Control, micromanagement will be counterproductive for microfinance sector

The mindset of control and micromanagement visible in the Malegam Committee’s report is likely to inhibit dynamism and innovations in the microfinance sector.

The committee, appointed by the Reserve Bank of India (RBI) “to study issues and concerns in the microfinance sector,” submitted its report on January 19.

The report has justifiably elicited many critical reactions.
Given the mandate, the committee’s recommendations relate to microfinance institutions (MFIs), which are non-banking financial companies (NBFCs). NBFC-MFIs account for only 34% (Rs18,300 crore) of the microfinance loans outstanding in India. Self help group-bank linkages and other institutional structures such as societies, trusts and cooperatives account for 58% and 8% of loans in India, respectively.

As the report covers only a part of the microfinance sector, additional inputs will be needed to promote uniform regulation for the entire sector.

The report does make some positive contributions.
First, it makes a case for creating a separate category of NBFC-MFIs so as to enable the specialised treatment that MFIs require as compared to other NBFCs, due to the population sub-group they serve.

Second, it suggests that MFIs should be free to decide whether to collect installments on a weekly, fortnightly or monthly basis. This is in contrast to the Andhra Pradesh (AP) MFI Act which mandates only monthly repayment. Studies have indicated that for sections of low income groups, weekly repayment of loans is appropriate.

They experience difficulties in holding surplus cash, primarily due to their inability to conveniently access savings accounts. The heterogeneous nature of low income groups with varying cash flow patterns, necessitates multiple models of microfinance instead of a “one size fits all” solution.

Third, the report specifically states that NBFC-MFIs should be exempt from the provisions of Money-Lending Acts. Such an exemption will prevent the misuse of such Acts by state governments to pursue short term partisan objectives at the expense of public interest.

Fourth, continued priority sector status recommended for the microfinance sector augurs well for continued availability of funding for MFIs.

Fifth, the report points out the drawbacks in the draft Microfinance Bill and the Andhra Pradesh MFIs Act. It recognises the conflict of interest inherent if Nabard, a sector participant, also becomes a regulator.

Finally, the report suggests standardisation in quoting interest rates; mandatory participation of MFIs in credit bureaus; and introduction of corporate governance norms for MFIs. These are urgently needed if the Indian microfinance sector is to reach its potential.

However, a number of the report’s suggestions also have severely negative implications both for the MFIs and their members.
First, the report suggests that MFIs should restrict their lending to households with annual incomes up to `50,000. In an interview, the chairman of the committee admitted that even assessing the precise value of a household’s income is difficult. He also claimed in the interview that the precise limit is not important. Then why provide such precise numbers in nominal terms whose real value will decline over time?

Besides, a number of households with incomes well above this threshold remain unbanked and restricting possibly their only means to access financial services does not serve national objective of financial inclusion.

An important advantage of microfinance over government-subsidised development financial institutions (DFIs), which have performed poorly, is its ability to restrict access to only those who need it. While the latter had restrictions on whom they could lend to as proposed in the report, in practice their loans were mis-targeted. MFIs on the other hand, reach those who need their loans most. They require compulsory attendance in group meetings; and charge interest related to their cost of lending funds. These do need to be brought down through process, organisational, and technical innovations.

The above restrictions and proposed interest rate cap and margin caps of the MFIs arguably dilute the very essence of microfinance.

The result could be that MFIs are converted into organisations similar to the now nearly extinct species of DFIs who did not reach the needy and also had considerable fiscal costs due to a high default rate. The ultimate contingent liability of DFIs is on the government budget, i.e. on the taxpayers.

Second, the report suggests that MFIs restrict loan size to Rs25,000. The present definition of microfinance loans is loans up to Rs50,000 (other than in the case of housing loans where the limit is Rs150,000). It would be expected that over a period of time this cap would need upward revision as borrower needs and capabilities increase along with such macroeconomic factors as inflation and increase in per capita income. A downward revision of the nature prescribed by the report is detrimental both to MFIs and borrowers. As larger loans reduce transaction costs, and often are more profitable, it could help MFIs in cross subsidising their smaller loans. As the MFI borrowers increase the scale of their microenterprises over time, a cap on borrowing could inhibit their plans and aspirations.

Various other restrictive measures have been suggested. For instance, 75% of an MFIs loans are to be directed towards income generation activities. A cap on margins of MFIs has been proposed with the cap being 12% for smaller MFIs (having loans outstanding less than Rs100 crore) and 10% for larger MFIs. The report also suggests that the minimum tenure of loans up to Rs15,000 should be at least one year while for larger loans it should be at least two years.

The restrictions are expressed using nominal monetary values which will decline in real value over time. More importantly, such detailed restrictions imply a controlling mindset on the part of policymakers and will serve to considerably dampen the entrepreneurial initiatives. Adversarial relationship between the MFIs and their customers, implicit in the report, does not create appropriate environment for co-creation of values with customers and other stakeholders.

The positive recommendations of the report are unfortunately overshadowed by the restrictive ones. While the problems observed in the microfinance sector, particularly in Andhra Pradesh are serious and need to be addressed through regulatory and other measures, these should not take the country several steps backwards in its pursuit of financial inclusion for low income groups. 

The RBI’s decision to solicit feedback on the report is a welcome step in the process of creating an enabling and facilitating policy and regulatory structures for the micro-finance sector.

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.