Microfinance has been always seen as an economic development tool for the downtrodden and poorest section of society. In its social objective, it is one of the most useful tools to battle poverty and give an equal chance to those who can contribute to the economy, but need help. In its simplest sense, it helps a financially backward person with no or little collateral to set up his own business by providing finance at convenient rates and repayment tenure. Over time it had moved on to many more services for financial inclusion and literacy.
For this reason, the Microfinance sector was in high regard. The Microfinance sector has seen an upheaval in recent times. However, since the advent of new Micro Finance Institutions (MFIs) with a more profit-linked and lesser social incentive, the sector has seen changes. The sector which was in limelight for its rapid growth and success in financial inclusion was suddenly seen in a bad light because of its alleged coercive practices. These practices got highlighted with suicides by certain borrowers in Andhra Pradesh, the state that has the largest chunk of MFIs. Andhra Pradesh passed an Ordinance bill and followed it up with a State Act to regulate the working of these MFIs. The Reserve Bank of India also set up a Committee under the chairmanship of Mr. Y. H. Malegam to study the issues and concerns in the Micro-finance sector. This Committee tabled its report on the 19th January 2011. This article summarises the main points coming out from this Report.
Introduction: The Committee has come out with a detailed report on the Microfinance sector — the reasons for the current crisis and possible redressal provisions. The Committee had the following objectives:
(i) To review the definition of ‘micro-finance’ and ‘MFIs’;
(ii) To examine the alleged malpractices conducted by these MFIs especially with respect to interest rates and means of recovery;
(iii) To specify the scope of regulation by RBI of these MFIs and suggest a proper regulatory framework;
(iv) To examine the prevalent money-lending legislation at the state level and other relevant laws;
(v) To analyse what role the associations and bodies of MFIs can play in enhancing transparency of MFIs;
(vi) To suggest a redressal machinery;
(vii) To examine the conditions for allowing priority- sector lending to MFIs.
The sub-Committee had confined itself to only the lending aspect of MFIs and not the other services like insurance, money transfers, etc. Further, the report commented on the unique characteristics of loans given by this sector, namely, that the borrowers are low-income groups, amounts are small, there is no collateral, the tenure is short and repayments are frequent.
The main players in the Microfinance sector are the Self-Help Groups (SHG) linked with the banks and Joint Liability Groups (JLG) linked with NBFCs. Both these types of groups are created by individuals who create savings, act as supporters as well as put peer pressure on each other in the group for effective utilisation of loans given by banks.
The need for regulation: Most of the NBFCs were non-profit organisations which had started the work with a purely social objective. However, over time some of these turned into for profit NBFCs. This attracted purely business-oriented entities to enter into the sector as they saw that there was a profit to be made from these activities. Such NBFCs also attracted a lot of private equity.
The Committee brings out the fact that though these NBFCs were handling a large amount of loan portfolio, no specific regulations were present. The Committee in its report has therefore stressed on the need for regulation of such NBFCs as a separate category of NBFCs operating in the MFI sector. The main reasons for this suggestion were that the borrowers were a particularly vulnerable section of society; the NBFCs compete against both the established SHG-Bank linkage programme and other NBFCs; credit to the MFI sector is important for financial inclusion; and banks have a significant exposure to loans given to such NBFCs.
For all the above reasons, the Committee has suggested a creation of a separate category for such NBFCs to be designated as ‘NBFC-MFI’ with a specific definition:
“A company (other than a company licensed u/s.25 of the Companies Act, 1956) which provides financial services predominantly to low-income borrowers with loans of small amounts, for short terms, on unsecured basis, mainly for income-generating activities, with repayment schedules which are more frequent than those normally stipulated by commercial banks and which further conforms to the regulations specified in that behalf.”
Conditions to be met: The Committee has also specified quite a few conditions which an NBFC has to meet for it to be classified as a ‘NBFC-MFI’. These conditions have been put in place after the Committee went through certain statistics and ground realities prevalent in this sector. The conditions are:
(i) 90% of the assets of an NBFC-MFI should be in the form of loans to the Microfinance sector.
(ii) These loans are to be given to a borrower whose annual household income does not exceed Rs.50,000.
(iii) The amount of loan and total outstanding of the borrower should not exceed Rs.25,000.
(iv) The tenure of the loan should be more than 12 months in case of loans lesser than Rs.15,000 and more than 24 months other cases.
(v) There should be no penalty on the borrower for pre-payment of these loans.
(vi) The loan is to be without collateral.
(vii) The total amount of loans given for non-income generating activities should not exceed 25%.
(viii) The repayment schedule would be at the choice of the borrower.
(ix) Other services provided by the MFIs should be regulated.
However, fulfilling all these conditions would mean a change in the existing business model of the MFIs. Therefore, these conditions are the main bone of contention for existing MFIs, who find them to be quite draconian.
Alleviation of other main concerns: The above conditions would essentially regulate the kind of loans given by such MFIs and the types of incomes earned by them. However, the main areas of concern with respect to MFIs are not yet addressed. Therefore the Committee has listed down each of these areas and suggested redressal provisions:
Pricing of interest: The very high rates of interest charged by certain MFIs were the main reason for the current upheaval. Therefore, the Committee has noted that interest rates should tread a fine balance between affordability of the clients and sustainability for the MFIs. Looking at the vulnerability of the borrowers, the Committee felt it necessary to put down a controlling rate of interest to be charged by such MFIs. However, instead of a fixed rate, the Committee has suggested for a margin cap which would regulate the difference in the cost of funds for the MFI and the rate of interest charged to the borrower. For deciding the cap, the Committee has gone into the financials of certain large and small MFIs and analysed several parameters and costs. It has suggested a margin cap of 10% for MFIs with a loan portfolio exceeding Rs.100 crores and 12% for those within. This cap would be applicable at an aggregate level and not for individual loans. The MFI would be free to decide the individual loan rate within an overall limit of 24%.
Transparency:
The Committee noticed that MFIs, apart from a base interest charge, also levy a variety of other charges in the form of an upfront registration or enrolment fee, loan protection fee, etc. The Committee has suggested that MFIs should only charge an insurance premium and an upfront fee not exceeding 1% of the gross loan amount apart from the base interest.
Further, it has suggested that for effective transparency, every borrower should be presented with a loan card which shows the effective rate of interest and other terms to the loan. The effective rate of interest should also be prominently displayed in all the offices, literature and website of the MFI. It has also denied charging of any upfront security deposit and standardised loan agreements.
Ghost borrowers:
Because of competition amongst MFIs, a deluge of loans are available to the borrower. This results in multiple lending and over-borrowing. This is exacerbated by the fact that loans disbursed have inadequate moratorium period before re-payment starts. Therefore, the repayment would start before the income is generated. This would prompt the borrower to either go in for additional borrowing, or repay from the loan amount itself. Further, MFIs use existing SHGs to reduce transaction costs. Thus the borrowers are tempted to take additional loans.
To alleviate these concerns the Committee has proposed that MFIs should only lend to group members; the borrower must not be a member of another group; not more than two MFIs should lend to the same borrower; and there must be a minimum period of moratorium. Where loans are borrowed in violation of these conditions, recovery of the loan should be deferred till all existing loans are repaid.
To reduce the problem of ghost borrowers, the Committee further recommends that all sanctioning and disbursement of loans should be done only at a central location under close supervision.
Another important tool necessary in the prevention of multiple lending is the availability of information of outstanding loans of an existing borrower. Therefore, a database to capture all outstanding loans as also the composition of existing SHGs and JLGs is recommended.
Coercive recovery practices:
The Committee has noticed the reports made of coercive methods exercised by the MFIs, their agents or employees for recovery of loans. It maintains that the main reasons for use of such coercive methods are linked with the issues of multiple lending, uncontrollable growth and employment of recovery agents.
The Committee has proposed several measures to resolve this issue:
i. Primary responsibility that coercive methods are not used should rest with the MFI. In case of default, the MFI should be charged with severe penalties.
ii. The regulator must monitor whether the MFIs have a proper code of conduct and system for training of field staff. The MFI should have a proper Grievance Redressal Procedure.
iii. Filed staff should be allowed to make recoveries only at a group level at a central place to be designated.
iv. An appropriate mechanism to introduce independent Ombudsmen should be examined by RBI.
Apart from the above, the Committee has recommended that the regulator should publish a Client Protection Code for MFIs and mandate its acceptance and observance not only by the MFIs themselves, but also by the credit providing banks and financial institutions. This Code should incor-porate the relevant provisions of the Fair Practices Guidelines prescribed by the RBI for NBFCs.
Improving efficiency:
The Committee has gone beyond recommending measures to alleviate only the main concerns of the MFI sector. It has also suggested some steps for improving the overall efficiency of the MFIs.
The key areas highlighted to improvement in efficiency are operating systems, documentation and procedures, training and corporate governance.
To this end, it has called for increased investment by MFIs in information technology to achieve bet-ter control, simplify procedures and reduce costs. Further, it has suggested inculcation of profes-sional inputs in the formation of SHGs and JLGs, imparting of skill development and training, and in handholding of the group after it is formed.
To decrease transaction costs by achieving better economies of scale and to improve control it was felt by the Committee that MFIs should obtain optimal size of operation. For this if consolidation in the sector may be inevitable.
On the basis of a capital adequacy ratio of 15% on a basic investment portfolio of Rs. 100 crores, the Committee has suggested for a minimum net worth of Rs.15 crores.
The Committee has underscored the importance of alleviation of the poor along with reasonable profits to investors in the MFI sector. These twin objectives call for a fine balance and therefore all MFIs should have a good system of corporate governance.
The Committee has recommended inclusion of independent board members; monitoring by the board of organisational level policies; and relevant disclosures in the financial statements.
The Committee has also recognised the fact that MFIs have a very large exposure to the banking system. More than 75% of their funds are sourced from banks. Therefore, adequate safeguards must be in place to maintain solvency.
The Committee has recommended appropriate prudential norms which should be different from other NBFCs looking at the unique nature of loans disbursed by MFIs. The Committee has suggested specific rates for provisioning of outstanding loans. Further, it has recommended maintenance of a higher capital adequacy ratio of 15% as compared to the existing 12% considering the high-gearing and high rate of growth.
It has been appreciated that interest rates can be lowered only if greater competition both from within the MFIs and without from other agencies should be encouraged. To this end, the Committee has recommended that bank lending to this sector should be significantly increased.
Currently all loans to MFIs are considered as prior-ity sector lending. As there is no control on end use and there is significant diversion of funds, it had been suggested to the Committee that MFIs should not enjoy the priority sector status.
However, the Committee has pointed out in its report that removal of this status may not be required if other recommendations made by it are implemented. In fact, competition within banks for meeting targets for lending to priority sector could reduce interest rates. But, those MFIs which do not comply with the proposed regulations should be denied the priority sector lending status.
The Committee has noted that in addition to direct borrowing the MFIs had assigned or securitised sig-nificant portions of the loan portfolio with banks, mutual funds and others. It has asked for full disclosure of such assignments and securitisations to be made in the financial statements of MFIs. Further, for the calculation of capital adequacy, wherever the assignment or securitisation is with recourse, full value should be considered as risk-based assets; and where the same are without re-course, value of credit enhancement given should be deducted from the net-owned funds. Banks should also ensure, before acquiring assigned or securitised loans, that loans have been made by the MFIs in accordance with the regulations.
The Committee mentions that a widening of the funding base for MFIs is needed. This is because there is a huge demand for MFIs. However, non-profit entities could not meet this demand. When for profit entities emerged, venture capital funds were not allowed to invest in MFIs and private equity rushed in. This has resulted in demand for higher profits with consequent higher interest rates and other areas of concern.
Therefore, the Committee has recommended establishment of a ‘Domestic Social Capital Fund’ targeted towards social investors who are willing to earn lesser returns of around 10 to 12%. This fund would invest in MFIs satisfying the social performance norms laid down by the fund.
For all the above measures towards alleviation of the areas of concern and improving efficiency, the Committee has noted that success would depend on the extent of compliance. To this end, it has suggested monitoring of compliance with the regulations will have to be borne by four agencies.
The primary responsibility would rest with the MFI itself and the management should be penalised in the event of non-compliance. The next level of monitoring would be by the industry associations which would prescribe penalties for non-compliance with their Code of Conduct. Banks can also play part with surveillance through their branches. The Committee has called on the RBI for considerably enhancing its existing supervisory organisation dealing with such NBFCs. It should also have the power to remove from office the CEO and/or director in the event of persistent violation of the regulations.
The Committee has also provided for certain suggested reliefs for MFIs.
Several states have money-lending Acts which are several decades old. These Acts do not specifically exempt NBFCs unlike banks and cooperatives. These NBFCs are already regulated by the RBI. The Committee has therefore recommended for exemption of these MFIs from the provisions of the money-lending acts.
The Central Government has drafted a ‘Micro Finance (Development and Regulation) Bill, 2010’ which will apply to all microfinance organisations except for banks, co- operatives, etc. The Committee has suggested some changes in the bill for exemption of smaller entities, functioning of NABARD as a regulator and market player, and disallowance of business of providing thrift services by MFIs.
As mentioned in the beginning, the Andhra Pradesh Government has enacted a specific legislation to regulate the MFIs operating with the state. The Committee has expressed that as most of the conditions set by this Act are already recommended by the Committee, a separate Act may not be needed.
Finally, the Committee has recommended that 1st April 2011 should be kept as the cut-off date for implementation of their recommendations. They have insisted that the recommendation as to the rate of interest should in any case be made effective to all loans given by MFIs after 31st March 2011. Certain relaxation as to other arrangements can be given by RBI, especially where MFIs may have to form separate entities confined to only microfinance activities.
Conclusion:
As can be seen, the Committee has gone in-depth on the issues faced by the Microfinance sector and has called for far-reaching changes. These changes, if accepted by the RBI, would materially alter the operation of MFIs in India. As would be expected, MFIs have strongly criticised the provisions suggested by the Committee. The specification of maximum interest rates that can be charged has irked the MFIs in particular. Mr. Malegam has mentioned in interviews that a limit is necessary. What this limit should be, can be decided by the RBI. The decision on these recommendations now lies with the RBI. As per news reports, the RBI is expected to give its view on the report by end of April 2011.
