Regulations key to orderly growth of microfinance

Microfinance started in India three decades ago as a small-scale endeavour by non-profit entities. At the start, two parallel approaches existed — the self-help group-bank linkage programme (SBLP), and the Grameen-style microfinance institutions (MFIs). While SBLP and its new avatar, the National Rural Livelihood Mission, form an important part of microfinance, it is the MFI model which requires regulatory tweaks for sustainable growth.

From 2004-05, the model evolved to specialisation and scale, for-profit, commercial and regulated companies dominated the market. This brought private capital, growth and scale. Growth, alongside SBLP, also brought customer protection issues — most notably manifested in the Andhra Pradesh (AP) crisis in 2010. Until then, there were no specific regulations for microcredit and the philosophy of regulation was echoed in Reserve Bank of India (RBI) governor Y V Reddy’s words: “Let a thousand flowers bloom”.

The AP crisis led to the microfinance regulations based broadly on the recommendations of the Malegam Committee. The RBI also introduced a new category — non-banking financial companies (NBFC-MFIs). Regulations formalised the existing realities of microfinance — private and specialised MFIs delivering small, unsecured, short-term loans — through NBFC-MFIs. They also took into account the need for customer protection, especially over-indebtedness and pricing, by defining market segments, products and pricing, along with other customer protection norms. Globally, nowhere does such an extensive regulatory framework exist for microfinance.

While these prescriptive regulations largely met the regulatory and industry objectives, spearheading growth, scale and diversification, over the last few years’ new developments have created gaps in the framework. Today, the sector caters to six crore women clients who had no access to formal credit before microfinance. 

However, from 2015 the market underwent substantive changes. Some of the largest NBFC-MFIs converted into banks and small finance banks. It has led to a situation where now NBFC-MFIs account for 35 per cent of market share, and the regulations are applicable only to them. As all institutions have similar products, clientele and operational methodology, applicability of rules only to NBFC-MFIs was causing field issues. This gap was sought to be plugged with the Code of Responsible Lending in 2019. However, considering its voluntary nature and the fact that a few lenders are not part of it, the time for a regulatory review was overdue.

Realising the criticality of this, RBI has now come up with a consultative document (CD) for regulation of microfinance operations. It is imperative for future orderly growth that it soon becomes policy. The core themes of CD which need to be put in place revolve around defining the microfinance client, ensuring there is no over-indebtedness and ensuring client protection.

The RBI’s CD defines microfinance clients based on the current household income limit applicable for NBFC-MFIs. It will be prudent to define the household not based on census norms, but more narrowly as a family of husband, wife and dependent children, conventionally used for credit underwriting. Similarly, the demarcation between rural, semi-urban and urban is a bit fuzzy in reality. Many microfinance clients have family members as migrants, permanent or seasonal, leading to blurred lines.

The RBI has proposed moving to a concept of “fixed obligation to income ratio”, keeping debt repayment to income ratio at 50 per cent. This moves the needle correctly from the current approach of basing it on the number of lenders and the loan amount. Two additional things are needed to make it foolproof — submission to credit bureaus, and bringing in SBLP loans under credit bureaus. The proposed regulation is an honest, market-enabling approach towards microfinance. 

The writer is Chief Executive Officer and Director of Microfinance Institutions Network