Uniform regulations proposed by the Reserve Bank of India (RBI) for entities in the microfinance industry, if implemented in their entirety, will mark the biggest reform since rules that took effect in 2011 laid the foundation for a modern microfinance sector in India.
A committee led by chartered accountant Y H Malegam had suggested the rules that 10 years ago paved the way for a new category of microfinance institutions (MFs) called the non-banking financial company (NBFC)-MFIs and loan pricing based on margin caps.
The panel recommended a 10% margin cap for bigger MFIs above their cost of funds and a cap of 12% for smaller ones.
No two MFIs can lend to the same borrower, it said, in a move to address the problem of over-indebtedness.
The panel was formed after the Indian microlending sector fell into a crisis in 2010 following a local law promulgated by the then Andhra Pradesh government for MFIs to rein in coercive loan collection practices that forced overextended borrowers to commit suicide.
Now, in a consultative paper released on June 14, the RBI has laid out several proposals that, if accepted, will be applicable to all lenders engaged in microfinance and introduce a level playing field for banks and NBFC-MFIs.
Among the proposals, the most important one is the proposed liberalisation of the interest rate pricing regime.
The paper says that microlenders can put in place a board-approved policy to arrive at all-inclusive interest rates charged to the borrower. The governing board of each NBFC-MFI can adopt an interest rate model taking into account factors such as the cost of funds, margin and risk premium and determine the rate of interest to be charged for loans and advances.
The rate of interest and the approach towards degrees of risk and rationale for charging different rate of interest from different categories of borrowers need to be disclosed to the borrower in the loan application form and communicated explicitly in the letter sanctioning the loan, the regulator said.
Second, a rule that more than two MFIs cannot lend to the same borrower is proposed to be scrapped. Instead, MFIs can lend to borrowers based on the household income limit. The RBI proposals say that the payment of interest and repayment of principal on all outstanding loans of the households at any point of time shall be capped at 50% of household income.
What do the proposed new rules mean for MFIs, which borrow money from banks and on-lend to small borrowers like grocers, vegetable sellers and pushcart vendors?
Microfinance industry associations welcomed the new proposals, saying they will bring in parity among all lenders engaged in microfinance.
"The Reserve Bank of India's consultative paper on the industry is forward looking and it will have an enormous positive impact on the sector," said P. Satish, Executive Director of Sa-Dhan, an industry association.
The Microfinance Institutions Network (MFIN), another industry body, also praised the proposed rules.
"It is heartening that RBI has proposed to resolve issues of regulatory arbitrage based on legal form and bring in parity within all microfinance lenders. MFIN has been engaging with RBI on this and Governor’s statement early this year about a harmonized framework had given us confidence, which has now come true," said Alok Misra, chief executive officer and director of MFIN.
But some critical questions arise at this point.
Going back to the old days?
By deregulating the lending rates (removing margin caps) and scrapping the two-lender rule, the RBI is essentially taking the MFI industry back to the pre-Malegam committee era, critics say.
Both recommendations were part of the 2011 Malegam committee recommendations to curb the problem of exorbitant interest rates charged by some MFIs and the even bigger issue of over-indebtedness of microfinance borrowers--the two main causes of the industry crisis in 2010.
"Even then there was a rule to have a board-approved policy for MFIs to decide the interest rates charged to the borrower. But not everyone followed it," recalled Kishor Kumar Puli, who used to head Trident Microfinance, which was hit hard in the Andhra Pradesh crisis and had to ultimately shut down.
Trident was the only major MFI that closed down during the AP crisis.
"There are two problems here (with the proposed RBI rules). Some MFIs may misuse the absence of an interest rate cap and could go back to 40%-50% annual interest rates. Such a situation existed prior to the Malegam committee rules. Secondly, the local media and local politicians will then use such unhealthy lending practices to tarnish the image of the entire MFI industry, which is what precisely happened during the 2010 crisis," said Puli.
Even during the AP crisis, not all MFIs were charging exorbitant rate of interest. But, due to the unfair lending practices of some the entire industry was dragged into a crisis.
With MFIs set to be free to set their own loan rates, the market will be more competitive for the lenders, but at the same time will pose the likely risk of rogue players misusing the new norms. Regardless of the call for fair practices, some microlenders could start charging usurious rate of interest and destroy the discipline achieved in the sector following the Malegam committee recommendations, said Puli.
Similarly, with respect to the two-lender rule, it will be extremely difficult for MFIs to make a proper assessment.
"Deciding the household income exactly will be a challenge in rural areas. To get an additional loan, local field officers could show an inflated income which will again lead to over-indebtedness," said Puli.
Samit Ghosh, the founder of Ujjivan Financial Services, said while the new proposals offer a level playing field, they may pose some challenges.
"How does the regulator ensure lending rates are coming down for the borrower post the scrapping of margin caps?" asked Ghosh.
"Secondly, assessing the household income will be tough on the field unless the RBI, in consultation with the industry associations, prepares data infrastructure to decide household income limits for different occupations. There can be a maximum and minimum limit," said Ghosh.
Microlenders experienced tough times in 2010-2012 during the AP crisis that resulted in job losses, forced the closure of several smaller MFIs and caused the deterioration of credit culture.
It took a decade for the microfinance industry to return to normalcy, based on the framework laid down by the Malegam committee. By scrapping the lending rate cap and the two-lender rule, is the RBI taking undue risk in the microfinance sector? The jury is still out on that question.