Banking Law

[By Aarya Parihar] The author is a student of Dr. Ram Manohar Lohiya National Law University. Account Aggregator Framework Have you ever wondered about consolidating all your financial data in one place? This is exactly the function the newly announced Account Aggregator Framework by Reserve Bank India (“RBI”)will carry out. This framework will put all your financial data in one place, that can be accessed by Financial Information Users (“FIUs”) for various purposes. One of the important functions is assessing the creditworthiness of an individual before sanctioning a loan by an FIU. The framework will consist of two more important players: Financial Information Providers (“FIPs”), who will provide the financial information, and Account Aggregators (“AAs”), who will store the financial information and will act as a link or consent/data fiduciary between the Individuals and the FIUs in providing data. AAs will extend the financial data forward only after receiving the due consent of the individuals. AAs can be a Non-Banking Financial Company (“NBFCs”) and other companies registered with the RBI. FIPs can be banks, mutual funds, pension funds, and some NBFCs, as may be notified by the authority. FIUs can be Banks, lending agencies, etc. The RBI framework of 2016 is the main piece of directive backed by an authority that discusses and lays down rules and regulations for the NBFCs signing up as AA. It also defines FIPs and FIUs in sub-section 3(xi) and 3(xii), respectively. Further, it lays the process of registration for NBFCs and also the consent architecture in place to protect the data of the individuals. History of Account Aggregator in India Account Aggregator in India is still at a very nascent stage. Its inception dates back to a meeting of the Financial Stability and Development Council Sub-Committee (“FSDC-SC”) held in 2013. The FSDC-SC for the first time manifested its desire to put in place a system where the financial data of individuals will be aggregated in one place. The Financial Stability and Development Council (“FSDC”) was set up in 2010 with the Finance Minister as its Chairperson, and other members included officials from RBI. Later, the Sub-committee was established with the Governor of RBI as its Chairperson. After that, there were different meetings every year of FSDC and FSDC-SC separately where the issue of Account Aggregator came up frequently for discussion. Finally, in the 552nd Meeting of the Central Board of RBI, the then Governor Shri Raghuram Rajan announced that the RBI would soon release the guidelines relating to the Account Aggregator framework. Thus, came the RBI’s Non-Banking Financial Company – Account Aggregator (Reserve Bank) Directions, 2016, which enumerated, among other things, definitions, duties, and procedures to carry out Account Aggregation in India. Open Banking in Other Jurisdictions The Account Aggregator Framework in India is similar to the Open Banking system in other countries. Open Banking refers to the consolidation of an individual’s financial data in one place with the involvement of banks, NBFCs, fintech companies, and government regulators. This data is shared securely among these entities, leading to a more accessible and efficient financial system. Some of the aforementioned players might be absent in one or the other jurisdiction since the Open Banking system varies around the globe. Nonetheless, the gist and crux remain the same: to consolidate and use the financial data of individuals for various lawful purposes. The implementation of Open Banking varies around the globe, with approaches categorized as mandatory, supportive, or neutral. In mandatory jurisdictions, implementation is forced by law, while in supportive jurisdictions, regulators encourage implementation without any legal requirement. In neutral jurisdictions, private industry leaders drive the adoption of Open Banking. The aim of Open Banking is to increase competitiveness and streamline the borrowing process, making it more inclusive. Some countries with mature Open Banking systems include United Kingdom, Singapore, Australia, and Japan. The rationale or aim behind Open Banking is also to increase competitiveness and to facilitate and quicken the financial borrowing mechanism. It aims to make it hassle-free and more inclusive. There are various countries where this system has become adequately mature and is working properly. I will discuss some of the countries with different approaches where this model has significantly matured or is adequately implemented. United Kingdom It can be safely argued that the Open Banking system in the UK is in its most mature phase if we compare it to that existing in any other jurisdiction. The whole ecosystem of Open Banking in the UK is authority-driven, or a mandatory approach is taken by it. It all started with a Retail Market Investigation Order 2017 by the Competition and Markets Authority (“CMA”) which required the nine largest banks to open up their financial data to third-party providers (“TPPs”) or entities mentioned in the order. The order laid down various guidelines and rules for the compliance by the banks and TPPs in the journey of Open Banking. Subsequently, the Open Banking Implementation Entity (“OBIE”) was formed to facilitate the implementation of the ecosystem devised by CMA. It is also important to allude to the Payment Service Regulation (“PSR”), which transposes Payment Services Directive 2015 (“PSD2”) into the national scenario of the UK. PSD2 is a regulation promulgated by European Union (“EU”), and it requires banking institutions to share financial data with TPPs after taking the consumer’s consent. It was mandated for all the EU nations to implement this directive in their national law by January 2018. PSD2 does not explicitly endorse Application Programming Interface (“APIs”) as the medium of sharing the information, whereas PSR of the UK requires Banks to utilise common APIs to share financial data. This piece of legislation is also instrumental in the growth of Open Banking in the UK. Technically, after Brexit, the UK has no obligation to follow the PSD2 directives, but due to constant interaction with European institutions, it still follows them to a certain extent. In March 2022, the OBIE was replaced with a cross-authority committee led by Financial Conduct Authority (“FCA”) and the and the Payment

[By Eilin Maria Baiju and Hemang Arrora] The authors are students of Gujrat National Law University. Introduction Post the Punjab and Maharashtra Cooperative Scam, the Banking sector of the country faced quite a setback affecting the financial market as well as disrupting the trust of innocent depositors. As eye-opening as it was for the banking sector, it also showed the Indian economy the need for regulating the conduct of the corporative bank sector. The cooperative banking of India had major age-old lacunas owing to the dual regulatory framework under the Reserve Bank of India and the Registrar of Cooperative Societies. That is the Urban Cooperatives Bank is supervised by the Registrar of Cooperative Societies whereas the licensing, regulation, and supervision are vested with the RBI. Under Schedule VII of the Indian Constitution, the regulation of corporate banks is a subject of both the State and the Centre. The problem originated from the 1966 rule[i] that extended the applicability of the provisions over certain categories of cooperative banks provided under the Reserve Bank of India. By the virtue of the 2020 amendment, these lacunas were attempted to be cemented and certain new progressive measures were implemented. These include changes pertaining to the cash reserve ratio, restrictions on holding shares and lending loans and advances, regulation of the board of directors, etc. Towards the end of this paper, the authors have also made a humble attempt to discuss how the amendment act possibly took away the Legislative powers of the State under Item 32 List II in Schedule 7 and discusses the constitutionality of the amendment act. Significance and Scope of Study The Banking Regulation Co-operative Societies Rules[ii] along with the amendment created Part V and extended the applicability of provisions to certain sectors of cooperative banking societies under the Second Schedule of the Reserve Bank of India Act.[iii] This not only constituted the conflict of interest between the Centre and the State but also helped in the budding of future scams in the banking sector. The scope of this study is to analyse the developments revolving around the 2020 amendment act[iv] and the recent measures of the Reserve Bank of India through various precedents and analyse the rationale behind the respective cases, by following a doctrinal type of interest. The Banking Ordinance: Formulation, Implementation, and Implications India’s banking system has often been criticized for its dual framework for regulating cooperative banks. There has always been a tussle between the Registrar of Cooperative Societies (‘ROCS’) and the Central Bank of India, i.e., the Reserve Bank of India (‘RBI’).[v] Although, at a broad level, the ROCS primarily deals with the administrative aspects of such banks like auditing and managing elections, on the other hand, the RBI deals with finance-related factors like the minimum liquidity ratio, maintenance of cash reserves, inspection, etc. The past indicates several flaws in the framework, which has led to inadequate measures in resolving those banks’ financial distress, which is finding it difficult to perform their everyday functions.[vi] A few of such failures include the government’s lack of success in reviving the cooperative bank of Madhavpura, wherein a ten-year plan scheme was implemented, but the same could not restore the bank.[vii] Similarly, in 2019, seeing Punjab and Maharashtra Cooperative Bank’s condition, the Reserve Bank of India was forced to issue directions under S.35A(1)[viii] to limit depositors’ daily withdrawals and take hold of the bank’s operations.[ix] The Rajya Sabha had recently passed the Banking Regulation (Amendment) Bill 2020 (Bill) in its session on September 22, 2020. Several aspects of the Bill will impact the banking industry long-term. It aims to alter the Banking Regulations Act (Act) and broaden its scope to include cooperative banks’ operations. While introducing the Bill in parliament, Finance Minister Nirmala Sitharaman stated that, in light of the recent failures of the Punjab and Maharashtra Cooperative Bank and other cooperative banks, it was imperative to regulate the conduct of such cooperative banks whose failures had severely impacted the financial market and disrupted depositor’s trust in the banking industry. Without a moratorium, devise a plan for reconstruction or merging Post the task of placing a bank under a moratorium, the Reserve Bank of India may propose a strategy for its amalgamation or reconstruction under the Banking Regulation Act. This could be done to ensure good bank administration or protect depositors, the banking system, or the wider public. For up to six months, banks that have been put under a moratorium are immune from legal action. Furthermore, banks will be unable to make any payments or discharge any liabilities during the moratorium. The Bill empowers the Reserve Bank to launch a bank restructuring or consolidation scheme without imposing a moratorium on a stressed lender.[x] Issuance of shares by the corporate banks Under the new BR Amendment Bill 2020, cooperative banks are exempt from the provision on the issuance of securities and shares. Other banks are permitted to issue equity or preference shares, and the RBI has the authority to impose preference share issue restrictions. In most cases, voting rights are distributed on a one-to-one basis. An equity shareholder’s voting rights are limited to 15 per cent under the Act (read with the directions of the Reserve Bank of India). Hence, no person would be entitled to demand towards surrender of shares issued by a co-operative bank in future. The bill changes the Banking Regulation Act to allow cooperative banks to offer equity, preference, or special shares to members or other persons who live in the banks’ operational zone at face value or at a premium, subject to the Reserve Bank’s approval. Unsecured debentures or bonds with a 10-year maturity period may also be issued by banks.[xi] Without clearance from the Reserve Bank, banks are unable to withdraw capital. Members are also not eligible for reimbursement from the bank if they relinquish their shares. Provisions related to the appointment of chairman, qualification of Board, etc. Prescription of management qualifications: Cooperative banks are exempt from the Banking Regulation Act’s restrictions on

[By Aayush Panwar] The author is a student of Gujarat National Law University, Gandhinagar. Introduction Banking and financial instruments are constantly evolving to suit the changing demands of the economy and business. Core banking and digitalization have contributed to the transformation of the banking industry from a traditional money lender to a modern banking system. Fintech and blockchain technology are the two fundamental components of digital banking. NEO Bank is one such evolution. NEO Bank is similar to any other commercial bank, with the difference of no physical presence, operating solely through digital modes. This is not a payment bank or e-wallet, it includes all the features of a commercial bank, and therefore no external bank account is to be linked to NEO Banks.[i] But these banks are not yet authorized with a banking license and are dependent on a banking service partner to provide other utility services like lending loans or issuing credit cards.[ii] This article throws light on necessity of NEO Banking, issues associated with its growth and proposing the solution to deal with this as NEO Banking will help in opening up a large horizon of fintech possibilities overcoming all the limitations of payment banks. Factors Affecting growth of neo banks There are various factors that are hampering the growth of NEO banks, especially in India. One of the pillars of the banking industry is the confidence of the public in the country’s banking system. For example, in Italy, only 37% of the population trusts the banking system of their country, and in France, a mere 27% of the population.[iii] In India, where a large portion of the population is not covered by the banking system, building trust through an online presence that does not involve cash is a herculean task. The NEO Banks, in the current legal scenario of the country, do not perform the core banking functions and offer limited products, which keeps away the High-Net-worth Individuals away from them. Another hurdle faced by them is the safety and security concerns which cannot be denied in the current scenario, where it is expected that the next world war will not be fought by arms and ammunition but will be a data war. Secured digital infrastructure, as well as awareness and assurance of customers, is a worrying fact. However, NEO Banks can easily overcome these hurdles keeping in mind the growth potential for such evolution in the banking sector. Legal Analysis Currently, in India, NEO Banks are just the FinTech companies performing some of the functions that appear to be banking functions, but as such, they cannot be called a bank. RBI does not allow for the grant of virtual banking licenses. RBI, in Master Circular on Mobile Banking Transactions, has mandated the physical presence of digital banking service providers. Since they are not recognized by the RBI and are therefore required to form a strategic partnership with the existing banks to provide services like the issue of debit/credit cards etc. They are also outsourcing their core banking functions to the license holders and provide services on their behalf. In many cases, such banks and fintech companies enter into an outsourcing arrangement where the non-banks verify data for credit requests or undertake the preliminary work for opening current accounts.[iv] This arrangement is governed by RBI Guidelines on Code of Conduct in Outsourcing of Financial Services by banks and RBI Guidelines on Financial Inclusion by Extension of Banking Services. In countries like the USA and Australia, NEO banks are recognized as banks.[v] Even Singapore and UAE have recently rolled out digital licenses to such entities.[vi]  But on the other hand, it cannot be said that the NEO Banks are working in an unregulated environment or are trying to doge the regulatory framework of various regulators, especially RBI. In one way or the other, they are regulated by the various laws, regulations, or bye-laws of the regulators, e.g., since they are in strategic partnerships with banks and NBFC, certain guidelines like Guidelines for engaging Business Correspondents under Master Circular on Branch Authorisation, Guidelines on Managing Risks and Code of Conduct in Outsourcing of Financial Services by Banks, Framework on Outsourcing of Payment and Settlement related activities by Payment System Operators and Master Direction on Digital Payment Security Controls. Apart from that, as NEO Banks also offer services like Investment Advisories and Insurance Products, they are also regulated by their respective regulators like SEBI Guidelines on Outsourcing of Activities by Intermediaries and IRDAI (Outsourcing of activities by Indian Insurers) Regulations. These are just some of the regulatory frameworks applicable to them, and there are various other rules applicable to them. All these regulations are applicable only through the contractual relationship between NEO Banks and their partner organisations. They are not regulated independently, which is a matter of concern. Notwithstanding the above rules, NEO banks are additionally committed to consent to information security regulations since they work with various administrations between the shopper and the financial establishments by giving an internet-based stage. The Indian information protection system is set out in the Information Technology Act 2000 and the Information Technology (Reasonable Security Practices and Procedures and Sensitive Personal Data or Information) Rules, 2011 (SPDI Rules). The laws will be more stringent with the passing of the Data Protection Bill, 2022. Role in Economy In India, it is very much evident that technological advancement has led to an increase in digital banking transactions. As per PWC, digital payments have increased many folds. In 2020, the country recorded around 50 billion digital banking transactions, and was expected to rise even more. In the span of one-year, mobile banking users have increased by 13% in value and 92% in volume.[vii] A study suggests that by 2025, around 70% of the transaction will be undertaken digitally, either over internet banking or mobile banking.[viii] This shows the tilt of the population towards the new digital banking solutions, which are more efficient and cost-friendly than the traditional banking system. As per the reports of Venture Intelligence,

[By Kapil Devnani]  The author is a student at the Hidayatullah National Law University, Raipur.  Section 138 of the Negotiable Instrument Act, 1881 (hereinafter “NI Act”) is a penal provision that allows the payee to institute a suit against the payer in case the cheque drawn by him got dishonoured. Recently, in the month of January 2022, three important judgements of different High Courts regarding this provision came. The first one is Parvaiz Ahmad Bhat & Anr. v. Fida Mohamamd Ayoub, given by the Jammu and Kashmir and Ladakh High Court; the second one is Rajeswary v. State of Kerala, given by the Kerala High Court; and the last one if Kodam Danalakshmi v. State of Kerala, given by the Telangana High Court. This blog is an attempt to comprehend the scope of Section 138 through these decisions. Parvaiz Ahmad Bhat & Anr. V. Fida Mohamamd Ayoub (Dishonour of cheque due to incomplete signature will be considered as an offence under Section 138) Facts of the Case In this case, the Petitioners challenged the complaint that was filed by the Respondent against them under Section 138 of the NI Act read with Section 420 of the IPC. The complaint was still pending before the CJM, however, by an order dated August 27th, 2020 the learned Magistrate issued the process against the Petitioners, to which the Petitioners responded and filed the petition before the Jammu and Kashmir and Ladakh High Court. The issue in this case was that the Petitioner’s cheque was dishonoured due to an incomplete signature on the cheque, and the High Court needed to decide whether or not this constituted an offence under Section 138 of the NI Act. The Petitioner argued that the Respondent’s complaint is not maintainable because the cheque got dishonoured due to incomplete signature and not because of insufficient funds. They relied on the case of Vinod Tanna v. Zaheer Siddqui,  (hereinafter “Vinod Tanna’s case”) in which it was held that the dishonour of cheque just because of incomplete signature will not attract Section 138 of the NI Act. Analysing the Judgement A mere reading of Section 138 is sufficient to conclude that this provision is attracted in two situations. First, when the individual drawing the check has insufficient funds in his or her bank account and second, if the amount to be paid is greater than the amount arranged to be paid from that account. However, there have been instances where the dishonour of the cheque was the result of some other reasons, but the judiciary allowed the application of Section 138. The Supreme Court in NEPC Micon Limited v. Magma Leasing Limited, held that Section 138 should not be interpreted strictly and for giving this verdict it relied on the cases of Kanwar Singh v. Delhi Administration and Swantraj and Others v. State of Maharashtra, in which it was held that the narrow interpretation of this provision will defeat the legislative purpose for which it was enacted. Walking on the lines of these judgments, the Supreme Court in M.M.T.C. Ltd. v. M/S Medchl Chemicals held that in case a cheque is dishonoured because of the instruction to stop payment, then Section 138 would be attracted. The only protection available with the petitioner in this case was the verdict of Vinod Tanna’s case, however, this verdict of the Supreme Court came up for consideration in Laxmi Dyechem v. State of Gujarat. In this case, the SC did not follow the ratio laid down in the case of Vinod Tanna and the reason was that the case of Vinod Tanna was based on the verdict of Electronics Trade & Technology Development Corpn. Ltd. v. Indian Technologists and Engineers Ltd, however, the same was overruled by the case of Modi Cements Ltd v. Kuchil Kumar Nandi. In Laxmi Dyechem, the Supreme Court held that in case the cheque is dishonoured due to incomplete signature or wrong signature, Section 138 will be attracted. Both the judgments of Vinod Tanna and Laxmi Dyechem were given by the bench of equal strength. However, Laxmi Dyechem’s case is the latest one and based on that the SC in the present case gave the decision in the favour of the Respondent and held that in case a cheque has been dishonoured just because of incomplete signature, then in that scenario Section 138 would be attracted.  Rajeswary v. State of Kerala (The Case of Cheque Bounce under Section 138 could be closed in case the fine is paid directly to the Complainant) Facts of the Case In this case, the accused was convicted by the trial Court under Section 138 of the NI Act for simple imprisonment for a period of 1 year and further to pay a fine of Rs.7,17,000/- and in case of default, additional imprisonment for further 3 months. Later on, the Kerala High Court modified the imprisonment of 1 year awarded by the Trial Court as a sentence to pay a fine of Rs.7,17,000/-. Following that, the convict paid the plaintiff the fine of Rs.7,17,000/-, which was acknowledged by the plaintiff himself when he issued a receipt of the transaction. Thereafter, the convict presented that receipt before the Trial Court and requested to close the case. However, the Court rejected this petition, stating that the convict was required by the Court’s Order to deposit the amount of fine in the Court, but he instead paid the fine directly to the plaintiff, so the Court could not accept the receipt of the payment and the case would continue. Aggrieved by this, the convict preferred an appeal before the Kerala HC. Analysing the Judgement The question before the HC was to determine whether the case of cheque bounce be closed in case the convict pays the fine directly to the plaintiff. To determine this, the Court relied on the judgment of Beena v. Balakrishnan, (hereinafter“Beena’s case”) in which it was held that if the person receiving the fine directly from the convict (in this case, the petitioner) files

[By Karma Shah and Diya Vaya] The authors are third year students at the Gujarat National Law University. Introduction Our nation is facing a massive issue of Non-Performing Assets (hereinafter “NPAs”). Put simply, an NPA is any bank asset or receivable that has stopped making payments to the bank and has remained unpaid for a specified amount of time. The Reserve Bank of India (hereinafter “RBI”), in its Master Circular, dated 30th August, 2001, has given an extensive definition of NPAs, which aids Indian banks in identifying and treating NPAs. In this definition, the RBI has specified the period after which assets stop giving returns as a meagre 90 days. NPAs are a threat to the Indian economy, as due to the strict prudential norms set by the RBI with respect to NPAs, banks have virtually stopped lending. This has led to the downfall of economic growth. An increase in NPAs leads to several unfavourable outcomes for the economy as a whole. These include, but are not limited to first, lower profit margins for banks and an increase in rates by banks for achieving a higher profit margin, second, reduction of liquidity in the organised financial sector, third, increased work-load on the judiciary, leading to an increased social cost to the society and lastly, stressed balance sheets of banks, less return to investors, and other such tangential issues. To combat this threat to the nation’s economy, Ms. Nirmala Sitharaman (hereinafter “the finance minister”) proposed the introduction and setting up of ‘bad banks’ in the 2020-2021 Union Budget. Moreover, most recently, i.e., on 16th September 2021, the finance minister laid down the framework for the National Asset Reconstruction Company Ltd. (hereinafter “NARC”), India’s first ‘bad bank’. This blog aims to, first, explain the meaning of bad banks and their crucial need in the contemporary Indian economy. Second, examine the recent framework establishing bad banks laid down by the finance minister, and third, analyze the impact on the banks and the national economy. Bad Banks – Meaning and Function Bad banks are those institutions that, simply put, buy the NPAs and bad loans of banks and other financial institutions in exchange for cash and/or securities. The first-ever bad bank set up in the world was by Mellon Bank in the USA. In practice, a bad bank plays the role of asset reconstruction. It buys the NPAs, bad loans, and other risky assets from various financial institutions, specifically banks. The bad bank then manages and recovers these over time. Hence, contrary to a conventional bank, their core and primary function is the recovery of NPAs and bad loans. Banks essentially isolate and divide their assets into two separate categories. One category contains the illiquid assets, including the NPAs, risky securities, non-strategic assets from businesses that are no longer beneficial to the bank, non-performing loans, and other high-risk or troubled assets. The second category contains the good and beneficial assets that perform well and represent the bank’s core business. A bad bank, a corporate structure, takes the NPAs and bad loans of such banks and provides cash and/or government securities in return. This allows the bank to clear their balance sheets, infuse themselves with liquidity, and helps them focus on their core business instead of trying and recovering the NPAs. The Critical Need for Bad Banks in the Indian Economy  The Covid-19 pandemic has led to an unprecedented negative impact on our economy. Cash flow has reduced, leading to issues of loan repayments, tax payments, and interest payments. Furthermore, NPAs have been blocking the progress of our economy since the last decade. In such a desperate financial scenario, the need of introducing bad banks in the Indian Economy was critically felt due to the following reasons: First, primarily to resolve the NPA crisis. NPAs have been a constant obstacle preventing the Indian economy from unleashing its true potential. NPAs have started to drastically increase in Indian Banks since 2013, forming almost 10% of the loans provided by the banks. As per RBI, NPAs of all the scheduled commercial banks have increased from 2.35% in 2011 to 8.21% in 2021, amounting to an increase of almost 250% in a decade. Moreover, due to the onset of Covid-19, RBI has presented a warning in its July 2021 Financial Stability Report that the gross NPA ratio may increase to 9.80 percent by March 2022 under the baseline scenario; and to 11.22 percent under a severe stress scenario. India has the third-highest gross NPA ratio. When a bank has a high NPA ratio, it spends a high percentage of its profits covering consequential losses incurred due to the high NPAs. This creates a situation of decelerating the cash flow in the economy, reducing the lending frequency of the banks and ultimately affecting the economy as a whole. . In this scenario, NARC is a much-needed expert entity required to fuel the economy’s growth, provide capital to banks and resolve the financial crisis. Second, to provide support to the Insolvency and Bankruptcy regime (hereinafter “IBC”). The IBC was enacted with the objective of debt recovery and reducing the NPAs in the economy, among others. However, it did not perform as per expectations. Furthermore, it is argued that the IBC and associated debt recovery mechanisms are still at a nascent stage in India. For IBC to resolve all issues of NPAs plaguing our economy it requires greater judicial capacity, manpower and time. This can be provided by the bad bank, which creates a separate entity for quicker and more efficient one-time resolution and debt recovery. Now, banks need not worry about debts and can focus on strengthening the economy. Furthermore, the appreciable role played by bad-banks in other countries is the greatest testimony of its potential to resolve the issue of NPA’s in India and accelerate economic growth. Hence, a bad bank is necessary to tackle the issue of the large stock of NPAs in the economy as a one-time solution. Impact of the recent framework on Banks and Indian Economy On September 16, 2021, the finance minister set

[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