2/2013 Regulation of Microfinance Institutions in India ? Â· Regulation of Microfinance Institutions in India Considering the importance of microfinance institutions in fulfilling the goals of financial inclusion, ...
IntroductionMicrofinance institutions (MFIs) perform acrucial function of facilitating financial inclusiongoals in developing countries through the provisionof micro-finance services. Micro-finance servicesinclude: (a) micro-credit facilities to the extent ofM05lac [or M10lac if so specified by the Reserve Bankof India (RBI)]; (b) the collection of thrift; (c)pension; (d) insurance services; and (d) theremittance of funds to individuals within Indiasubject to prior approval by the RBI.MFIs in India have grown tremendously in termsof size, outreach, and financial maturity since theiremergence in the 1980s. Recent RBI reports withregard to microfinance activities state that alongsideself-help group (SHG)-bank linkage programmes,MFIs, such as non-government organisations(NGOs) and non-banking finance companies(NBFCs) have emerged as important sources ofmicrofinance delivery in India. Consequently,incentives have been provided for penetration ofbanking into unbanked areas and encouraging MFIsas intermediaries. However, the growth of the MFIshas been geographically disproportionate. TheMalegam Committee report noted that distributionof microfinance penetration is more than half of thetotal MFI portfolio of India in the Southern regionwhile the Eastern region has over one fourth of thetotal MFI portfolio.This briefing paper presents a picture of theregulatory instruments governing differentmicrofinance entities in the country. Specific featuresof regulation of NBFC-MFIs, and the current stateof the conflict between State Money Lendinginstitution actors and the RBI has been captured.Prudential and non-prudential norms of regulationand their consequent impact on competition havebeen dealt within this paper.RegulationLegal Structure of MFIs:A microfinance institution under the MicrofinanceInstitutions (Development and Regulation) Bill,2012 includes the following entities: (a) a societyregistered under the Societies Registration Act, 1860;(b) a company registered under section 3 of the2/2013Regulation of MicrofinanceInstitutions in IndiaConsidering the importance of microfinance institutions in fulfilling the goals offinancial inclusion, it is essential to understand the body of laws, rules and regulationswhich govern this financial tool. Following the aftermath of the Andhra Pradeshmicrofinance issue and the subsequent rise of the microfinance industry nevertheless,various prudential and non-prudential norms were evolved by the regulatory bodiesin the country in order to effectively regulate microfinance institutions. However, anoverlap between the areas dealt with by various authorities governing microfinanceentities on critical issues like interest rate determination create uncertainty on the basicconditions of thriving in this sector for participant institutions. This briefing paperdeals with some of the problems in regulation of microfinance institutions and presentssolutions which should be taken into consideration.2in specified priority sectors at concessional rates ofinterest. Currently only MFIs registered as NBFC-MFIs are designated as a priority sector. The numberof priority sectors has recently been reduced, whichsuggests that banks will be relying more heavily onlending to MFIs to meet the priority sectorrequirements. In order to register as a NBFC-MFI, an institutionmust meet requirements specified by RBI. RBIrequires that a minimum of 75 percent of a NBFC-MFIs loan portfolio must have originated forincome-generating activities. Additionally, an NBFC-MFI must have 85 percent of its total assets asqualifying assets (excluding cash, balances with banksand financial institutions, government securities andmoney market instruments). A qualifying asset is aloan which meets the following criteria:1. Borrowers household annual income does notexceed M60,000 or M1,20,000 for rural andurban areas respectively.2. Maximum loan size of M35,000 (first cycle)and M50,000 (subsequent cycles).3. Maximum borrower total indebtedness ofM50,000.4. Minimum tenure of 24 months when loanexceeds M15,000.5. No prepayment penalties.6. No collateral.7. Repayable by weekly, fortnightly or monthlyinstalments at the choice of the borrower.Deposit Mobilisation: Regulation stipulates that onlyNBFCs and Cooperatives are permitted to acceptpublic deposits, though NBFCs must adhere toadditional stringent regulations,2 and Cooperativesare only permitted to accept deposits from itsmembers. There also exists what is called a depositslimited for NBFCs linked to the institutions NetOwned Fund (NOF). No MFIregistered as an NBFC currently acceptsdeposits because regulation requiresthat institutions must obtain aninvestment grade rating, which no MFIhas obtained so far.Access to Capital: MFIs in theory canraise capital through various methods,including borrowing from domestic andforeign debt markets, obtaining grantsand loans from subsidised lendingfunds, attracting foreign equityinvestment from capital markets,though legal structure of MFIs restrictcapital acquisition from some of thesesources.Companies Act, 1956; (c) a trust established underany law for the time being in force; (d) a bodycorporate; or (e) any other organisation, which maybe specified by the RBI if the object of the institutionis the provision of microfinance services. It does notinclude a banking company, co-operative societiesengaged primarily in agricultural operations orindustrial activities or any individual who carrieson the activity of money-lending and is registeredas a moneylender under the provision of any Statelaw.A MFI in India acquires permission to lendthrough registration (Table 1 provides details of theregistration requirements). MFIs are registered as oneof the following five types of entities1:1. Non-Government Organisations engaged inmicrofinance (NGO MFIs), comprising ofSocieties and Trusts;2. Cooperatives registered under theconventional state-level cooperative acts, thenational level Multi-State CooperativeSocieties Act (MSCA 2002), or under the newState-level Mutually Aided CooperativeSocieties Act (MACS Act);3. Section 25 Companies (not-for profit);4. For-profit NBFCs; and5. NBFC-MFIs.Table 1 tabulates the major regulationsapplicable to NBFCs as stipulated by the RBI. Majorregulatory aspects include priority sector lending,deposit mobilisation, access to capital, the MoneyLending Act, and state level regulations.Priority Sector Lending: Priority sector lending is agovernment initiative which requires banks toallocate a percentage of their portfolios to investmentTable 1: MFIs by Type of RegistrationCategory Type of MFI RegistrationNot for NGO MFIs: Societies Registered under SocietiesProfit & Trusts (500) Registration Act, 1860and / or Indian Trust Act 1882Section 25 Section 25 of CompaniesCompanies (10) Act, 1956Mutual Cooperatives (100) Registered under State CooperativeBenefit Societies Act or Mutually AidedCooperative Societies Act (MACS) orMulti-State Cooperative SocietiesAct, 2002For-Profit NBFC (50) Companies Act, 1956 & registeredwith RBINBFC-MFI RBI Circular, May 2011Source: M-CRIL Microfinance Review 2010, http://www.m-cril.com/Backend/ModulesFiles/NewsEvents/M-CRIL-Microfinance-Review-Nov2010.pdf3NBFCs can receive both equity and debtinvestments. They can raise foreign equityinvestment, though a minimum investment restrictionrequirement of US$500,000 applies, also with a capof no more than 51 percent stake in the institution.Grants and subsidised onward-lending funds fromdomestic and foreign sources are not restricted,provided that the foreign grants do not exceed theceiling of US$5mn per year.Money Lending Act: The Indian Moneylenders Act1918 has been adapted by various state governmentsto restrict interest rates charged by moneylenders.Although the primary purpose of this act is to protectthe vulnerable section from usurious interest rates thatmoneylenders charge, some states have applied theact to Societies and Trusts also to restrict their lendingactivity. Other states have applied the MoneyLending Act to other forms of MFIs.State Level Regulation: In late 2010, the AndhraPradesh government enacted the Andhra PradeshMicro Finance Institutions (regulation of moneylending) Ordinance, which was later enacted in toAct, to regulate the activities of MFIs. The Act stopsMFIs from collecting old loans and originating newloans until the institution registers with the districtauthorities where they operate. The Act alsomandates an interest rate cap such that the totalinterest charge cannot exceed the principal amountof the loan. The Act also entrusts a great deal ofdiscretionary power to the registering authorities andimposes restrictions on collection practices.Regulation by the RBI and Money LendersLegislationsMicrofinance entities have approached the courtsto resolve the issue of dual regulation3 by the RBIand under the State Level Money Lenders Legislations.These microfinance entities contend that an NBFCengaged in microfinance operations, if it has registereditself under RBI norms, should be exempt fromregistration under the state money-lending norms.This is because certain aspects pertaining to thefunctioning of the NBFCs such as procuring a licence,the regulation of levy of interest and rate of levy ofinterest would be subject to dual regulation ifexemption from state-money-lending legislations isdenied.State-wise, there are two questions which have tobe answered to predict whether the issue of conflictbetween a State Money Lenders Act, and the RBInorms will be resolved in the same fashion: the issueof dual regulation, and specifically, whether RBInorms (such as the Fair Practices Code) willencompass the regulation of interest by the RBI. Thesecond facet is critical in determining the profitabilityof operation because the interest rate prescribed byState Level Money Lending legislations is so low asto render the enterprise unviable.The High Court of Kerala opined that the RBIAct and the State Money Lenders legislation dealtwith two different spheres and no exemption couldbe granted to entities which were registered undereither legislation. On the contrary, an attempt tobalance the conflict between state legislationsprescribing conditions of levy of interest, and theRBI norms was made by the Gujarat High CourtJudgment. Though money-lending may be regulatedby a State Act, but an NBFC, as an entity, itsoperation is dealt with by the RBI. It is only ajudgment by the Supreme Court which will dispelprominent doubts over this issue.The RBI had addressed the issue of interestregulation through the Fair Practices Code andcorresponded with the respective state governmentsto assert that it should be given a clear reign overNBFCs, and to advocate that NBFCs dealing withmicrofinance operations should be exempt fromregistration under the State Money Lenders Act.However, certain state governments refused to regardRBI submissions that NBFCs should not be subjectto dual regulation by both the Centre, and the StateMoney Lending legislations. Certain stategovernments feel that this decision was a matter ofState policy.Policy InitiativesUnder the Microfinance Institutions(Development and Regulation) Bill, 2012, theCentral Government may, by notification, constitutea Council which is known as the MicrofinanceDevelopment Council to discharge the certainfunctions under the Act. Apart from this State levelMicrofinance Councils and District MicrofinanceCommittees are also formed.In a perception survey, the majority ofstakeholders (68 percent) were of the opinion thatMFI sector in India needs to be regulated. To controlthe on-going problem of over-borrowing andunsustainable debt of MFIs, majority of therespondents (63.7 percent) suggested that thecreditor should conduct an ability to pay test (knowyour customer exercise) before extending multipleloans.4Regulation ToolsRegulation of NBFC MFIsNBFC MFIs are subject to the followingconditions: (i) Minimum NOF of M5 crore (if theNBFC is registered in the North Eastern Region ofthe country, the minimum NOF requirement isRs2crore) and (ii) not less than 85 percent of its netassets4 are in the nature of qualifying assets5.Theloan is required to be extended without collateral;the aggregate amount of loans which are given forincome generation are not less than 75 percent ofthe total loans given by the MFIs. The income derivedby the NBFC-MFI with the remaining 15 percent ofits assets are to be in accordance with the regulationsspecified in that behalf.6 An NBFC which is not anNBFC-MFI shall not be permitted to extend loansto the micro-finance sector which exceeds 10 percentof its total assets.7Capital AdequacyCapital adequacy requirements are used by nearlyall countries to reduce the leverage and thus risk ofMFIs that are subject to prudential regulation. InIndia, NBFC-MFIs shall maintain a capital adequacyratio consisting of Tier I and Tier II Capital whichshall not be less than 15 percent of its aggregate riskweighted assets. The total of Tier II Capital at anypoint of time shall not exceed 100 percent of Tier ICapital.Pricing of Products All NBFC-MFIs are required to maintain anaggregate margin cap of not more than 12percent. The interest on individual loans is not toexceed 26 percent per annum and is to becalculated on a reducing balance basis. The processing charges must be less than 1percent of the gross loan amount. Theprocessing charges are not required to beincluded in the margin cap or the interest cap. When NBFC-MFIs are engaged in the provisionof insurance services, the NBFC-MFIs can onlyrecover the actual cost of insurance for thegroup, livestock, health, for both the borrower,and the spouse. The administrative charges areto be recovered per the IRDA guidelines.Fair Practices in Lending The three components which are taken intoconsideration in the pricing of the loan are (i)interest charge, (ii) processing charge and (iii)insurance premium. NBFC-MFIs areprohibited from collecting a security deposit/margin from the borrower. The effective rate of interest which is chargedby the NBFC-MFI will be displayed in all itsoffices, its website, and the literature issuedby the entity. NBFC-MFIs are not permitted to collect apenalty on a delayed payment.Other practices A standard form of a loan agreement is requiredto be used. NBFC-MFIs are required to ensure that themodes of recovery are non-coercive. They arerequired to ensure that a Code of Conduct isimplemented which incorporates the principleson Fair Practices as issued for NBFCs videcircular CC No. 80 dated September 28, 2006. Multiple Lending, Over-Borrowing and GhostBorrowers. NBFC-MFIs can lend to borrowers who arenot members of more than one Self Help Groupor Joint Liability Group. Not more than two NBFC-MFIs should lendto the same borrower. A minimum period of moratorium which isnot less than the frequency of repaymentshould operate between the grant of the loanand the due date of the repayment.Non Prudential Regulations:1. Permission to Lend: Permission to lend is grantedthrough registration in countries with moreadvanced regulatory frameworks. Many countriesoffer a special microfinance window forregistration of MFIs, which allow regulation andlegislation to be specific to these MFIs. Somecountries offer multiple windows to allow fordifferent types of institutions.2. Consumer Protection: Successful consumerprotection regulation levels the information gapbetween institutions and consumers. Regulationmust protect consumers and allow forinnovation, while not imposing excessive costs.Cambodia, Peru, Ghana, and many countries inEastern Europe and the former Soviet Union haverecently implemented new price disclosure rulesthat strive to ensure these objectives.83. Credit Reference Service: The great majority ofcountries believe that credit reference serviceswould improve conditions for both customers andinstitutions.5It is in the light of limitations of currentregulations, the desired regulatory interventions andlessons from a cross-country evaluation of MFIregulation practices that the MicrofinanceRegulations Bill is evaluated. The Bill includes thefollowing features: Designation of RBI as the sole regulator forall MFIs. Power to regulate interest rate caps, margincaps, and prudential norms. All MFIs must register with RBI. Formation of a Micro Finance DevelopmentCouncil, which will advise the centralgovernment on a variety of issues relating tomicrofinance. Formation of State Advisory Councils tooversee microfinance at the state level. Creation of Micro Finance Development Fundfor investment, training, capacity building, andother expenditures as determined by RBI.Competition in the SectorTable 2 summarises the competition assessmentof the microfinance sector in India:Factors ImpedingEffectiveCompetition1. Barriers to Entry2. LimitingProduct Scope3. Barriers toraising finances4. StateGovernmentIntervention5. ProductTransparency6. Priority SectorLending7. NBFC StatusPresent StatusA company must have Rs5crore NOF (shareholder equity plus internally-generated reserves),to register as an NBFC.Regulation greatly restricts the type of products that can be offered, particularly relating todeposits. To be able to accept deposits, an NBFC must obtain a specified minimum creditrating (FA from CRISIL, MA from ICRA, BBB from CARE, tA from FITCH), minimum capitaladequacy ratio of 15 percent, and two years of completed operations. For qualifying institutions,additional ceiling limits exist based on credit rating. Furthermore, the period of a deposit,payable interest rates, brokerage incentives, and demand deposits are all strictly regulated.Section 25 MFIs are not permitted to take deposits.Due to these restrictions, no MFIs arecurrently mobilising public deposits. This regulation also restricts other product offerings whereMFIs have outstanding obligations to customers, such as insurance or pension products.RBIs Foreign Investment Promotion Board (FIPB) has set foreign direct investment (FDI) rulesfor start-up companies not traded publicly on a stock exchange, which includes NBFCs: 1. ForFDI up to 51 percent, minimum initial capitalisation of US$0.5mn 2. For FDI 51 percent-75percent, minimum initial capitalisation of US$5mn 3. For FDI 51 percent-75 percent, minimuminitial capitalisation of US$7.5mn and capitalisation of US$50mn within 24 months 4. FDIabove 75 percent is allowed for companies with capitalisation greater than US$50mn. Theserestrictions greatly affect investment opportunities for medium and smaller MFIs, which maynot be able to attract such large investments.Currently, state governments can intervene and enforce additional regulation on MFIs regardingpermissible products, methods of collection, and code of conduct. A lack of nation-wide regulatorystructure makes the MFIs expansion into multiple states difficult to manage, and much lesstransparent. A case in point is the recent Andhra Pradesh MFIs Act, 2010. This Act requires allMFIs to register with the Andhra Pradesh government, and subjects them to a number ofadditional regulations specific only to Andhra Pradesh.Currently, there are no uniform product transparency requirements that would make institutionsprovide essential financial information, such as effective interest rate or possible future fees.Product transparency is essential to ensuring fair competition. A customer must be able toaccess information regarding product benefits and risks, so that institutions offerings can becompared.Only select institutions which meet a number of regulatory requirements qualify for prioritysector lending. Companies that wish to provide products and services outside the scope ofthese (narrow) requirements do not qualify for priority sector lending, and thus face significantlyhigher financing costs.Many institutions operate as NBFCs for financial and regulatory benefits; however these licensesare greatly restricted by RBI. The licenses are notably difficult to obtain, even if all requirementsare met, and many companies end up opting for NBFC status just for the privilege of operatingas an NBFC.Table 2: Competitive AnalysisEndnotes1 Status of Micro Finance in India 2009-2010, NABARD, www.nabard.org/pdf/Status%20of%20Micro%20Finance%202009-10%20Eng.pdf. For a detailed description of various legal forms werecommend Sa-dhans Existing Legal and Regulatory Framework for the MFIs in India: Challenges and Implication2 Manual on Financial and Banking Statistics, Box6.2, Chapter VI, Reserve Bank of India,http://rbidocs.rbi.org.in/rdocs/Publications/PDFs/78928.pdf3 While banking is an exclusive subject in the domain of the Parliament by virtue of Entry 45 of List I of the VIIth Schedule,Entry 30 of List II authorises the State Legislature to enact on money-lending, money-lenders, and relief of agriculturalindebtedness.4 Net assets are the total assets other than cash and bank balances and money market instruments.5 Qualifying assets refer to the loans which satisfy the following criteria: (i) loans disbursed by an NBFC-MFI to aborrower with a rural household annual income not exceeding Rs. 60,000 or urban and semi-urban householdincome not exceeding Rs 1,20,000.6 Master Circular- Introduction of New Category of NBFCs Non Banking Financial Company Micro FinanceInstitutions (NBFC-MFIs)-Directions, Dated July 2, 2012, DNBS.(PD)CC.No.293/03.10.38/2012-13, availableonline at http://www.rbi.org.in/scripts/BS_ViewMasCirculardetails.aspx?id=7392.7 Non-Banking Financial Company Micro Finance Institutions (Reserve Bank) Directions, 20118 Brix, L. and McKee, K. (2010).Consumer Protection Regulation in Low-Access Environments: Opportunities to PromoteResponsible Finance, CGAP Focus Note 60. Washington, DC: CGAP, February CUTS International 2013. This Briefing Paper is published by CUTS Centre for Competition, Investment & Economic Regulation(CUTS CCIER), D-217, Bhaskar Marg, Bani Park, Jaipur 302 016, India. Ph: +91.141.228 2821, Fx: +91.141.228 2485, E-mail:firstname.lastname@example.org, Website: www.cuts-ccier.org. CUTS Briefing Papers are to inform, educate and provoke debate on specific issues. Readers areencouraged to quote or reproduce material from this paper for their own use, but CUTS International requests due acknowledgement and a copyof the publication.Conclusion and Recommendations: Clearly, the current regulatory structurerequires reforms, and the MicrofinanceRegulations Bill seems to meet most of therequirements as can be identified from thecross-country analysis of best practices. It isfurther important to observe how the issue ofdual regulation by the RBI and the States isdealt with. Compulsory registration of all institutionsengaged in the provision of microfinanceservices is a positive feature of the bill.However, the current NBFC minimum capitalamount (M5 crore) should not result in creatinga barrier to entry. Allowing MFIs to engage in deposit takingmust be explored as an option. Regulation should promote the diversificationof funding sources to encourage equity andforeign debt investments. Flexibilities whichafford opportunities for smaller institutionsto obtain foreign equity investment amountshould be inserted into the regulatoryframework.