In the past five years AP, experienced two major MFI financial crises, one took place this past year and the other in 2006. The circumstances for the crises were similar and led to a state-wide lending freeze. MFIs faced accusations of usurious (unfairly high) interest rates, opaque pricing models, inappropriate collections methods, poaching clients from SHGs and culpability in suicides. Both crises brought to light improvements that the industry will want to focus on; improving client protection, developing credit bureaus, and creating an environment of sustainable growth.
Both crises brought out a number of grievances.
High interest rates: Indian MFIs charge different clients between 24% and 40% interest per annum. Recent equity market studies indicate that a well run MFI charging 28% on a loan will have a return of approximately 8-10%. So what are alternatives for poor clients? Option 1: traditional moneylenders which still charge higher rates and tend to be a rougher crowd than MFI representatives. Option 2: borrowing from SHG (Self Help Groups), which receive preferential lending rates from commercial banks, thanks to a lending subsidy from the Indian government through a variety of financial vehicles. SHGs lend to clients at annual interest rates of 24-48%.
Multiple borrowing: Although it happens, multiple-borrowing takes place rarely, due to two factors poor clients are more risk averse in general and once they join a group of similarly risk averse borrowers that will take a loan together, the resulting group of borrowers ends up even more risk averse than individuals. With that said, borrowers that take more than one loan tend to make national and local news as they are the ones that will likely take their own life in the event of inability to pay back borrowed funds.
Coercion in collections: Micro-lending relies on the model of lending to groups that have potential to maintain a high level of fiscal discipline, which is enforced by members of the borrowing group internally. Paying back as a group will open up opportunities for future loans. However this model relies on the ability of clients to make weekly repayments on their loans and everyone falls on hard times at some point in their life. Since the reality of default exists, protections for individual clients fallen on hard times can be instituted by financial institutions. Such regulation will protect the vulnerable individual debtors and MFIs lending to them from public outrage and liquidity issues associated with panics. Additionally, in a few rather rare instances some MFIs have hired a few less than upstanding collectors who have used less than reputable methods to collect on loans. Since abuse of customers by collectors has occurred in the past, regulation that codifies acceptable ways of collecting on loans may be a good idea.
The Malegam Committee was born in October 2010 to look at the MFI crisis and propose remedies. The committee is part of the Reserve Bank of India. Implementing regulations coming from the RBI will supersede state level regulation already in force. Proposed regulations by the Malegam Committee will likely enter force around April 1, 2011. The new regulations aim at both protecting consumers and allowing MFIs conduct the business of lending.
New regulation would cap interest rates offered to clients of MFIs at 24%, limit the size of the loan to 25000 Rupees ($550 USD) and restricts the number of loans per borrower two just two. In order to control the MFIs’ profit margin the Committee proposes a cap on the differential between the lending institutions’ cost of borrowing and lending to clients at 10%. The Committee proposed a separate regulatory category for MFIs; non-banking financial companies (NBFC-MFI), requiring MFIs portfolios to include at least 75% of loans for income generation, and allowing borrowers to choose frequency of payments; weekly, bi-weekly, or monthly payments. A microloan qualifying household must earn fewer than 50000 Rupees ($1200 USD) annually. The Commission also proposed capital requirements for micro-lending institutions. Regulation of MFIs is proposed through the National Bank for Agriculture and Rural Development in cooperation with the RBI.
So what do these regulatory proposals mean? Regulation affects the MFIs, the SHGs (indirectly), their clients and the overall micro-credit industry in India. Implications for all three groups are different. What are the effects on micro-lending institutions? The good news is that regulation of MFIs remains under national and not state government institutions, allowing for a regulatory approach relatively far from local political and social upheavals. The downside is that no other non banking financial companies have a proposed interest cap looming. Self Help Groups (SHGs), which compete for MFI customers and vise versa, do not fall under the same set of regulation, potentially giving them a competitive advantage over MFIs.
Market competition with other financial institutions offering similar services for a better price provide stronger incentive for efficiency than interest rate caps. Interest rate caps will not bring get customers improved and better priced products. While I outlined some of the more straight-forward recommendations by the Malegam Committee earlier, I found other recommendations either hopelessly confusing or contradictory. If all proposed regulations are passed and enforced, they will likely drive well run and relatively efficient MFIs out of business, because they may not be able to fulfill all regulatory requirements. On the other hand, additional regulation while expensive and painful in the short term, may help rebuild MFIs’ credibility both as fair lenders to their customers, sound investments for both private funders and large multi-nationals, and borrowers of good standing for commercial banks. New regulation will also help unfreeze the micro-lending marketplace after the last financial crisis, giving more opportunities to MFIs and their customers.
The SHGs in the short term will gain a competitive advantage in providing financial services to current and new customers, while MFIs work through new regulations and ways to conforms to their new regulatory environment. In the short term, some SHGs may end up losing business, because of interest caps on MFIs. While it is unlikely that interest rate caps on MFIs will help them become more efficient, the caps are in fact lower than SHGs’ interest rates. So once the MFIs work out compliance issues they will at the very least offer less expensive financial services to customers, which may lead to some SHG customers choosing to bank with MFIs.
The SHGs, the MFIs, and the Indian government see the micro-lending customers as their chief concern and the reason for new proposed regulation. Do they win? In my opinion, customers will likely lose. Why? Customers seeking micro-lending loans in the short term and possibly in the long term as well see less different options for sources of financing. Some MFIs are bound to go out of business. MFIs may close their doors due to inadequate capital in reserves, loss of investor confidence, inability to comply with new regulation, or continued large numbers of non-performing loans. Interest caps on MFIs will not incentivize them to become better and leaner lenders, thus regulation will not result in an improved and less expensive product. Through new regulation customers will gain more flexible payment plan options and protection in terms of the way that lenders may collect on their loans. At the end of the day, customers will see a micro-lending market with fewer options, pretty much the same interest rates, no drastically improved financial products, and slightly stronger consumer protection.
- Bansal, Hema "SHG-Banking Linkage Program in India." Micro Finance Focus 9 August 2009. <http://ifmr.ac.in/cmf/mrap/wp-content/uploads/2009/04/shg-bank-linkage-program.pdf>
- “Malegam Panel Proposes 24% cap on Interest rate on MFI Loans.” The Hindu. 19 January 2011. <http://www.thehindu.com/business/Economy/article1103090.ece?css=print>
- Moksim, Julie. “MICROCAPITAL BRIEF: Reserve Bank of India (RBI) Subcommittee Proposes Regulation for Microfinance Institutions (MFI).” Microcapital.org. 26 January 2011. <http://www.microcapital.org/microcapital-brief-reserve-bank-of-india-rbi-subcommittee-proposes-regulation-for-microfinance-institutions-mfi/>
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- Ravi, Medha. “MICROCAPITAL BRIEF: Reserve Bank of India (RBI) Proposal a Positive Step Argues Tripathi…But Andhra Pradesh Government Oversteps.” 19 July 2011 <http://www.microcapital.org/microcapital-brief-reserve-bank-of-india-rbi-proposal-a-positive-step-argues-tripathi%E2%80%A6-but-andhra-pradesh-government-oversteps/>
- Rhyne, Elizabeth. “On Microfinance: Who's to Blame for the Crisis in Andhra Pradesh?” Huffington Post. 2 November 2010 <http://www.huffingtonpost.com/elisabeth-rhyne/on-microfinance-whos-to-b_b_777911.html>
- Shylendra, H S. “Microfinance Institutions in Andhra Pradesh: Crisis and Diagnosis.” Economic and Political Weekly 20 May 2006 <http://www.microfinancegateway.org/gm/document-1.9.27434/33479_file_EPW.pdf>