita.shankar@nus.edu.sg) a research scholar at the Lee Kuan Yew School of Public Policy, National University of Singapore. Views are personal.