Business Law

EPGP 2012-13, Term-I

Microfinance and Regulatory Framework in India

1214029 1214043 1214013 1214007 1214051

Meenakshi Krishnamoorthy Pavan Kumar Korlepara Ashish K Sawant Ankit Singh Rajinder Sambhi

Microfinance Regulatory Framework in India

Table of Contents
History of Microfinance sector in India ................................................................................... 3 Issues in Microfinance sector ................................................................................................. 6 Need for Regulation in Microfinance sector ........................................................................... 7 The Legal Framework ............................................................................................................ 8
Andhra Pradesh Microfinance legislation 2010 ................................................................................8 Micro Finance Regulatory Bill 2011 .................................................................................................8

Analysis of the Micro Finance Bill 2011 ................................................................................ 11 Conclusion ........................................................................................................................... 13 ABBREVIATIONS .................................................................................................................. 14 Appendix ............................................................................................................................. 15
The AP fiasco................................................................................................................................ 15

REFERENCES ........................................................................................................................ 16

Indian Institute of Management, Bangalore

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History of Microfinance sector in India
India boasts of having a third of the worlds poor. As per World Bank, an estimated 37% of its population earns less than US$1.5 a day i.e. below international poverty line. The poor in the country have no access to lending from commercial banks owing to high transaction costs involved in screening the borrowers given the lack of info about their risk profile and repayment capability, monitoring the end use of funds. These costs are significant considering the small amounts of loan involved and the limited geographical reach of the banks in rural areas. Moreover, the poor cannot provide the collateral which is a mandatory requirement for loan disbursal by commercial banks. This leaves the poor to the mercy of local moneylenders or loan sharks who charge exorbitant interest rates at times ranging from 50% to 150% annually, demand high repayment frequency and exploit the vulnerable borrowers. This need for easy access to collateral free credit associated with minimal documentation requirements, adequate payment frequency and moratorium periods has led to the emergence Microfinance Institutions (MFIs) which seek to meet the demand for short tenure small loans of the vulnerable sections of the rural populace loans at rates lower than that charged by the moneylenders. The money provided by the MFIs was meant to be channelized to investment activities, repayment of high interest borrowings, family emergencies, smoothening liquidity and not consumption. MFIs have a potential to Alleviate poverty by providing financial services and easy access to credit for investment activities to low income groups Empower women and improve their economic and social status by providing a new credit line for their micro-businesses. Facilitate income generation leading to better access to healthcare and education for children Few MFIs also aim to provide a broad range of services for the poor, such as training, health provision in addition to credit to ensure overall social development of the poor. World over microfinance has been looked upon by policy makers and academicians as an important instrument to combat poverty. The largest microfinance institutions are found in countries such as Bangladesh, India, Indonesia and Thailand. Indian MFI landscape has SKS Microfinance Limited, Spandana Sphoorty Financial Limited, Share Microfin Limited, Asmitha Microfin Limited as its prominent institutions. 1 MFIs rely on innovative and unconventional methods suited to local circumstances to reduce lending costs. Majority of the MFIs have adopted the group lending system pioneered by Grameen Bank of Bangladesh. The group lending seeks to address the problems of adverse selection (inability to distinguish projects with respect to their risk profiles when allocating credit) and moral hazard (diversion of funds to consumption rather than investment or activities other than agreed upon with the lender) involved in lending to the low income individuals owing to high cost of information and monitoring. In group lending, the MFI lends to a designated group called Joint Liability Group (JLG) typically comprised of 10-15 people belonging to the same society who have information about each other and are jointly liable to repay the loan incentivizing borrowers to monitor and screen each other. The social contract Indian Institute of Management, Bangalore Page 3

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ensures high repayment rates. Most of the JLGs had women as they were known to be reliable and have payback ratios as high as 96-98%. Moreover MFIs can achieve economies of scale by maximizing their reach leading to lower transaction costs. They can act as extended arms of commercial banks which have the funds for priority sector lending but find it unviable owing to high transaction costs and limited reach in remote areas. Moneylenders would be forced to bring down their interest rates owing to increased competition from the MFIs. To start with, MFIs in India relied on loans at below market interest rates extended by western donors, NGOs and priority sector lending extended by commercial banks, for their funding. The NGOs and the banks did not hold any equity in the MFIs. Off late as the microfinance activity scaled up, MFIs have witnessed increased commercialization after Private equity investors and commercial banks have picked up stakes in them lured by high profit (interest rates range from 30 to 60%)and repayment rates(over 95%), far above commercial lending. Absence of regulation in microfinance has provided an incentive to unscrupulous MFIs and their financiers to charge very high interest rates from poor borrowers and thereby make super profits. Many MFIs like SKS Microfinance have raised funds through Public offerings, thereby enriching the promoters and employees. MFIs charge annual interest rates to the tune of 26% to 60% with weekly or monthly repayment frequency.

Indian Institute of Management, Bangalore

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Institutional Arrangement for Microfinance Disbursement in India

Indian Institute of Management, Bangalore

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Issues in Microfinance sector
With the gradual commercialization of MFIs, the microfinance sector has come to be plagued with following issues2 a) Exorbitantly high rates of interest MFIs driven by profit motives started charging very high interest rates to meet the expectations of their investors and enrich their promoters. In certain cases the money collected from the borrower towards interest used to exceed the principal by a significant amount. In case of large MFIs the interest rates were in the range of 30-50% with an average of 36% while in the case of smaller MFIs the average interest rates stood close to 28%. b) Lack of transparency in interest rates and other charges MFIs used to pass on operating costs to the borrowers in terms of hidden charges in addition to the interest on the gross amount of loan. The poor needed the loans quickly and did not have the time or capability to compare the offers, understand the agreements and choose the right lender based on sound information. The information was not available in local language in certain cases adding to the woes of the borrowers. c) Multiple Lending & over borrowing As the competition among MFIs to reach maximum number of borrowers increased, they started lending to individual borrowers as well many of whom looked to micro-credit as a source of easy money at least in the short run and tended to become part of multiple Self Help Groups and Joint Liability groups and draw borrowings from each one of them. In certain cases the borrowers serviced loans from one MFI by borrowings from others, effectively revolving credit. This led to the borrowers falling into a debt trap thereby exposing them to exploitation by the lenders. Bad debts on the books of MFIs ballooned significantly owing lack of credit history and outstanding loans. d) Upfront collection of security deposits In order to minimize risks, many MFIs have started collecting security deposits in cash which the real needy find hard to pay. This became an impediment in the way of access to easy and affordable credit. Moreover no interest was paid on the security deposit. Alternately MFIs used to recover security deposit from the loan amount at the time of disbursal. The interest is charged on the gross amount while the borrower has only the net amount available for use resulting in distortion of interest structure. e) Coercive methods of recovery The employees and agents of MFIs resorted to coercive practices to recover loans. The instances of use of such exploitative means have increased with the increasing rate of potential defaults owing to multiple lending and over borrowing. f) Deserving Poor are Still not Reached The extreme poor find it hard to be members of JLGs as other members may find their inclusion adding to their risk and liability in case of a default. Moreover MFIs require the borrowers to save regularly which might not be feasible for those not having a regular income which is often the case.

g) Regional Disparity Most of the microfinance activity in India is concentrated in states where
there is easy availability of capital for MFIs especially southern states. The two main factors resulting in regional concentration of MFIs are the readiness of commercial banks to lend to MFIs operating in areas where the ecosystem is already evolved and preference of MFIs to Indian Institute of Management, Bangalore Page 6

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operate in areas with more economic activity which as this translates to better repayment rates and reduced risk. This has raised doubts about the effectiveness of MFIs in meeting their intended objective of poverty alleviation and social good.

Need for Regulation in Microfinance sector3

Though the initial mandate of MFIs was to enable financial inclusion of the poor and extending micro credit, competition and over commercialization of the industry mandates the need for prudent regulation. Regulation for sure will increase the operational cost for MFIs as well as introduce significant delays in the credit reaching the end customers but the below mentioned aspects mandate the need for a prudent regulation: Self-sustainability of MFIs: MFIs have traditionally been dependent on donors and governments but they need to reach a stage to become self-sufficient in terms of sourcing and managing funds in the long term. Safeguarding the stability of financial systems Mitigation of risk due to currency mismatches Prevention of money laundering and funding of terrorism Protection of the interests of the donors and financial institutions Protection of the interests of the poor Improvement in efficiency and effectiveness of the MFI system Establishing jurisdictions to seek remedies for conflicts Help expand the reach for MFIs to source funds Build confidence among the financial institutions and donors Limit/define the boundaries of operation Standardize norms and practices across the MFI industry

Indian Institute of Management, Bangalore

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The Legal Framework
Andhra Pradesh Microfinance legislation 20104
The Andhra Pradesh government passed Andhra Pradesh Micro Finance Institutions (regulation of money lending) Ordinance in October, 2010 to clamp down on harassment of the poor borrowers by the microfinance companies. The overview of the regulatory framework introduced in the ordinance is described as under: a) Mandatory registration of all Microfinance institutions through the Project Director (PD) of District Rural Development Agency (DRDA) for rural areas and PD of MEMPA(Ministry of Elimination of poverty in Municipal areas) b) MFIs should declare the rate of interest and mechanism of loan recovery. No interest cap was set in the ordinance, but it stipulated that the amount of interest cannot exceed the principal. c) Barred MFIs from collecting any security deposits. d) MFIs were not allowed to grant a second loan when the first loan is not fully repaid. As the loans were issued through Self Help groups (SHG), no one member could hold a simultaneous membership in two different SHGs. e) If the regulatory authorities received any complaint from the public and if compliance issues were identified, the authorities had the right to issue a cease or desist order. f) The ordinance retroactively waived loans where a sum of twice the principal had been repaid. g) MFIs could collect the repayment of the loan only in the panchayat office and could not demand weekly repayments. h) Redressal mechanism to address complaints/civil suits with the help of district high courts. If charges are proven, the penalty imposed could extend up to 10,000Rs and/or 6 months imprisonment in jail. Later, in December 2010, Andhra Pradesh government passed the legislative bill based on the ordinance in the parliament. The legislation created severe hardship for the microfinance industry as well as the borrowers. The retrospective write offs imposed by the legislation amounted to 6000Cr rupees which drove many MFIs to bankruptcy. Many of the MFIs went through corporate debt restructuring with the major banks, but had to rely on the income from the loans in other states to pay off the debts or grant new loans. Banks and lenders were no longer willing to provide the capital. This had a ripple effect in the availability of credit to the borrowers and the SHGs could not cover up the gap.

Micro Finance Regulatory Bill 20115

Meanwhile, the Reserve Bank of India formed an expert committee headed by the eminent Chartered Accountant Y.H. Malegam6 to study issues in the Microfinance sector. The expert committee assessed Indian Institute of Management, Bangalore Page 8

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microfinance sector both from the perspective of the companies and the borrowers. The committee also examined the regulatory frame work introduced by Microfinance bill passed in the Andhra Pradesh and came out with a set of recommendations. The recommendation sought to make RBI as the sole regulator and proposed a national legislation for regulating the sector rather than state level legislation. The recommendations from the Malegam report was largely accepted by the government and formed the basis of Microfinance Regulation bill drafted in early 2011. The Cabinet finally approved the Bill in May 2012 which will bring the sector under national law. Once the bill is passed in the Parliament, the state level legislation in Andhra Pradesh will be nullified. The 2011 Bill defines the clients and scope of services for microfinance companies as under: Client Client" means any member of the micro finance institution or self-help group or any other group availing the micro finance services from such institution or group Microfinance services Microfinance services include the following Micro credit facilities involving such amount, not exceeding in aggregate five lakh rupees for each individual and for such special purposes. Reserve Bank had the right to revise the sum to 10 lakhs Collection of thrift; Pension or insurance services Remittance of funds to individuals subject to prior approval of the Reserve Bank

The key aspects of the Bill are described in the section below. Microfinance development council The bill recommends creation of a Microfinance development council comprising of eminent, senior level executives from the field of rural banking, Reserve bank of India, Department of Women and Child development, Department of Housing and Alleviation of Urban poverty, Department of small scale industries and NABARD. The council will advise the government on the formulation of policies for the orderly growth of the sector and promote financial inclusion. State/District Microfinance Council The State Microfinance Council is aimed to monitor the micro financing activities in the state and ensure that the activities are following the stipulated regulation. The State Council is also expected to implement redressal mechanisms and measure the effectiveness of the schemes implemented. The State Council has to provide a quarterly report to the Central Bank on the overall microfinance credit levels and effectiveness in the state. The District Microfinance councils assumed the same set of responsibilities at the district level. Indian Institute of Management, Bangalore Page 9

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Registration of microfinance institution As per the law, any new Microfinance institution has to obtain a registration certificate from the Reserve Bank. The Reserve bank will evaluate the application based various factors such as business objectives, net owned fund or capital requirement of Rs 5 Lakhs, other services etc. before awarding the certificate. Reserve, Account, Audit and Returns Reserve Bank has mandated the formation of a Reserve Fund out of the profits earned from the microfinance services. Companies will not be allowed to use the funds without permission from the Reserve Bank. Companies will have to file duly audited annual reports and file returns. The bank also had the right to order for a special audit, if it suspects of any violation of regulatory compliance. Functions and Powers of Reserve Bank The Reserve Bank has the power and responsibility to regulate and ensure orderly growth of the sector. The Reserve Bank will devise and implement policies and measures to ensure good governance. The policies are aimed to balance the interest of both borrowers and microfinance institutions. The aspects of policies include accounting policies, credit rating norms, type of fees that can be charged for loans, mechanism and location of loan recovery, training, adoption of information technology to reduce overall cost of business etc. The Reserve Bank has the power to decide the maximum margin cap for Microfinance sector based on the prevalent borrowing costs and bench marks for the related services. The microfinance institutions are expected to declare the annualized interest rates to the borrower and details of fees levied before signing the loan agreement. The Bank also held the right to order for a special audit on the companies account and if any regulatory compliance issues are detected and if discrepancies are proven the bank had the power to issue a Cease or Desist order. Delegation of power to National Bank The Central Government, in consultation with the Reserve Bank can delegate the powers to National Bank or any other agency controlled by the Central Government. However, the power to impose penalty, to make rules, and issue a Cease or Desist order will still rely with the Central Bank. Microfinance development fund The Reserve Bank will formulate a Microfinance Development Fund by way of collecting government grants, donations from institutions, donors, other private and public entities. Reserve Bank will manage the fund and the income received will be used for providing capital assistance, grant or loans to microfinance companies, training, capacity building, dissemination of information, to meet expenses incurred for promoting microfinance activities etc. Offences and Penalties Indian Institute of Management, Bangalore Page 10

Microfinance Regulatory Framework in India

If it is found that any of the microfinance company has contravened any regulations underlined in the Act, they can be imprisoned up to two years or can be fined up to five lakh rupees. No civil court will have the power challenge the penalty imposed by the Reserve Bank.

Analysis of the Micro Finance Bill 2011

The Microfinance bill aims to implement a strong regulatory framework and addresses the key problems of exploitation, coercive practices, over borrowing, lack of control and governance. The following section analyses the key aspects of the Bill and how it address the aforementioned issues. RBI the sole regulator implementation through State and District Councils The bill makes RBI the sole regulator and gives sweeping power to the RBI by bringing microfinance industry under its oversight. On the one hand, it ensures a uniform regulatory framework for the sector and avoids any conflict of interest between regulators. On the other hand, many analysts argue that the RBI should not be a regulator for banks on the grounds that it will remove its focus from its main function i.e. monetary management. Additionally, the RBI does not have the organizational presence in the rural areas and it will be very difficult for the RBI to conduct its regulation and supervisory functions As a response to this challenge, the bill proposes creation of State and District Councils who will do the implementation and monitoring of the schemes and processes. The bill also proposes quarterly reporting to collect feedback and make necessary policy corrections if the existing ones were found ineffective. Social objectives and equitable growth of MFIs It is clear from the microfinance crisis that though the vision and mission of the MFI companies were to advance credit lines to the poor people and foster financial inclusion, the drive to expand rapidly led them to seek private equity capital. Entry of private equity capital made for-profit objective more pronounced than providing affordable credit to the poor resulting in exorbitant interest rates. However even not for profit microfinance companies need access to capital or debt if they have to grow and provide credit lines to the poor in the remote areas of this country. The new bill well balances both social and financial objective by setting up a cap on the interest rates that can be charged to the borrowers in line with the prevailing borrowing costs and still allow them to earn fair profits. This will protect the borrowers as well as keep up the interest of private equity firms in microfinance. The bill also recommends creation of Microfinance Development Fund from government grants, donations, funds from private and public companies to provide seed capital and grant, training assistance to microfinance companies. Framework for good governance The microfinance bill has created a good framework for governance and transparency to regulate rogue behavior of the corporates driven by profit motives at the expense of the poor people. The declaration of interest cap, fees and other charges, responsible modes of recovery, moral codes of conduct are Indian Institute of Management, Bangalore Page 11

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modeled to ensure that borrowers are treated with dignity and not exploited. Creation of reserve fund, capital adequacy ratio, mandatory annual reporting and income returns, declaration of level of securitization of loan assets are some of the measures adopted by the Reserve Bank in the framework to scrutinize the operations of the MFIs and ensure that the assets are deployed for microfinance objectives. The framework also explicitly recognizes the self-regulating organizations that are able to balance the social and stakeholder needs and achieve equitable growth. Customer protection The Andhra Pradesh microfinance debacle brought the customer protection to the limelight. The bills regulatory framework addresses issues of harassment and exploitation of the borrowers through the following regulatory framework. The framework highlights punitive measures if the MFI indulges in coercive loan recovery practices. The actual monitoring of the MFI practices on the ground will be done by the State and District councils. The RBI will also formulate redressal mechanism and implement them through State and District councils to address the issues of the borrowers. If the investigation reveals that MFI is not complying with the law, RBI has can instruct the MFI to cease operations or imprison or impose fines. The regulation also stipulates a cap for the maximum amount of loan that an individual can draw as 5 lakhs, to protect the poor from over borrowing. Credit Rating of the MFIs The recommendation to create credit rating guidelines will encourage a healthy competition between the microfinance companies. Credit rating should reflect the good governance, transparency, cost efficiencies, diversification to new geographies and will form the basis of company selection for investors. Credit rating will force companies to be more self-regulating and achieve good governance if it directly translates into lower borrowing costs. Social Entrepreneurship The success of SKS Finance led to the entry of multiple players in the microfinance industry who unfortunately competed in the same geographic regions that led to the problem of plenty. The attractiveness of the industry lies in the impressive returns, which will now be curbed by the regulator. The question that remains to be seen is will the regulation deter creation of microfinance companies? With that said, there are companies that make good returns without exploiting the poor through innovative financial services, effective deployment of technology. Janalakshmi 7is one such example. This company8 concentrates on the urban poor like maids, security guards etc at one end, and small enterprise level financing for example slum clinic at the other end of the spectrum. Through proper diversification and strong company governance company is able to get attractive returns through efficient processes and usage of technology and does not tax the poor. Janalakshmi has no difficulty in getting the funding as lenders are convinced about good governance and attractive returns.

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Microfinance Regulatory Framework in India

While Janalakshmi has proven that Social Entrepreneurship can create social benefits and financial returns and these two aspects are not mutually exclusive, Indias poverty level needs such institutions in a larger scale. While the bill has stipulated a cap on interest to protect the poor, it failed to add measures to incentivize companies like Jana Lakshmi and attract new players. In our view, number of companies entering the market will decline once the law is implemented.

Conclusion
The Microfinance Institutions (Development and Regulation) Bill, 2011, which is introduced in Parliament in May 2012, vests regulatory power with RBI. As a Regulator, RBIs key challenge will be to balance the complementary objectives of the lenders (equity holders) and borrowers. On the other hand, too many safeguards in governance shouldnt impede the growth of social entrepreneurship in terms of setting up MFIs. In order to encourage the entrepreneurship, Government could adopt certain schemes such as providing Tax holiday on profits in the initial period, land availability for institution at cheaper rates and Information support mechanism for startups from Government. The Microfinance Bill 2011 seems to be missing such measures, which can incentivize the entrepreneurship. The experience of AP act has raised certain serious concerns on the governance issues. The Bill is largely an attempt to provide prescriptive regulation since a basic framework is required to meet the scale. There is no doubt that monitoring the regulation increases costs. The effectiveness of the regulation is in setting up effective monitoring methods and paying attention to the negative feedback and applying appropriate policy correction for the overall health of the industry. The importance of self-regulation in the microfinance sector is more important than the prescriptive framework. Therefore, contribution of value framework, moral frame work, and ethical framework is equally important along with the legal framework9. This will improve overall governance and reduce the monitoring costs. The Government should reward self-regulating organizations through incentives such as lower borrowing costs, better credit rating etc. It is clearly evident that the self-sufficiency and financial sustainability are the key imperatives of the MFI .The Government, at any point in time evaluates the effectiveness of the policy by balancing the social benefits and sustainability of MFIs. The bill lacks incentives for the social entrepreneurship. The Government should offset the cap in the interest rates through some other incentive mechanism to attract MFIs.

Indian Institute of Management, Bangalore

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Microfinance Regulatory Framework in India

ABBREVIATIONS
SHG JLG NABARD DRDA MEMPA AP Self Help Groups Joint Liability Groups National Agriculture Bank for Agriculture and Rural Development District Rural Development Agency Ministry of Elimination of poverty in Municipal areas Andhra Pradesh

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Appendix
The AP fiasco10
The state of Andhra Pradesh has a unique leadership position within Indian microfinance. Indian MFIs have the largest concentration in AP in terms of numbers, scale and the overall MF loan portfolio. The state government played a vital role in financial inclusion in the state through SHG programs and also allowed the JLG models to coexist. The conflicts started emerging when multiple factors/scenarios got into play MFIs, though initially ventured as a social cause, started aggressively looking for capital, PE infusion and also started expanding the scale of their operations. Competition pushed the focus from a social perspective to commercialization. MFIs started focusing more on showing results in terms of scale of operations, reach, repayment rates and other modes of showcasing efficiency in their operations. The overzealous nature of this competition created multiple problems like aggressive dole out of loans, applying (coercive) measures to increase repayment rates, innovative financial models. One theory suggests that state govt. was unable to digest the fact that MFIs were able to attract clients and achieve a better repayment rate despite charging higher interest rates. In one way the MFIs were undercutting the financial inclusion programs. They were of the opinion and possibly might have basis (statistics) for building a general opinion that MFIs were not prudent in their operation and were charging unsurious interest rates, using coercive methods to collect the interest, moving away from social missing and thus leading to borrowers being pushed to commit suicides.

The above factors coupled with political compulsions resulted in AP government promulgating the AP Microfinance Ordinance on 15th Oct, 2010. This had far reaching and adverse consequences for the MFIs operating in AP and also helped develop apathy and distrust towards MFIs in general in India. MFIs sort of lost the mantle of being the bearers of social mission of financial inclusion.

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REFERENCES
1

Impact of Microfinance: A Critical Survey

http://www.epw.in/h-t-parkh-finance-column/impact-microfinance-criticalsurvey.html?ip_login_no_cache=1c4f49e57fd52b3379af3d28c2ef0828 2 Microfinance: Profiting from Poor http://www.epw.in/letters/microfinance-profiting-poor.html

3 4

www.heinonline.org Regulation and Supervision of Microfinance http://indiamicrofinance.com/download-andhra-microfinance-ordinance-908172.html 5 http://www.ujjivan.com/pdf/Microfinance_Bill_in_Parliament.pdf 6 http://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/YHMR190111.pdf 7 http://www.janalakshmi.com/ 8 http://business-standard.com/india/news/how-janalakshmi-got-totopthe-mfi-heap/477791/ 9 http://www.epw.in/discussion/microfinance-industry-india-more-thoughts.html www.heinonline.org Designing an Effective Framework 10 http://intellecap.com/assets/163/First_Update_to_White_Paper_on_Indian_Microfinance_Crisis_2010.pdf

Indian Institute of Management, Bangalore

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