As microfinance grows, so does the need for better regulation

The growth of the microfinance sector globally has made its regulation an important concern for policy makers. This is suggested by a recent consultative paper on core principles relating to supervision of microfinance activities of commercial banks placed for discussion on the Bank for International Settlements’ website (www.bis.org).

The microfinance sector has also grown impressively in India. According to the Microfinance India State of the Sector Report 2009, there were 76.6 million microfinance accounts in the country as of March, 2009; while the total microfinance sector loans outstanding were Rs 35,900 crore.

The Reserve Bank of India (RBI) has identified the growth of microfinance sector as an important avenue through which the broader national goal of making a broad range of financial services accessible to increasing proportion of the population, usually referred to as financial inclusion goal, can be reached. The RBI considers lending by banks to the microfinance sector as part of their priority sector lending requirements. Both these aspects increase the importance of ensuring orderly development and sound governance and regulatory structures for the microfinance sector.

In India, a draft Microfinance Bill document was introduced in 2007, which subsequently lapsed. Another draft document (which curiously is not called a Bill) has recently been made available on the Nabard website (www.nabard.org).

Active consultation of the sector stakeholders is being sought through the medium of the Solution Exchange e-discussion group organised by UNDP (www.solutionexchange-un.net.in). The document has elicited a large number of responses, suggesting ways in which the draft document can better meet the needs of various stakeholders.

An analysis of the draft document suggests that it is not substantively different from the earlier draft Microfinance Bill. The earlier Bill had a number of shortcomings, which are not addressed in the new draft. It therefore forms an inadequate basis for regulating the microfinance sector.

First, it designated Nabard, an active and large sector participant, as the regulator. This is contrary to good governance practices as there is potential for conflict of interest if a major service provider also becomes a regulator. The case of Employees’ Provident Fund Organisation, which acts as a service provider as well as regulator of exempt provident funds, illustrates the need to separate the roles of service provider and regulator. 

Second, the Bill confined its scope to only certain categories of microfinance institutions (MFIs), providing scope for regulatory arbitrage. It is important to address this limitation as larger and more commercially oriented entities such as sovereign wealth funds, private equity and hedge funds, which together form the “shadow banking” sector, which largely escapes national and international regulations, have begun to target the microfinance sector as potentially high-profit asset class.

The large commercial banks are also increasingly entering this sector with the same objective. The systemic risk that the microfinance sector could potentially pose has therefore increased, and correspondingly so has the need to regulate this sector.

A third limitation was that it permitted deposit collection by some types of MFIs without adequate safeguards. As the contingent liability of such deposits of such deposits will be on the government, it is essential that this limitation is addressed.
To address the above limitations and to take into account the concerns of the stakeholders, the following approach is suggested.

There are two main areas where regulation is necessary. First, regulation is needed to address the need for access to savings instruments and affordable remittance and payment services including those involved in various government schemes for low income groups.

Currently, the microfinance sector focuses primarily on lending. Regulatory constraints have contributed to this focus.
It is proposed that a few large MFIs with satisfactory track records can be permitted to convert into MFI banks so that they can provide savings as well as mobile banking services. Given the large geographic area of the country, licences to collect deposits need to be provided selectively to entities, so as to enable effective regulation.

Changes in current provisions to introduce innovations in service delivery, such as permitting MFI banks to partner with mobile companies to offer mobile banking services merit serious consideration. Such innovations can substantially reduce transaction costs and facilitate progress towards the goal of financial inclusion.

The RBI should be entrusted withthe responsibility of regulating the MFI banks, as they are likely to pose systemic risk. As the RBI regulates commercial banks in India, it is in a better position to address this risk.

There is, however, a need for the RBI to enhance its capabilities to regulate and help develop the microfinance sector and coordinate regulation of the “shadow banking” sector entities. Nabard’s traditional focus and competence is not well suited for this task.

The second area of regulation concerns non-prudential regulation, which does not involve systemic risk but is essential for good governance and orderly development of the sector. This area involves transparency with regard to charges, mitigating mis-selling of financial products, operating practices such as monitoring and collection of loans, and norms for provisioning of loans.

As an example, interest rates charged by the MFIs are often not quoted in transparent annualised terms. Often, loans involve upfront fees and service charges, making calculation of effective interest rates complex and therefore non-transparent.

It is proposed that the non-prudential regulation of all MFIs may be carried out by an oversight board (OB), which should report to the RBI. The board should be broad-based in nature, consisting of representatives from government, banks, MFIs, SHG federations, Sa-dhan (the association of community development finance institutions) and NGOs (non-government organisations). The size of the board should, however, be manageable for effective oversight and functioning.

The above suggested framework involves having two regulators for the sector. While RBI would be the regulator for MFI banks permitted to offer savings and mobile based remittance services, the OB will set benchmarks for the industry to safeguard consumer interests.

This framework addresses the systemic risk and the need for good governance and orderly development. It will also ensure that there is no conflict of interest between a service provider and a regulator.

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.