RBI Consultative Document on Microfinance: Transforming the Landscape

[By Tushar Chitlangia & Vipasha Verma] 

The authors are students at the National Law University Odisha. 

Introduction

The Reserve Bank of India (RBI) released a Consultative Document on Regulation of Microfinance on June 14, 2021 (Document). Microfinance is a type of banking service which provides loan to small borrowers at favourable terms. Prima facie, the major policy changes the Document aims is abolishing the inconsistency of a regulatory framework and dealing with the issue of over-indebtedness of the borrowers. However, the Consultative Document presents some challenges that need to be detailed out.

RBI has recommended assessment of household income, while also capping outstanding loans at 50%of household income. Additionally, the Document suggests that requirement that 50% of the loan portfolio of the Non-Banking Financial Company-Micro Finance Institutions (NBFC-MFIs) is to be advanced for income generation activities, should be abolished. Further, it increases the limit of minimum of Net Owned Fund (NOF)requirement, which raises certain issues for NBFC-MFIs in an economy ravaged by the pandemic. Conversely, the Consultative Document also recommends sagacious policies such as abolition of external benchmarking for NBFC-MFIs, and of the interest rate ceilings.

In this post, the authors present a critical review of the key policy changes introduced by the Document and provide suggestions at the institutional level to smoothen the implementation of these policies over the years.

Assessment of Household Income

In the past five years, the pool of borrowers in the microfinance sector of India has doubled, to around 5.8 crore. However, roughly 1 in every 20 Indian is indebted to a lender. Default risks are substantially high due to the lenders inability to predict borrower cash-flows during and after each cycle. Take for instance, the case of Assam, where micro-lenders classified borrowers with more than five loans as eligible for another. This is typically due to dependence of lenders primarily on information furnished by the borrowers on assets, income, and expenditure. These declarations are mostly of poor quality and not necessarily the best indicators of eligibility as the target demography are low-income households, wherein income varies with seasons and in most cases, assets do not generate cash. It is therefore, essential, to institute a robust cash-flow assessment mechanism.

Micro-lenders adopt the practice of “lending to the limit”, which implies that outstanding loan (including interest) will be till 50% of that household’s income. The Document further underlines a few “criterion of income assessment”, but ultimately relies on Board policies of the micro-lenders. Due to the prescriptive nature of limits and the open-endedness of the criterion, micro-lenders have no real incentive or assume liability beyond adhering to them on surface level. Therefore, RBI must consider establishing a uniform policy to mandate all micro-lenders to carry out income assessments under a legal obligation.

Instead of dependence on unverifiable declarations, this policy must include adding cross-checks of primary and secondary sources of income, a consumption roster with questions broken down into relevant purchase periods, and data check points (based on cross-checks) to capture informal loans. Further, micro-lenders must adopt cash-flow based underwriting, such a process would require lenders to capture details of occupational profiles, income flows, expense flows, and debt flows of the entire household, either directly or through the use of proxies and questions and combining these with information from credit bureau records. This would allow lenders to assess sustainability of the income under adverse conditions.

RBI, by enumerating assessment processes in detail will increase adherence and limit a risky customer base going into the future.

Consumption Loans

Microfinance is an innovation that fosters entrepreneurship. It allows recipients to develop a wide range of productive activities that generate revenues. However, in the recent years, it has been observed that customers have had little success. There are increasing levels of indebtedness owing to repayment inability. The major reasons for which have been: first, using credit loans for consumption purposes, and second, borrowing from multiple sources (mostly informal) to service debt, and the deteriorating effect of cumulative debt is worse since they earn no profit.

The document has abolished the limit of minimum percentage of loans to be lent for income-generation activities, citing that most borrowers depend on micro-lenders for consumption needs. However, the Malegam Committee, in its report, had observed that the main objective of micro-credit is to move its customer base out of poverty by using the loan for income-generating activities and developing a stable income. Further, it had argued that credit used for consumption purposes might increase the financial burden on the poor due to over indebtedness. Unless customers are able to progress from lower to higher incomes, they may become permanently dependent on the bank. Therefore, there is significance in income-generation activities. The RBI, by abolishing this limitation, allows micro-lenders to forego assessments that were an essential element of providing microcredit, such as evaluation of the clients’ business model for profit-generation, and providing workshops for entrepreneurship expertise. This is because any incentive to uphold the purpose of microcredit is lost.

The RBI has mentioned that microcredit as consumption loans is essential in the Indian context. But without income generation there will be minimal income sustainability. It is imperative that RBI enforces the creation of different loan products for unplanned/consumption expenses, through an appropriate mix of savings and micro-insurance products through policy and guidelines. RBI, by reinstating a limit, will ensure that the micro-lending sector does not dilute to a basic personal loans bank.

NOF Requirement

The document leaves the doors open to consider whether the extant minimum NOF requirement for NBFC-MFIs should be increased or not. The current minimum NOF requirement for NBFC-MFIs is Rs. 5 crores (and Rs. 2 crores for the NBFC-MFIs located in the North-East region). A Discussion Paper released by RBI on January 22, 2021,suggested that the minimum NOF requirement for all NBFCs, including NBFC-MFIs, should be increased to Rs. 20 crores. The reasons given were that there are high costs to be incurred to maintain the necessary IT infrastructure, and there is a need for the NBFCs to be adequately capitalized.

However, in the authors’ opinion, the suggestion to increase the minimum NOF requirement in already cash crunched economy due to the Covid-19 pandemic does not seem prudent. Particularly, the small NBFC-MFIs have fallen prey to the devastating consequences of the pandemic. Instead, there needs to be sustained government support in terms of funding and guarantees to the MFI players. The government’s support is a key aspect to ensure that MFIs can lend to the targeted sector that has lost their major source of income. It is noteworthy that the Central Government is supporting the MFI sector by giving guarantees to the loans advanced by commercial banks to MFIs. However, to incubate more MFIs at the grassroots level and rebuild the economy, such measures and the current minimum NOF requirement are required for a sustained time so that more borrowers can benefit, albeit indirectly.

External Benchmarking

From April 1, 2016, till September 30, 2019, there was a Marginal Cost of Fund Based Lending (MCLR) system to calculate the interest rates of loans. However, the MCLR system, an internal benchmark system, did not transmit benefits to the borrowers when the RBI lowered the repo rate. Therefore, w.e.f. October 1, 2019 the banks were obliged to benchmark their floating rate to some external benchmark like repo rate for retail loans, personal loans, and loans to MSMEs. The same is not the case for NBFC-MFIs, and the Document recommends that it should not be implemented for NBFC-MFIs in the future too. It is a common belief that freedom has to be given to the banks to set their own rates to recoup their costs. This assumes importance for the NBFC-MFIs as they are generally not allowed to take deposits, and therefore to advance loans, they largely depend on funding by the banks. Further, NBFC-MFIs have higher operating costs due to locational spread, quality of human capital etc. Therefore, due to the peculiar cost structure for NBFC-MFIs, it is prudent, as suggested by the Document, that Board approved policy should be there for deciding the interest rate and there should be no capping of interest rates.

Interest Rate Ceiling

The Document has suggested that there should not be any interest rate ceiling for NBFC-MFIs, which is a departure from the earlier practice. Applying ceilings for interest rates had a host of consequences that would not have been healthy for the growth of the MFI sector. It is a step in the correct direction that the interest rate ceilings have been recommended to be abolished. Some of the problems associated with interest ceilings are discussed below.

First, the NBFC-MFIs can increase non-interest charges to recoup their costs. This will reduce transparency and make it more difficult for the small borrowers to avail loans who already have less financial awareness. Second, NBFC-MFIs may also reduce credit extensions to high-risk borrowers i.e., small borrowers, as low-interest rates would restrict them in advancing risky loans. Third, the microfinance lenders generally expand the customer segment by the profits; therefore, low interest rate may cause reduced lending due to decreased profits. A natural way to bring down the interest rates of the NBFC-MFIs would be to increase competition by opening new branches.

Conclusion

The Document includes necessary changes; however, there is an urgent need to consolidate credit profiles by reinforcing credit bureaus and making them readily available to lenders for assessment policies to function. Further, deepening the reach of financial literacy programs will instill financial discipline and save unnecessary costs for micro-lenders. The Document is an essential step by the RBI, and rather anticipatory.

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