25
Feb

The Impact of Interest Rate Controls on Financial Inclusion: A Comparative Analysis

– By Sucharita Mukherjee, CEO, IFMR Capital

The future regulatory environment for microfinance is being shaped by the recommendations of RBI’s Malegam Committee, set up to study issues and concerns in the microfinance sector. The report stresses the importance of protecting the interests of low income households, who by virtue of their economic position, are in a weak bargaining position when compared to the provider of financial services. Although, there is perfect agreement among all concerned that microfinance institutions (MFIs) are an important plank in the agenda for financial inclusion, many of the recommendations of the committee may indeed lead to financial exclusion for a vast majority of low income households in India. The committee recommends that effective interest rates charged by microfinance institutions be subject to a floating ceiling of 10 to 12% over cost of funds, and a fixed ceiling of 24%. This article seeks to analyse the impact of the interest rate cap on the microfinance sector, serving more than 20 million clients today.

Valuing a Ceiling on Interest Rates

How can we ascribe a value to a ceiling on interest rates? An interest rate cap can be compared to a series of European call options which exist for each period the cap is in existence.

In mathematical terms, a cap payoff on a rate L struck at K is

formula

Where,

N is the notional amount, in this case, the amount of debt funding raised by the MFI

α is the day count fraction corresponding to each period for which the cap is in existence

K is the strike price, or in this case, the effective cap on the funding rate of an MFI

Using an absolute cap of 24% on the interest rates to be charged on micro-loans, and operating costs of 9%, this implies a ceiling of 15% on the funding rate of an MFI at 0% return on equity.

If we consider a 15% return on equity, this adds 3.39% to the overall costs, thus implying a ceiling on the funding rate of an MFI at 11.61%[1]. In order to hedge itself against the risk of an increase in funding rates, an MFI would periodically need to purchase an interest rate cap corresponding to the tenor of its debt. While interest rate options are often embedded in bond issuances with put or call options, these are not traded independently or on the exchange. The above interest rate cap can be priced using the Black Derman Toy model with the required inputs of the yield curve and the term structure of volatility. Given long term interest rate volatility has been estimated at approximately 18 %[2], the pricing of such an option is likely to be in excess of 1%[3] per annum.

Over the past three years, debt funding costs for MFIs have ranged from 11% to 16%; however, the recent events in Andhra Pradesh have precipitated a liquidity crunch for many microfinance institutions, with borrowing rates now at the higher end of this range.

chart

An analysis of government bond yields over the last ten years show that 10 year yields have ranged from 6 to 12%. Over the last five years, however, the range has been narrower from 6 to 9.5%[4]. AAA and AA corporate bond spreads have been around 200[5] bps in the last five years, this implies that the benchmark funding rate for AAA and AA corporate and financial institutions would have ranged from 8 to 11.5%.

As the credit rating for MFIs is at best in the investment grade range, 200 bps can be estimated as the approximate premium demanded by the market for a bond issuance by a MFI[6], therefore, in the last five years MFI debt issuances would have ranged from 10 to 13.5%. The implicit interest rate cap at 11.6% therefore lies in the middle of the estimated range at which MFI debt issuances would have been priced in the market. The value of an interest rate cap is lower when a call option is “out of the money”, i.e., the strike price or the cap interest rate is much above current spot interest rates.

However, in this case as the implied cap interest rate of 11.6% is actually lower than the actual cost of debt funding raised by most MFIs, it can be inferred that this cap is very expensive for the microfinance institution. In short, the MFI would have effectively sold an interest rate cap and received zero premium for it. It is not clear whether the interest rate ceiling is subject to review, if so, on what basis, and at what frequency? The longer the interest rate ceiling applies, again, the more expensive the price of the call option, as the option seller must be compensated more for committing to a fixed-rate for a longer period of time.

Assessing the Potential Impact of Interest Rate Ceilings on MFIs

In light of this, a majority of MFIs will need to make significant strategic changes to their business model, enabling either a sharp reduction in operating costs or a sharp reduction in funding costs or both. Evidence from other countries shows that pricing caps have historically hurt the poor as they incentivise originators to expand only to easily serviceable geographies and ignore remote areas and lower income clients[7].

Even in countries with deep, well-developed credit markets such as the UK, US and Western Europe, research shows that interest rate ceilings have not impacted the cost of credit to low income borrowers. It has been proved not to be an effective means of addressing exploitative lending and indeed has had severe negative repercussions on the availability of credit for those on low incomes and the credit impaired[8].  A more detailed analysis of the impact of interest rate controls in these countries with a long history of credit markets, will give us a clearer understanding of the likely impact of the introduction of any rate ceilings in India.

The Experience in Developed Credit Markets

Research in European, US and UK credit markets show that markets with rate ceilings exhibit less diversity in the credit products available in the market and the range of credit models offered to low income households is sharply narrower. Tailored credit products for low income households, which tend to feature high rates are either unable to develop, in the case of established ceilings or forced out of the market, where ceilings are imposed. For instance, the UK and US have well-developed and segmented products for low income households such as payday loans[9], rent to own[10], auto title loans[11] and secured credit cards[12], whereas neither France nor Germany (with rate ceilings in place) have a distinct low income finance sector.

The absolute exclusion of the low income population in France and Germany has created the conditions for illegal lending. It is estimated that 10 to 12% of low income households in France and Germany have used unlicensed lenders as compared to 4% in the UK, due to the lack of legitimate credit options. In India, informal money lenders charging “triple digit” interest rates will thrive given that the rate ceiling may choke off the supply of credit to low income households from the formal financial sector. As money lenders do not fall within the ambit of the RBI, it will be impossible to enforce codes of practice and ensure “fair” treatment to those on low incomes.

Germany provides a good example of how a rate ceiling, particularly when combined with disincentives to default, can result in a highly risk averse lender set. Credit scoring thresholds and criteria have been set at levels that would tend to exclude potentially higher risk groups, such as those who are self employed or short term contract labourers. Comprehensive documentary evidence, including signed statements by employers and long term employment contracts are required to support credit applications, with this condition rigorously enforced.

Lenders have also withdrawn from markets where ceilings are newly imposed. In Florida, a rate ceiling for auto title loans was imposed at the end of 2000; this led to the reduction in the number of auto title lenders from 600 to 58 in one year. Similarly in the state of Alabama, Georgia and North Dakota, after the imposition of rate ceilings on pay day loans, a majority of lenders discontinued this product offering. Evidence over a thirty year period in the US credit markets also suggests that competition rather than rate ceilings determine the price for mainstream credit.

Are There Lessons We Can Learn?

Given the effects on product innovation and market withdrawal, the consumers most likely to be impacted are those operating outside the financial mainstream, the unbanked low income households. The outcome in India of such a regulation may be devastating for low income households if it results in the cutting off of their only access to formal financial service providers.

In the banking sector, historically, the prime lending rate set by banks has served as an effective interest rate ceiling for small loans below the size of Rs. 200,000, this has been one of the reasons for the abysmally low penetration of bank credit in low income households, both in rural as well as urban areas. In September last year, interest rates were substantially deregulated by replacing the PLR with the base rate, a floor rate. The introduction of the base rate could pave the way for the entry of mainstream commercial banks into the microfinance sector, as this represents a huge untapped market opportunity. Such competition from banks as well as regionally focussed financial institutions, in the absence of a rate ceiling, may catalyse the development of credit products for the diverse requirements of low income households.

Low income households require access to not just unsecured group loans, but also other types of credit, both for liquidity, consumption and production, such as pre-harvest finance, agricultural commodity backed loans, gold loans, two wheeler loans, cattle loans and tractor finance. Regulation on interest rates that intends to protect the interests of low income households must apply not just to a single narrowly defined credit product, but the entire gamut of credit products that a low income household requires and uses. For instance, interest rates on gold loans, a fully secured credit product popular with low income households during an emergency, range from 12 to 28%, well above the proposed interest rate ceiling prescribed by the Malegam Committee. The median interest rates charged, however, are now in the range of 12 to 18%, this sharp reduction has been made possible by transparency and competition among the players. In particular, the entry of commercial banks in the gold loan market increased competitive pressure, forcing existing players to reduce their rates.

The Reserve Bank of India must carefully consider the impact of interest rate ceilings before introducing such a fundamental shift in policy. We must learn from the experiences of others that competition, innovation and transparency can be the only permanent ways of bringing affordable access to credit for all. “Quick-Fix” solutions like interest rate ceilings may be tempting in their simplicity, however in reality may actually create credit exclusion.



[1] For ease of comparison, all numbers and assumptions have been taken from the Malegam committee report

[2] Bond Valuation and the Pricing of Interest Rate Options in India, Jayanth R. Varma, Indian Institute of Management, Ahmedabad

[3] Source: Kumar, Anand: “Valuation of Caps on Debt Funding Rates”, Draft

[4] Source: Bloomberg

[5] Source: FIMMDA Corporate Bond Database

[6] IFMR Capital Deal Portal

[7] CGAP Occasional Paper No. 9

[8] “The Effect of Interest Rate Controls on Other Countries”, Department of Trade and Industry (UK)

[9] Payday loans are small loans to tide over short term liquidity needs between one payday and the next.

[10] Rent to own is a rental contract in which title to goods(typically white goods or electronics) remains with the store until the end of the contract, usually 12-24 months

[11] Auto title loans are high cost short term credit secured on the borrower’s vehicle to largely unbanked car owners

[12] Secured credit cards are those that are partly or fully secured by cash deposits

15
Feb

Regulating Microfinance in India: IFMR Trust’s feedback on the Malegam Committee’s report

The Malegam Committee’s (referred to hereinafter as the “Committee”) recommendations to increase the supervisory capacity of the RBI, to make MFI regulation consistent at the national level, to promote good corporate governance and to increase bank lending to MFIs are welcome.

At the same time, many of the tactical and operational prescriptions made by the Committee require to be examined in the context of (a) broadening the RBI’s financial inclusion agenda, (b) regulatory approaches to pursuing this agenda (c) operationalising the recommendations in an effective and inclusive manner and (d) ensuring sustainable development and orderly growth of the industry by limiting externalities and developing a series of best practices.

Definition of the Sector

1. Under 2.1 of the Committee’s report, the Committee has defined microfinance as “an economic development tool whose objective is to assist the poor to work their way out of poverty. It covers a range of services which include, in addition to the provision of credit, many other services such as savings, insurance, money transfers, counselling, etc.

2. At the same time, the Committee has confined itself to “micro-credit” for the purpose of the report.

3. The Committee has subsequently defined a separate category – NBFC-MFIs – for NBFCs operating in the microfinance sector, and stated that, in such firms, over 90% of assets must comprise of “qualifying assets”. At the same time, the Committee suggests that NBFCs should either allocate over 90% of assets to “qualifying assets” or less than 10%

4. We suggest that it is counter-productive to limit micro-credit or the supervision of micro-credit to NBFCs in the fashion as described above for the following reasons:

a) These recommendations, if accepted, would prevent the transformation of microfinance into full service finance for rural customers.

a. One of the main reasons for becoming an NBFC is that the entity is then able move beyond traditional JLG lending, and gradually start to offer larger loans, individual loans, enterprise loans, crop loans, equipment loans, etc. while continuing to offer the original JLG product.
b. This allows the entity to meet completely the requirements of those borrowers that need larger amounts as well as use the wider product-scope to spread its cost structures over a much larger pool of assets and bring its lending rates down, eventually well below even the caps specified by the Committee for the traditional JLG product.
c. Entities operating in this space would have to grapple with low value of transaction and still remain viable. Multiple sources of revenue would provide such viability to such entities.

b) The 90/10 recommendations (Clause Numbers 5.9 and 5.10), if accepted, would essentially freeze the sector to permanently stay in its current form since nobody else would even be allowed to address the needs of this sector and no other business models would evolve.

a. And for this reason, there would also then be no impetus for interest rates to come down further below the caps specified by the Committee. Costs of operations, using new technologies and economies of scope and scale can be brought down to as much lower levels relatively quickly.
b. This would also take away the entities’ incentive to invest effort in working in a challenging environment.

c) The recommendations would leave out significant microfinance providers from the regulatory framework

a. It is quite possible that Banks may emerge as substantial providers of micro-credit and other forms of microfinance, but microcredit (as defined by the committee) may not form 10% of their assets. This will leave out a significant institution-type from the regulatory ambit. The proposed regulation must cover all microfinance providers

i. However, it may be argued that microfinance, at present, is being provided by multiple non-profit entities that are not within the regulatory ambit of the RBI. Recognising this, we propose that microfinance regulation must cover at least all existing forms of entities regulated by the RBI, i.e. Banks and NBFCs
ii. The microfinance operations of such entities, be in micro-credit, micro-savings, distribution of micro-insurance etc., must be reported separately as an SBU to the RBI, to permit efficient information dissemination, transparency and effective regulation
iii. For entities outside RBI’s regulatory ambit, regulation could make the principals (in case of business correspondents) and lenders (in case of microcredit) to the providers aware of the importance adherence to client protection standards by the providers. These principals and lenders should be actively encouraged to broaden their due diligence and monitoring processes to ensure that the providers are not just maintaining financial discipline but also adhering to ethical standards of client protection.RBI must also actively use such measures to enforce covenants on entities not regulated by RBI to create a level playing field and uniform standards.

d) Further,

a. If entities were forced to concentrate over 90% of their assets in the microfinance sector, lack of diversification within their asset portfolios could emerge as a significant systemic risk.
b. In India, portfolio protection for institutions providing services to low income rural households against the vagaries of systemic and catastrophic losses, i.e. rainfall reduction, weather variations, crop losses, floods and other events etc. are still not available on a large scale

5. Hence, we recommend that the definition of microfinance be applied at a functional level, rather than at the entity level. This would imply that entities providing microfinance would be required to create separate business units, tailor internal policies to provide efficient service delivery and at the same time be able to leverage internal financial, technology and process strengths in this regard.

6. Ensuring complete access to finance for every individual and every enterprise in India will require continuous innovations in financial products, delivery channels, and human resource management by a wide array of strong firms competing with each other to do business with the low-income household in a responsible manner. By opening up the sector to multiple institutions will enhance competition and meet the regulator’s objectives

Capital adequacy requirement

7. The committee has not offered any rationale for the Rs. 15 crore minimum capital requirements even for pure non-deposit taking NBFCs despite recommending very conservative loan limits and being aware of the very low default rates that have been observed for this sector in India for over a decade.

8. Such a requirement clearly favours the established large microfinance providers, which making it even more difficult for smaller, locally focused entities to emerge.

The issue of “Qualifying Assets”

9. The Committee has defined a low income household as one with annual household income less than Rs 50,000

10. IFMR Trust’s experience is that though a large number of microfinance clients belong to households with less than Rs. 50,000 annual household income, there are also a very large number of households with higher incomes who can and do benefit from microfinance mechanisms.

a) This happens mainly because of limitations of the credit appraisal methods of traditional financial providers. Many rural and urban low income households cannot access credit through these mechanisms – their assets cannot be easily collateralised; their incomes are hard to estimate; and their past repayment records are not recorded in accessible databases.
b) So, though most poor are financially excluded, many financially excluded households have household incomes exceeding Rs 50,000. Much of urban microfinance caters to such clients. Restricting microfinance to the poor will make the financially excluded non-poor more vulnerable.

11. We believe that it would be detrimental to the interests of a large section of the population to define low income households in the manner as recommended by the Committee. Further, this definition implies that originators (and perhaps their lenders) have the wherewithal to collect information regarding household income, which is unlikely and expensive

12. The Committee has also stated that credit to individual clients be limited to Rs 25,000 per member

13. This is not clear and raises the following questions

a) What are such households to do when their credit needs outstrip Rs 25,000 per individual member?
b) Shouldn’t the committee focus on “regulating the lender” rather than “regulating the household’s debt needs”?
c) Is it not wasteful for such a household to approach multiple lenders, rather than avail of a single “one-stop shop” solution for financial needs?
d) Effect of inflation on household credit requirements are not factored in

14. Given the above negative effects on a household’s credit access, we find it difficult to believe this is the Committee’s intention. We suggest that it is up to the household to determine its own debt needs and requirements, and for the provider to determine the creditworthiness.

15. Given that the objective is to regulate the originators, we suggest the following approach

a) The Committee has opined that multiple loans given to a single household may increase the risk of non-repayment and amplifies systemic risk
b) At the same time, it is the objective of the committee to ensure that the maximum number of households come under the coverage of financial inclusion
c) Therefore, to incentivise organisations to enhance coverage and limit multiple lending to a single household it is proposed that a higher capital charge be levied upon institutions providing the third or further loan to a single household (at the time of providing the loan)

a. Therefore, the first loan to a household could attract a capital charge of 75%, the second loan 100%, the third loan 125% and so on
b. This could be tracked by stipulating the use of biometric authentication, and a credit bureau

16. It is useful to note that the group-based method (followed at present by MFIs as well as SHGs) ensures that each borrower is forced to assess his / her co-borrowers before forming a group. The ability of this methodology to impose credit discipline is well-documented. Even during the current crisis, IFMR Trust has monitored repayment behaviour in over 200 districts across the country outside Andhra Pradesh, where repayment behaviour has been flawless1

Our experience tells us that, contrary to popular belief, low income households are rational and well able to take complex financial decisions. Rather, such households are limited by the quality and depth of the financial instruments that they have access to. This evidence is bolstered by the book “Portfolios of the Poor” and a recent impact study2 conducted in Hyderabad by MIT researchers.

17. The committee seems to be taking a view that it not only needs to regulate the lenders, but also the households’ financial lives. It should focus on regulating the lenders and developing ways to indirectly reduce the risks of over-leveraging and systemic risks. Therefore, credit discipline on lenders through usage of capital charge, is a better risk management tool that will also form an effective check on over-lending, rather than imposing an external limit on the borrowing ability of households.

18. Further, it is incorrect to assume that rural households have no collateral at all to provide for raising debt. Banks are known to have substantial exposure to the agricultural sector that is collateralised through land holdings, household gold and farm equipment

a) We had earlier made the argument favouring using microfinance providers for delivery of multiple services for efficient service delivery at lower cost
b) Though much of microfinance has focused on credit, it should include other services as well. IFMR Trust’s experience with remote rural households across three states (Tamil Nadu, Uttarakhand and Orissa) shows the benefits clients can get from such complete offering, and how such a multi-service approach helps the institutions improve efficiency by leveraging economies of scope, which can be tapped in the context of financial services.
c) Therefore, we submit that organisations should be permitted to offer a complete suite of financial services to low income households viz.

a. Loans – both secured and unsecured. Secured loans that require a high penetration of distribution include crop loans, loans against warehouse receipt, MSME loans etc.
b. Distribution of savings, either through Banks or through mutual funds
c. Distribution of insurance – life, cattle, weather, crop, accident, health etc.
d. Remittances

d) It is necessary that such organisations develop the breadth of knowledge and understanding that is necessary to understand low income household needs and prevent mis-selling. This is something that can be periodically audited by the RBI

Pricing of Loans

19. The Committee feels that “Given the vulnerable nature of the borrowers, it becomes necessary to impose some form of interest rate control to prevent exploitation”

20. Evidence from other countries however shows that pricing caps have historically hurt the poor3 . Pricing caps and margin caps incentivise originators to expand only to easily serviceable geographies and ignore remote areas and lower income clients.

21. Further, the sharp increase in financing costs for MFIs post the AP Ordinance has indicated that originators are not insulated in any manner from high borrowing costs during either (i) a liquidity crunch or (ii) a credit situation / event risk

22. IFMR Trust has, on several occasions, opined that the current interest rates and margins charged by MFIs are high and there is room for reduction. However, at the same time, we believe that competition and transparency should pave the way for reduction of rates rather than impose a hard cap. This is indeed the view RBI has taken on pricing of services offered by banks through business correspondents, allowing banks to decide the price they want to charge, but requiring them to have the pricing approved by the boards, and transparently communicate it to RBI and other stakeholders.

23. Suggestions to this effect include enhancing competition, imposing transparency in pricing (already recommended by the Committee) and monitoring the originators by tracking reduction in interest rates over a period of time

a) Further, originators could be encouraged to augment lending revenues through fee based income achieved through distribution of specially tailored products for low income households, e.g. livestock insurance, low ticket savings and remittances. This would permit originators to reduce costs on lending products
b) Originators that provide other forms of secured products, together with unsecured loans, could also avail of cheaper funding from lenders that could be used to reduce lending rates for the unsecured loans

Purpose / end use of the Loan

24. The Committee believes that microfinance should largely focus on income generating purposes, and has opined that a minimum of 75% of microfinance loans should be for “income generating purposes”

25. This topic needs to be examined from three aspects:

a) What exactly is an “income generating loan”?
b) What are the current purposes for which borrowers are using loans?
c) Loans used for functions that other services usually fulfil

26. What exactly is an income generating loan? Evidence shows that loans are used by low income households for a variety of purposes including:

Trust_Malegam1

It is difficult to opine that households should be restricted from using external financing for any of the above activities, especially when the middle-class and the rich are permitted to borrow for all of the above purposes and have access to funds as well

27. It is clear from studies that low income households have utilised MFI loans for a variety of purposes. Recent evaluation of an MFI’s urban microcredit programme in Hyderabad revealed a variety of uses for the loans:

Trust_Malegam2

While such percentages vary widely across households, it is clear that each household is faced with a specific set of economic, social and risk variables that require a certain course of action. It is counterproductive to impute (or impose) a specific end-use pattern to a household.

28. Loans used for functions that other services usually fulfil: Since most of these households may not have a savings facility, they might be using a short-term loan to “save-down”, instead of “saving-up” as one does using a savings bank account. Some researchers have also posited that microfinance helps because it acts as a disciplining device for people to save, and they can use the discipline of weekly repayments to help bind themselves into putting money aside, which they otherwise would not have been able to do5 . Transformation of small amounts into lump sums is an important function for households6 , and in the absence of other mechanisms (like savings account, recurring deposits), microfinance serves as a mechanism to help make this transformation. These other purposes (consumption smoothing by transforming small amounts of money into lump sum; reducing cash outflows by repaying expensive old debts; etc) can be and often are welfare enhancing

29. Traditionally the low income household is only familiar with credit as a tool for financial needs and have developed coping mechanisms based on access to credit. While other financial products would clearly be useful to such households, they would need time to adapt to such tools.

30. While financing for certain end-use could be encouraged (i.e. through the priority sector guidelines), it is counter-productive to impose end-use restrictions on households when no such restrictions exist on higher income households. It is conceivable that, through disincentives on multiple-lending, originators would take greater care in ascertaining the repayment capability of the household, as well as diversify into products that would be directly linked to business activities, e.g. retailer loans, crop loans, small business loans etc.

31. The view the Committee eventually takes on the manner in which poor women conduct their financial lives and their maturity and sagacity is deeply disturbing. Microfinance plays multiple roles in the lives of low income households including seasonal cash management (so that school fees can be paid even during the seasonal troughs); asset transformation from small savings to larger valued assets (such as higher quality roofs and beds); refinance of high cost loans from money lenders; and as a substitute for good commitment-savings products. This is also acknowledged by the Committee but while making its recommendations it surprisingly reaches an opposite conclusion without citing any research or offering any rationale for overlooking its own earlier observations or suggesting any alternative solutions.

32. These recommendations of the Committee along with those restricting the amounts she can borrow and severely limiting the choice of providers that she can access, constitute an infringement of the rights of the low income household, particularly women, to conduct their own financial affairs as they think best fit. Similar stipulations, if imposed on middle and upper income households would be resisted very strongly, but have been recommended for imposition on poor women without any evidence that they are in any way less rational than high and middle income customers and good evidence that the opposite is actually the case.

Incentives for Orderly Growth

33. The Committee has recommended the creation of a Credit Bureau for ensuring orderly sharing of information. We wholeheartedly support this initiative and believe that fully functional (and competing) credit bureaus are essential for the orderly development of the sector

34. Further, and very critically, the Committee has suggested that a single regulator is necessary and sufficient to monitor microfinance activities. This is extremely important, especially in the context of the AP Ordinance, and will go a long way towards dispelling uncertainty on the legal and regulatory environment

35. We also have a few other suggestions regarding the role that the RBI can play in facilitating orderly growth. These include:

a) Ensuring incentive alignment of stakeholders to enable market-based regulation –

a. Use of the priority sector guidelines
b. Securitisation

b) Ensuring continuity of service
c) Promoting healthy competition amongst originators

36. Incentive alignment

a) The priority sector guidelines can be used very effectively by the RBI in controlling and at the same time incentivising originators and lenders to behave responsibly. The Committee has recommended continuation of priority sector for microfinance advances and we are in support

Some additional steps that could be brought in the priority sector guidelines:

a. Unsecured loans provided to a household could attract a higher priority sector weightage than secured loans (the RBI has already moved a step in this direction by stating that gold loans made for agricultural purposes may no longer be treated as direct or indirect agricultural advances)
b. First and second unsecured loans given to a household could have a higher weightage than subsequent loans – tracked through a credit bureau

b) Securitisation and other capital market transactions: traditionally, originators of financial services to low income households have been far too dependent on bank borrowings (the Committee estimates that 75% of loans to MFIs are from banks)

IFMR Trust has been working closely with high quality originators to assist them in availing capital market financing through securitisations and bond issuances. We strongly feel that the additional transparency imposed by a capital market transaction is very beneficial in incentivising originators to “raise the bar” in MIS, reporting, operational processes and systems, so as to be able to meet the scrutiny of rating agencies and investors

37. Continuity of service: Continuity of service delivery should be seen from the perspective of “who is taking risk on whom”, because based on this the importance of and strategy for ensuring continuity of service delivery will be determined.

Clients taking risk on the institution (Savings, Insurance, Investment, Remittance): For services like savings and insurance, there is a strong case for high level of prudential regulation to prevent failure of institutions, because of the need to protect clients’ savings and insurance. For these services, the regulation should continue on the path of letting prudentially regulated, well-capitalised, well-diversified institutions provide microfinance through agent-led models, like the business correspondent model. To ensure continuity of these services, the continuity of both the principal and the agents is necessary.

The principal institutions (banks, insurance companies, asset management companies, etc) are already governed by detailed prudential norms, which are meant to minimise the risk of failure. For such agent-led models, the regulator should make the principal financial institution (eg. banks appointing the business correspondent) responsible for ensuring continuity of service delivery to the clients, with penalties if an acquired client is not able to access the service continuously for a certain period of time. These principal institutions should then draft their own due diligence and monitoring criteria to ensure this.

At the same time, the model should ensure that every originator (who serves as an agent) has sufficient risk participation to prevent the risk of moral hazard.

Institution taking risk on the clients (Loans): Considering the fact that most of the microfinance providers (except banks) in India do not mobilise public deposits, we believe that the RBI need not take further steps towards regulating such institutions except defining basic prudential norms on institutions that are non-systemically important.

However, we strongly believe that the RBI should focus on ensuring that a microfinance originator’s practices do not have negative externalities for other originators. IFMR Trust’s experience is that maintaining high quality field processes is a must for microfinance. Hence, regulation that is focused on reducing negative externalities will be immensely useful. Some suggestions:

a) Develop an external audit mechanism through third parties: Such third parties auditors could (i) verify through sample checks the quality of origination and reported profiles of customers, (ii) define process standards for processes in origination, collection, risk management etc7 and audit the same, (iii) provide feedback to the institution on their findings, (iv) provide inputs to the lenders of such originators

b) Use differentiated capital charge, as outlined earlier, to prevent multiple lending

Client Protection

38. The Committee has recommended certain steps with regard to client protection including

a) Prevention of coercive collection practices
b) Customer protection code
c) Transparent pricing

39. We are in agreement with the broad line of thinking and offer a few suggestions regarding the same

a) While it is fair to state that borrowers of group-based lending are not to be visited for non repayment at their residence, the same is not true for borrowers of individual loans / business loans / crop loans etc. The RBI should make a distinction between loans where group liability serves as a cushion against individual default, and individual unsecured loans

b) Where security is available to the originator (property, gold, movable assets), the originator should have clearly defined, board-approved, policies regarding any appropriation, auction and disposal of such assets. Such policies must follow the Fair Practices Code and every such incident of recovery from security must be monitored at the highest level in the originator’s organisation

c) IFMR Trust’s stringent underwriting guidelines stipulate that no originator should use the services of or incentivise third parties to originate and service the loan clients. While it has been observed that originators use group leaders or center leaders for such purposes, this must be completely stopped

d) Transparent pricing to clients must be enforced, displayed in loan agreements, explained during customer interactions etc. The RBI could consider prescribing standard communication components which cover various methods of calculation of interest (Upfront fees, flat rate, reducing balances rate etc.) and also various repayment cycles (Equated, ballooning, variable) to bring them to ‘effective cost to client’ numbers so that clients can make informed decisions

e) Prevent mis-selling: Regulation should prescribe fair origination practices by microfinance providers. Some activities that should be actively discouraged are: compulsory bundling of products, miscommunication about product features and giving wrong advice to clients. Explicit confirmation from the clients that such practices have not been indulged in should be obtained by external process auditors to create pressure towards adherence

f) Mechanism for redressal of grievances: All originators must be required to have in place timely and responsive mechanisms for complaints and problem resolution for their clients. This requires ensuring that clients are able to contact a person who can then address their grievances effectively and in a time-bound manner. Apart from this the regulator must make available mechanisms outside of the institutional framework to address unresolved queries or queries of larger magnitude. The banking ombudsmen with enhanced capacity would be best placed to perform this function without conflict of interest

g) Privacy of client data: The privacy of individual client data must be respected in accordance with the existing laws and regulations, and such data cannot be used for other purposes without the permission of the client. Explicit regulations around when and how information sharing is possible should be notified. Severe implications must be notified to ensure that originators do not overstep on this requirement

IFMR Trust believes, and has learnt through experience, that small, local financial institutions are best placed to understand the financial needs of low income households and deliver financial services to their doorstep. It is critical to avoid a situation where regulation favours large players over smaller ones. Several provisions of the Committee’s report that may have this unintended consequence are:

➢    Interest rate/Margin cap
➢    Allowing only 2 lenders per household
➢    Minimum networth

These recommendations favour the largest existing originators, are likely to drive smaller MFIs out of businesses, and create entry barriers for any new players. The larger originators benefit from economies of scale and will be more easily able to comply with the increased capital requirements.  They will be more easily able to build the infrastructure recommended and move faster into the market place where they could corner the maximum market share thereby preventing the entry of smaller or newer MFIs in that market.

We strongly feel that such measures will be detrimental to the financially excluded and will not serve the RBI’s motive of financial inclusion. Permitting only larger originators to flourish will imply an oligopolistic situation, lesser product innovation, poor customer service and ultimately choking the household’s credit requirements.

We believe that there is an important role for the regulator to play in making sure that innovation is encouraged among responsible players in a manner that benefits low income households, and we are hopeful that the RBI will agree with our view when it reviews the Malegam Committee’s report.

(1) This observation is based on (a) over twenty field visits conducted in states outside AP, post the AP Ordinance, (b) data from securitized pools in over 200 districts, (c) behavior of borrowers of IFMR Trust’s own retail financial services venture in remote rural areas of Tamil Nadu, Uttarakhand and Orissa
(2) The paper titled “Miracle of microfinance? Evidence from a randomised evaluation” can be found here: http://econ-www.mit.edu/files/4162
(3) CGAP Occasional Paper No. 9. http://www.cgap.org/gm/document-1.9.2703/OP9.pdf
(4)These percentages don’t add up to 100 because some loans were used for multiple purposes.
(5)http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1598959
(6)See page 17 of http://www.portfoliosofthepoor.com/pdf/Chapter1.pdf
(7)IFMR Trust has developed detailed underwriting guidelines for such providers of financial services, including detailed process and system guidelines that such an institution must follow

9
Feb

Technology to the rescue of MFIs

– By Sameer Segal, Founder & CEO, Artoo

[Artoo Slate is a software solution designed for microfinance field staff that takes the entire process of data collection and loan disbursement online. Sameer has been recognized as one of Asia-Pacific’s most promising young social entrepreneurs by the Paragon100 Fellowship. He holds a B Tech from the National Institute of Technology, Karnataka and is a StartingBloc Fellow (MIT Sloan). His passion is inclusive technology, something he discovered during his internship with Ujjivan. He, along with Co-founder of Artoo, Indus Chadha, has developed Artoo Slate which helps microfinance companies cut down on operation costs. He shares with us in this guest blog, how technology can make a difference to microbanking institutions that cater to the bottom of the pyramid.]

The Malegam Report is finally here. At first glance, we were all glad to see how well balanced it appeared. But now we have to begin to make sense of the constraints that it places on MFIs in the short term. In the words of Vijay Mahajan of BASIX: “some provisions are so severe that some MFIs will be facing death by April”.

Indeed, most MFIs must be grappling at the moment with what changes they will need to make to stay alive.

If MFIs need to reduce costs, remove redundancies, and improve efficiencies at all levels, they need to centralize their operations. Centralizing will also help MFIs ensure the quality of the customers they acquire and thereby reduce risks. To centralize operations and still maintain competitive TATs for all customer-centric activities (e.g. customer acquisition, loan disbursement, and repayments) is the hardest part of the puzzle that needs to be cracked. It will be only possible for MFIs to consolidate branches and have their field agents operate over larger geographies (improving borrower to employee ratio) when they can monitor and remotely manage their staff and activities. For that they need technology. 

We believe, however, that this needn’t be a question of the survival of the fittest. It could serve as an opportunity for visionary MFIs, regardless of their size and strength, to re-imagine their operations in a way that, while respecting the RBI’s imminent mandates, dramatically reduces their Operating Expense Ratio (OER) and enables them to remain profitable and survive in the face of the Malegam Report.

At Artoo, we wish to catalyze development through inclusive technology and empowering communication. Our software framework, Artoo Slate, can help MFIs bring down their OERs to meet the RBI’s requirements in a timely manner while enabling them to remain profitable. We believe it has the potential to help MFIs become more productive in helping their customers rise out of poverty. Here’s our take on what the Malegam Report is asking MFIs to do and how we might be able to help.

1

 Artoo Slate is a software solution that takes the entire process of data collection (under 18 minutes for complete customer acquisition process*) and loan disbursement online (70+% of Loan Applications can be processed in the field on the same day*). It will capture rich data from the field, do away with the back and forth of paper, avoid innumerable delays (reduction in turn-around-time (TAT) from 3+ days to 1 hour*), and drastically reduce expenses (courier, Document Management System Hubs & outsourced data entry). It will allow for easy exchange of data between field staff and backend systems (CBS/MIS) in a way that will reduce time spent (41% of center meetings take under 1 min to update paper work) on customer query clarification and identification and resolution of errors in customer profile and loan application forms. Even while the credit bureau is stabilizing, it will enable MFIs to implement a field credit check upfront for renewal loans based on internal data and assessment. 

artoo2 

Our framework enables field agents to operate remotely and helps distributed MFIs to centralize their operations, while improving their TAT for all customer-centric activities. MFIs can monitor their business on a real time basis: pick up on trends (mass default, political/economic turbulence) as and when they happen directly from the field (defaulter information available instantaneously as compared to 10-15 days lag in previous implementation*). In addition, MFIs can track their social performance on a daily basis.

It is an intuitive interface that has been designed keeping in mind field staff’s educational training and exposure to technology. It will also serve as platform through which MFIs can train (e.g. basic English skills, computer skills, updates on new products and offerings) their field staff on-the-go and monitor them on a real time basis to improve their overall service quality. MFIs can improve their field agent quality and build their capacity, reducing their attrition to short-term focused aggressive competitors.

3

Artoo Slate, in the hands of the field agent, promises to be a scalable way for the MFI to engage more effectively with their end customers through videos, graphics, and other interactive media (imparting life skills, financial planning, healthcare information, conversational English, etc.) Engaging with the end customer will not only give them a reason to attend center meetings but also allow them to recognize their MFI as a real partner in their struggle to climb out of poverty, giving forward-thinking MFIs an opportunity to differentiate themselves, improving customer loyalty and therefore profitability.

Application

We have been really lucky to pilot our solution, Artoo Slate, at Ujjivan microfinance, and are happy to share the interim results of our pilot here. The pilot covers a branch in urban Bangalore and includes processes of customer acquisition, collections, branch transactions, and field agent training.

6
Feb

Who should govern NBFCs?

Does the RBI’s claim to regulate NBFC (MFIs) have more merit than Federal state governments’ claims? An analysis of constitutional provisions by Vishnu Peri, IFMR Mezzanine Finance.

A verdict on the Malegam committee report’s efficaciousness is still out. However there is a consensus arising about the benefits of a few suggestions. One of these being, if the recommendations of the Malegam report are accepted, the need for a separate Andhra Pradesh Micro Finance Institutions (Regulation of Money Lending) Act (henceforth the Act) will not survive.

The AP state government has responded to the report in general and this recommendation in particular with dour criticism and expression of support for its legislation. Further the AP government is claiming the protection and empowering cloak of the Indian constitution for the continuance of its Act. Rural development principal secretary R Subrahmanyam was cited in a news report claiming:

“According to the List II of the Constitution, the regulation of money lending is the original jurisdiction of the state government. An Act is the will of the people. Accordingly, whether or not the need for AP MFI (Regulation of Money Lending) Act exists will be decided only by the AP Legislature and not by the RBI”.

Other criticisms were levelled at the report which was submitted to the RBI in a 5 page report, excerpts of which can be found in the public domain. However for the purpose of this article we will focus only on the above statement, whereby state government regulation is given primacy over central regulation.

The constitutional powers debate:

The primary issue in our context is one of jurisdiction. Is regulation by federal units of India valid if a class of institutions are already under the purview of ‘central watchdogs’.

The primary argument utilised by the AP govt deals with the concept of separation of powers which is enshrined by the Indian constitution via Article 246. This article combined with Schedule VII lists the areas which are the exclusive domains of the Centre, the State and common areas of interest.

Under List I which lists central government’s sphere of responsibility the following entries are relevant:

Entry 38: Reserve Bank of India.

Entry 43: Incorporation, regulation and winding up of trading corporations including banking, insurance and financial corporations but not including co-operative societies.

Entry 44: Incorporation, regulation and winding up of corporations, whether trading or not, with objects not confined to one State, but not including universities.

Under List II which lists state government’s sphere of responsibility the following entries are relevant:

Entry 30: Money-lending and money-lenders; relief of agricultural indebtedness.

Entry 32: Incorporation, regulation and winding up of corporations, other than those specified in List I, and universities; incorporated trading, literary, scientific, religious and other societies and associations; co-operative societies.

The Rural development principal secretary R Subrahmanyam is depending on entry 30 List II cited above to derive sustenance for the Act. A preliminary reading of the above entries leads us to see AP government’s Act as a case of constitutional over reach; especially when the act seeks to infringe onto RBI’s turf. The entries and hence the constitution is clear that the state government can only regulate those financial corporations which are not regulated by the central govt. Further the RBI is under the exclusive control of central regulation. Money lending under entry 30 list II cannot be given such a wide interpretation so as to encompass areas under exclusive central regulation and thus defeat the language and spirit of the constitution.

If we assume the above argument to be valid, RBI and its regulatory powers are derived from List I and will be equivalent to central government regulation. Thus in the present context we are dealing with over-regulation of NBFCs’ by state and central laws.

With the insertion of chapter IIIB in the RBI act, it has become compulsory for NBFCs to register with the RBI, which has specified various restrictions in the context of income recognition, asset classification,capital adequacy norm, provisioning requirements and disclosures in the balance sheet.

The objects and reasons for insertion of Chapter-IIIB would assume importance in order to better understand the controversy. The same reads as under:

……..For ensuring more effective supervision and management of the monetary and credit system by the Reserve Bank, it is desirable that the Reserve Bank should be enabled to regulate the conditions ……… The Reserve Bank should also be empowered to give any financial institution or institutions directions in respect of matters, in which the Reserve Bank, as the Central Banking institution of the country, may be interfered from the point of view of control over the credit policy. The Reserve Bank’s powers in relation to commercial Banks should also be enhanced and extended in certain directions, so as to provide for stricter supervision of the operations and working*…….. (emphasis added)

The aforesaid makes it clear that the intention of the Parliament to insert the provisions of Chapter-IIIB inter alia is to control and regulate the conditions for acceptance of deposit and to control the credit policy of Non-Banking Finance Companies and the financial institutions**.The overarching nature of RBI regulation can be seen through section 45Q:

“The provisions of this Chapter shall have effect notwithstanding anything inconsistent therewith contained in any other law for the time being in force or any instrument having effect by virtue of any such law.”

This non-obstante clause overrides provision of any other law for the time being in force. Further, besides section 45Q, section 45JA is important as it allows the RBI to direct all or a class of financial institutions and to formulate policy for the same. This will put the burden on RBI to direct MFI NBFCs as it has the wherewithal and legislative competence for the same; not state governments who have experience of only regulating state corporations and money lenders. The Malegam report supports this notion when it forwards the idea that the State is often not the best agency to act as a regulator and this task is best left to an independent regulator.

The High Courts of Maharashtra and Gujarat have upheld the primacy of RBI over state regulation on these same grounds, in the cases of Vijay P vs. State of Maharashtra*** and Sundaram Finance vs. State of Gujarat****.

The Malegam report records that ideally there should not be any overlap of regulation and regulators for the smooth functioning of financial services. The above points buttress this argument and show that legally speaking there cannot be any overlap and the NBFCs must either be governed by List I or II. __________________________________________________________________________________________

*(2010)51GLR1529

**Ibid.

***(2005) 128 Comp Cas 196 (Bom)

****(2010)51GLR1529

27
Jan

Protection versus service – The RBI should rethink its entire model of regulation

By Ashok V. Desai

[The author is an independent columnist. This article is a reproduction of his column from The Telegraph]

The Reserve Bank of India is an exceptionally clean and efficient organization. It discourages contact between its staff and outsiders in the belief that personal contacts are an essential component of corruption. That could make it unfriendly to outsiders. But it promises quick response to letters, and almost invariably gives it. It minimizes discretion by making clear rules. Its rulebook runs into thousands of pages; but the result is that everyone knows or can find out rules, and everyone gets equal treatment. In brief, the RBI is an admirable institution; if the Central and state governments ran half as well as it, Indian lives would be much improved.

But, as can happen with rule-bound institutions, it is extremely compartmentalized; it does not see the interconnections between the various areas it oversees. And it has strong preconceptions. In particular, it dogmatically protects the interests of banks, and of government banks in particular, and is consequently biased against change and innovation. How much damage this blinkered approach can do is illustrated by the report prepared for its directors by a sub-committee to study issues and concerns in the microfinancial institutions sector.

To begin with, the committee’s terms of reference were so narrowly defined that it considered only MFIs and defined them as only lending institutions; it consequently ignores the larger purpose, which is to extend financial services to the villages and the poor. Contrast this with the Raghuram Rajan Committee of the Planning Commission, which is never mentioned by the RBI. It said that the poor have three kinds of financial needs: credit, security, and earning from savings.

It would save costs if the needs were fulfilled by the same institutions; for that, financial institutions need to be diversified. The RBI’s model of the institutions as extensions of banks is ill-suited to the needs. There is plenty of evidence of its weakness, for example cooperative credit societies and rural banks.

The Rajan Committee pointed out that microfinance organizations needed to raise money from somewhere. The answer was obvious to the MFI committee: the money would come from the banks. But there is an even more obvious answer that it strenuously avoided: the money can come from their clients. In other words, the MFIs would be much more viable if they could take deposits — if they were banks themselves. And the need is not for a dozen or two; to reach 700 million people in half a million villages, thousands of banks would be needed. The RBI hates this idea, and relates how experiments with small and rural banks have failed. If banks are to be made failure-proof, they must start with huge capital; the RBI would not think of anything less than Rs 300 crore. They would have to have promoters with deep pockets; and since there are not so many of them around, only a handful of new bank licences can be given.

But if the Rajan Committee is right, the fault did not lie with their smallness. Cooperatives failed because they were used only to channel credit from state governments; they came under the control of local politicians who gave themselves loans and forgot to repay. This was, for example, the story of the Maharashtra sugar cooperatives, but it will never be mentioned in any official document because the politicians who ruined the cooperatives were the pillars of the Congress. The record of state-sponsored credit institutions is at least as bad as that of private ones.

The MFI committee wants the MFIs to confine themselves to lending to the deserving poor, and wants to place a ceiling on the interest rates they charge. Both proposals are designed to make MFIs less profitable and therefore more susceptible to failure. Interest rates charged by moneylenders go to very high levels. That is what creates a business opportunity for MFIs. They can charge high rates and still lend more cheaply than moneylenders. But the rates are not high just because moneylenders are crooks and exploit their borrowers. Costs of giving small loans to a large number of borrowers in villages are high; so are the risks. They will affect MFIs as much as they do moneylenders, and MFIs will have to charge high rates if they are to survive and to put something by for expansion. Hence it is a thoroughly bad idea to control their interest rates, or their margins — and it is impossible to control both together, as the committee’s chairman, Yezdi Malegam, a chartered accountant, should know.

More generally, the MFI committee wants to confine MFIs to lending to the deserving poor, and for that purpose, to collect considerable information about their income, their borrowings and so on. One wonders which world the committee is living in. A villager may do some agricultural labour while it is available. She may go and work on some public works if any are going on. She may go to the next town and do some domestic work. The poor find work wherever they can, and travel for it. The MFI committee wants MFIs to pursue the poor and compile a record of how much they are earning, how much they have borrowed and from whom, and so on. It expects the itinerant poor to cooperate with the MFIs and give them all the information from day to day. This is unrealistic; if MFIs keep collecting such detailed information, they will be able to lend to very few.

But then, the MFI committee does not expect them to lend to the poor. It wants every poor person to join a “self-help group”, borrow through it, and repay through it. It wants the MFI to sit in the courtyard of the village council and wait for SHGs to come and transact business; it would prohibit anyone from an MFI to ever go near an individual’s home. It has a closely defined, structured model in view: banks would finance a very small number of MFIs, MFIs would deal only with SHGs, and all SHGs would be attached to and sponsored by the establishment of the village. This would be very convenient for the RBI; it would simply reproduce its current model of bank regulation and extend it to villages.

It seems to me that the Malegam report has been designed to enable the RBI to keep close control of rural credit and to keep its hands clean. It is simply not concerned with creating competition, bringing down the costs of financial services, or taking to villages the variety of financial services that townsmen are used to or with encouraging innovation. As I have said, I have a high opinion of the RBI’s competence. I also think that the government has created too many financial regulators, chiefly to create jobs for its favourite bureaucrats, and that we could do with fewer. But it could not make a bigger mistake than allow the RBI to regulate MFIs; that would be the way to deal rural financial development a death blow. In fact, the RBI’s recent attitudes make me wonder if it has lost the plot. Maybe it should rethink its entire model of regulation.