India’s Microfinance Bill Answers Most Questions

The Government of India promised a new draft microfinance legislation, and it has delivered. The consultative process adopted, the work done by the Malegam Committee, and the regulations issued by the Reserve Bank of India (RBI) and the participation of the lenders, practitioners and others have made the draft comprehensive and well-rounded. The Andhra Pradesh statute, despite its debilitating impact on the sector, seems to have triggered this comprehensive response from the Union government. The need to regulate the microfinance sector in customers’ interest and also the need to avoid a multitude of microfinance legislation in different states has led to this bill which keeps registered microfinance institutions (MFIs) out of the ambit of money lending laws.

The chief features of the bill are that every institution in microfinance should register with the regulator, transform into a company when they attain a significant size, be subject to a variety of prudential and operational guidelines that are introduced by the regulator, provide periodic information to the regulator and face penal action for violation of law or any rules framed. The bill provides flexibility of RBI to apply different measures, vary the same and delegate the powers to regulate to NABARD.

The grievance redressal procedures, mandatory enrollment to credit bureaus and code of conduct enforcement through industry associations will improve customer protection. The creation of national and state councils should provide wider sector participation in policy making. The proposed microfinance fund that would not only provide grants but also bulk finance to MFIs is a very welcome proposition.

Requiring all institutions, regardless of form, to register as an MFI is a critical and necessary step toward effective regulation. The reason for excluding cooperative societies accepting deposits from members only from the definition of an MFI is not clear. There are MFIs which are cooperative in form that deal with members only. That does not make the members any better protected. If the cornerstone of the bill is customer protection, it should be extended to cooperative MFIs as well.

National versus state level supervision

While the proposal to set up a strong advisory council at the national level is welcome, the council should be vested with a role in regulation and supervision. It should be asked to consider periodic reports prepared by the regulator on the state of practice in the sector and compliance with regulation by the institutions. In addition to other functions described in the bill, the council could perform the functions that Board of Supervision¹ performs in respect of banks. The State councils are a good way of involving the state governments. But the councils should be linked to the national council and given a role with content rather than just creating them. Without a significant role and participation in some manner in the activities of the national council, the state councils will become either defunct or deviant. The proposal for appointment of an ombudsman is a welcome measure and will boost the industry’s own effort to handle grievances better.

The step of keeping MFIs outside the purview of money lending is a forward looking step that would improve availability of financial services in the hinterland. Officials in AP have taken exception to a particular provision in the draft bill that seeks to keep MFIs outside money lending law. This is nothing new, as banks regulated by the Banking Regulation Act are kept outside the purview of state jurisdiction. Only when the institutions are unregulated and the practice is exploitative and coercive that the States’ powers under money lending Act become enforceable. The bill introduces regulation relating to form, business, processes, products, pricing and provides a high degree of flexibility to RBI to adopt measures to enforce customer protection practices of a kind not seen in banking regulation.

The requirement of systemically important MFIs to become companies should be strengthened by taking away the option to transform in to a not for profit company under section 25 of companies Act. The existing regulatory framework of RBI is lenient towards section 25 companies; in fact there is no regulatory effort spent on such companies. When MFIs become systemically important they should be actively regulated.

Pricing and interest rates                                                                                                                                                                                              
Sections 23 and 24 of the proposed bill contain the substance of RBI’s regulatory powers. The powers of RBI to issue directions under section 24 are comprehensive and cover almost all aspects of functioning of the MFIs. For the first time the concept of APR is used in the industry to demystify the pricing of loans. While there seems to be a provision for recognition of Self-Regulatory Organization of MFIs, the process of recognition has not been spelt out. The industry associations have a critical role to play in assisting the regulators. In section 25, the bill has chosen to implement margin caps rather than interest rate caps. Absolute interest rate caps are anti-market and introduce rigidities. However RBI has been given the powers to impose an APR cap. The specific mention of margin cap under section 25 leads one to believe that the margin cap will be imposed across the sector and the APR cap will be used only in exigencies.

An interesting insertion is the possibility of RBI refinance to MFIs. The proposed Microfinance Development Fund is intended to provide loans, refinance, grants, capital and any other form of financial assistance. The size of the fund and the RBIs stance on financing microfinance sector will be eagerly awaited. The refinance facility (whether offered by RBI or arranged through financial institutions) would be a significant step forward for the resource starved sector.

Penalties                                                                                                                                                                                                                                                                           
The bill proposes penalties for MFIs of a maximum of Rs 5 lakhs (almost $11,000) which seem paltry in comparison with the size of MFIs and the damage potential of ill-advised actions. There is a need to raise the maximum penalty and relate the same with the nature of violation of law or regulatory advice, and possibly made proportional to the size of the MFI. Section 38(1) facilitates RBI to delegate powers under the Act to NABARD. The wording is carefully done to offer flexibility to RBI to delegate powers in respect of select class of MFIs. This will ensure that regulatory load can be distributed between RBI and NABARD. SIDBI could have been brought on board and offered space in regulation. Perhaps the high level of its financial support to MF sector has restrained the government from including SIDBI on account of the potential for conflict of interest.

Post Andhra Pradesh                                                                                                                                                                                                     
Section 42 should provide a sense of relief to the sector reeling from the aftermath of the State legislation on MFIs in Andhra Pradesh. The registration with RBI effectively protects MFIs from State Government action under money lending laws. This is a long overdue requirement for conduct of business in microfinance. States with competing microfinance programs kept themselves above law and influenced the governments to take action against other MFIs. The sector had been reduced to a state where microfinance became a hazardous business that had to be controlled to the point of extinction. The proposed bill restores the freedom of enterprises to run a business in financing vulnerable people, subject to reasonable regulations.

MFIs and deposits                                                                                                                                                                                                                      
The bill, without overtly saying so, hints at the possibility that MFIs will be permitted to mobilize thrift (small illiquid savings). If the regulations are introduced for this and MFIs permitted to mobilize thrift it would be an exciting development as it makes meaningful financial inclusion possible. The tough task of ensuring depositor protection remains unexplained. Whether the bill could have gone a step further and mandated coverage of MFI mobilized thrift under deposit insurance as is the case in some other countries?

The strong customer protection content reflects a significant change in stance on part of the government – that even borrowers are entitled to protection. The actual measures indicated in the proposed legislation mostly take in to account potential abuses in pricing, competition, and irresponsibility on the part of lender. The bill requires implementation and enforcement in some cases. The regulatory capacity has to be ramped up and the small and medium MFIs capacity to comply with regulation would also need to be beefed up. The bill is an important first step; several more steps in translating the bill to action are required before we reach a stage that restores the vitality of the sector.

Right now the bill is just a draft and needs to be passed by the Indian Parliament. More than a 100 million people are keeping their fingers firmly crossed.

– 2008,2009, and 2010 Also check out the Financial Inclusion Regulation Center’s India profile page for more information.

¹Set up by RBI in respect of commercial banks and financial institutions and NABARD in respect of cooperative banks and RRBs.

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.