India Microfinance Bill Offers a Mixed Bag to Investors
The draft Indian Microfinance Institutions (Development and Regulation) Bill 2011 has been made available by the Central Government for comments. The bill has been under preparation for a long time and in its last avatar left out the for-profit Microfinance Institutions (MFIs) outside its ambit completely. However, in its new avatar, the bill appears to be a comprehensive piece of legislation that wants to resolve the long standing challenges that the microfinance sector has faced. The change in the thinking of the government in terms of introducing the comprehensive microfinance bill to replace the old one and emphasizing the supremacy of the regulator, the Reserve Bank of India (RBI) is a consequence of the events in Andhra Pradesh where the State Government has introduced a State level Act to regulate MFIs. It thus is best if we look at the Bill from that perspective and comment on its ability to answer the key challenges it had identified to resolve.
My reading is that there were three key issues that the government was grappling with and it wants to use the bill to address them comprehensively.
a) To establish the supremacy of RBI as the key regulator for the Microfinance Sector and to resolve all political and regulatory ambiguity. The action of the Andhra Pradesh Government in bringing about the State level act that crippled the microfinance movement was a key trigger and the bill is an attempt to resolve the issue of multiplicity of regulation in microfinance.
b) Acknowledge that poor, needy, and underserved clients in the microfinance domain need extra protection and hence introduce measures that would make sure that the client is protected.
c) Microfinance as a business must have limits to profitability and while scale is important, the investors must not make disproportionate profits. Without going into a debate on the merits of these assumptions I think it would be worthwhile to see if the bill does address some of the concerns or challenges.
The Microfinance Bill seems to say enough to clearly dissuade state governments to try and replicate the Andhra Pradesh bill. It clearly lays down the rights of RBI as a regulator and clearly treats microfinance as an extension of the banking sector. The bill makes a mention of thrift, remittances, pension, insurance and other services to clearly indicate a departure in treating microfinance as credit alone business and through this it is clearly making a distinction between microfinance industry and money lenders.
The Bill goes a step further to address any confusion that may arise due to multiplicity of regulation by asking every institution involved in microfinance to register with RBI under the act even if they are already registered with RBI as an NBFC. The Bill has not only tried to address concerns expressed by states but has created provision for them to participate through the State Advisory Council and provide inputs to the regulator.
Verdict: The bill’s constitutional validity can be challenged by the State Government and the State of Andhra Pradesh has indicated that it may approach the Supreme Court against it. But it appears that there is enough content and pith in the proposed bill for it to be able to withstand its constitutional validity over the issues of State vs. Central list and jurisdiction issues. The strong push to demonstrate microfinance as an extension of banking activity also makes a strong case for this being a centrally administered legislation.
As an Investor: Investors dislike ambiguity and what has happened in Andhra Pradesh is an investor’s worst nightmare. In the current situation, absolute clarity is the only thing that would bring back investor interest in microfinance and for that to happen the absolute support of Central Government and clear supremacy of RBI as the single regulator are of utmost importance. The bill in that sense is possibly correcting an anomaly and hence is a step in the right direction.
The big concern that the bill brings to the mind of the investor is the rights it has given to RBI to approve, merger, demerger, change in capital structure that may mean that exits would become a bigger challenge. In the absence of definition of ownership and control one may need clarification if investment or sale of equity by financial investors would need RBI approval.
Client is ‘God’ goes the maxim and in case of microfinance surely the State and Central Government do believe so. One of the key reasons for the current crisis in Indian microfinance is the stated belief of the Andhra Pradesh Government that the clients are not being treated properly.
The bill has tried to address client needs by introducing obligations and putting in place extensive monitoring and reporting requirements.
Verdict: The bill has tried to put in place a grievance redressal mechanism to make sure clients grievances are addressed. Additionally the bill gives RBI the power to recognize the Code of Conduct for MFIs through a self regulatory organization and a client protection code, provisions of which would be good guidance for what MFIs can and cannot do which are steps in the right direction. The presence of Central and State advisory committees would ensure that there are enough eyes on the implementation of these codes as well and penal provisions put in place may act as deterrent for those who do not adhere to these provisions.
Investor Point of View: As an investor with a conscience, protecting the client who is vulnerable is a very desirable step. However in trying to implement these client protection mechanisms on the ground, cost implications have not been taken into account. While the bill is silent on the income of the borrower as a criterion for deciding his eligibility for loan, RBI guidelines inadvertently, in my view, actually penalize clients instead of protecting them by imposing restrictions on the income of the client to receive microfinance loan. As an investor in microfinance, I see this penal provision for the well performing clients as a serious flaw.
Ironically, on one hand microfinance is being questioned to prove its usability in bringing about a change in the income of the poor, while the law drafted ensures that in case it does bring about a change in his income, the client may not be eligible for future loans. This would lead one to question the very viability of the business which is compelled to lose its well performing clients!
Microfinance as a business must have limits to profitability and while scale is important the investors must not make disproportionate profits.
The Bill has retained two key recommendations of the Malegam committee on capping the interest rate and putting in place margin caps. These provisions have been put in place to make sure that microfinance institutions do not profiteer from the poor.
Verdict: For a country that has otherwise decided to move from regulation to de-regulation, this is a retrogressive step. However one may want to agree with the regulator and the formulators of the bill that such provisions are needed to protect the interest of the poor who are not in a position to negotiate a better deal for themselves. The only question I have is, whether the drafters of this the bill analysed if the profitable and large MFIs are within these caps and if not, how far outside these caps they are?
A closer look at the numbers of large MFIs clearly indicate that the competition and pressure to scale have pushed them to move into these thresholds already and in that sense are compliant to these terms. The question one is left wondering is if the steps were really needed and has the bill and associated guidelines have removed the incentives for these companies to bring down these rates further?
Investor Point of View: The margin cap and interest rate caps are blessings in disguise in some sense. The introduction of such steps while being retrogressive, have scared away short term, opportunistic investors from the sector making it easier for long term investors to find good deals at a reasonable price. However, on the flip side, these moves have given to the MFI, a reason not to push these rates down further because there is an artificial limit already set in place as the benchmark for performance. Margin cap similarly has clearly done away with incentives for the microfinance institutions to rework their cost structures and use technology to bring down their costs once they have reached a certain benchmark. It seems that inadvertently, the bill has put in place incentives and penal provision that are not aligned to other provisions of the bill namely better technology penetration and bringing down the interest rates.
Finally, I am yet to find a magical microfinance entrepreneur who can successfully operate a business that has a fixed interest and margin cap, in an inflationary economy like India where interest rates are increasing every day.
As an investor in the sector, who took the risk of investing in microfinance as early as 2005, I must say that the bill has features that may mitigate the risks of reappearance of the 2010 October crisis. However, I remain disappointed by the failure of the bill or RBI to address the consequence of the meltdown that is being faced by the sector. Neither the bill nor Reserve Bank of India has shown any alacrity in recognizing the significance of current challenges to the microfinance industry nor have they tried to address the destruction of MFIs in Andhra Pradesh, some of whom have provided services to people for years and has attracted investments from across the globe.
However, it does try to answer questions for investors who want to move into the sector now and hence it may not be inappropriate to term the new bill a mixed bag.
India’s Ministry of Finance released the much awaited draft microfinance bill which is to be introduced in the country’s parliament shortly. This post is the next in a short series of commentary on the bill by a variety of experts from the region on what the bill means for India and the global microfinance industry.
Two important points covered in the Bill merit the attention of the investors. They are 1.Diversification of MF services and 2.Income Recognition and Asset classification
1. In the case of first point, while defining the MF services, the Bill indicates various financial services involving small amount viz. Thrift, micro credit, micro insurance, pension, remittance etc., If the MFIs undertake more than one business activities covering all the services to the target group, it would enable them to enhance their income from diversified services instead of depending on risk infested single micro credit services .Further it would also facilitate the poor clients to access more of MF services from single institutions and enable them to realize a sustainable livelihood. Investors therefore need to insist the MFIs to employ required skilled manpower and engage in providing diversified services to the poor clints so that both the social and financial goals could be achieved with a balanced return on one hand and a minimization of risk on the other.
2. Regarding second point, it is stated in the Bill (Chapt.5.24. 1 ) that in the public interest RBI may give directions to MFIs relating to Income Recognition(IR) and Asset classification, Provision for bad & doubtful assets etc., based on risk weight for assets. These accounting standard norms are all no doubt vital tools for assessing and maintenance of ‘health status of Asset of any financial institution for that matter including MF institution concerned. However while applying these concepts in MF arena keeping the target client exclusively from poor community, one should not fail to perceive the inherent phenomenon of correlation between the ‘Income Recognition’ at institutional level and the ‘Income Generation ‘ (IG)at poor customer level.. To study in depth the functioning of these asset related concepts , the correlationship indicates that the productivity of asset (micro credit) , used at poor customer’s level for ‘ Income generation’ , is bound to influence the performance of asset at institutional level in terms of recovery performance and have chain effect ultimately on ‘Income Recognition. It is therefore imperative to arrange ‘provisions’ in terms of adequate MF services coupled with non financial services either singly or severally for ensuring the productivity of the micro asset at client level first so that it will lead to sustainable income generation. Consequently, this process is resulting in good repayment and eventually facilitating for income recognition of asset etc., at institutional level. So to say if non financial ‘provisions’ integrated with MF services are appropriately taken care of for the functioning of micro asset at filed level , then with all the assets well performing, there is no need for financial ‘provisions for bad and doubtful debts at institutional level.. This value chain process would facilitate for earning sustainable income for the MFIs and assured return to the investors with the sense of social participation for the cause of the disadvantaged poor segment. This correlation factor between IR and IG therefore assumes importance in the context of mandatory maintenance of 75% of total asset under priority sector credit portfolio for IG activity as stipulated for NBFC-MFI(Malegam Committee).
The impact of omnipotent of new Avatar largely hinges on the effective implementation of all the players at all levels right from the Investor to the poor client with more ethical considerations..