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.


Malegam Committee recommendations carry the risk of financial exclusion

We appreciate the Malegam Committee’s recommendations to increase the supervisory capacity of the RBI , to make MFI regulation consistent at the national level, to promote good corporate governance, to increase bank lending to MFI’s, and to make available alternative sources of equity.

We are less enthusiastic that the Malegam Committee chose to focus their efforts narrowly on the product design of the JLG loan instead of understanding the way microfinance functions and proposing the proper role of market players in ensuring orderly growth of this sector.

Ensuring complete access to finance for every individual and every enterprise in India will require a flurry of 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.

Efforts to stifle this innovation by the Malegam Committee – no matter how well intentioned – must be reconsidered.

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.

Although we appreciate the positive intention of the Malegam Committee, the report that it issued has numerous sections that will undoubtedly (1) hurt low-income households, (2) protect the largest incumbent MFIs, and that (3) perpetuate the convenient myth that low income households are more irrational than the rest of us.

The following is our perspective with respect to several sections of the report that we believe require additional consideration.

Recommendations that will hurt low income households



Recommendations that will protect the big incumbent MFIs

Many of the recommendations favour the largest existing MFIs, are likely to drive smaller MFIs out of businesses, and create entry barriers for any new players.

The larger MFIs 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.


Recommendations that improperly assume that low income households are more irrational than the rest of us



Malegam Committee Report on microfinance released

The Reserve Bank of India has released on its website the Report of the Sub-Committee of the Central Board of Directors of Reserve Bank of India to Study Issues and Concerns in the MFI Sector.

The Sub-Committee has recommended creation of a separate category of NBFCs operating in the microfinance sector to be designated as NBFC-MFIs. To qualify as a NBFC-MFI, the Sub-Committee has stated that the NBFC should be “a company which provides financial services pre-dominantly to low-income borrowers, with loans of small amounts, for short-terms, on unsecured basis, mainly for income-generating activities, with repayment schedules which are more frequent than those normally stipulated by commercial banks” and which further satisfies the regulations specified in that behalf.

The Sub-Committee has also recommended some additional qualifications for NBFC to be classified as NBFC-MFI. These are:

  1. The NBFC-MFI will hold not less than 90% of its total assets (other than cash and bank balances and money market instruments) in the form of qualifying assets.
  2. There are limits of an annual family income of Rs.50,000 and an individual ceiling on loans to a  single borrower of Rs.25,000
  3. Not less than 75% of the loans given by the MFI should be for income-generating purposes.
  4. There is a restriction on the other services to be provided by the MFI which has to be in accordance with the type of service and the maximum percentage of total income as may be prescribed.

The Sub-Committee has recommended that bank lending to NBFCs which qualify as NBFC-MFIs will be entitled to “priority lending” status. With regard to the interest chargeable to the borrower, the Sub-Committee has recommended an average “margin cap” of 10 per cent for MFIs having a loan portfolio of Rs. 100 crore and of 12 per cent for smaller MFIs and a cap of 24% for interest on individual loans. It has also proposed that, in the interest of transparency, an MFI can levy only three charges, namely, (a) processing fee (b) interest and (c) insurance charge.

The Sub-committee has made a number of recommendations to mitigate the problems of multiple-lending, over borrowing, ghost borrowers and coercive methods of recovery. These include :

  1. A borrower can be a member of only one Self-Help Group (SHG) or a  Joint Liability Group (JLG)
  2. Not more than two MFIs can lend to a single borrower
  3. There should be a minimum period of moratorium between the disbursement of loan and the commencement of recovery
  4. The tenure of the loan must vary with its amount
  5. A Credit Information Bureau has to be established
  6. The primary responsibility for avoidance of coercive methods of recovery must lie with the MFI and its management
  7. The Reserve Bank must prepare a draft Customer Protection Code to be adopted by all MFIs
  8. There must be grievance redressal procedures and establishment of ombudsmen
  9. All MFIs must observe a specified Code of Corporate Governance

For monitoring compliance with regulations, the Sub-Committee has proposed a four-pillar approach with the responsibility being shared by (a) MFI (b) industry associations (c) banks and (d) the Reserve Bank.

While reviewing the proposed Micro Finance (Development and Regulation) Bill 2010, the Sub- Committee has recommended that entities governed by the proposed Act should not be allowed to do business of providing thrift services. It has also suggested that NBFC-MFIs should be exempted from the State Money Lending Acts and also that if the recommendations of the Sub-Committee are accepted, the need for the Andhra Pradesh Micro Finance Institutions (Regulation of Money Lending) Act will not survive.

The Sub-Committee has cautioned that while recognising the need to protect borrowers, it is also necessary to recognise that if the recovery culture is adversely affected and the free flow of funds in the system interrupted, the ultimate sufferers will be the borrowers themselves as the flow of fresh funds to the microfinance sector will inevitably be reduced.


It may be recalled that the Reserve Bank of India in October 2010 set up a Sub-Committee of its Central Board of Directors to study the issues and concerns in microfinance sector, under the Chairmanship of   Shri Y H Malegam, a senior member on the Reserve Bank’s Central Board of Directors. Other members of the Sub-Committee included Shri Kumar Mangalam Birla, Dr. K C Chakrabarty, Deputy Governor, Smt. Shashi Rajagopalan and Prof. U R Rao. Shri V K Sharma, Executive Director, Reserve Bank of India was the Member Secretary to the Sub-Committee.

Download the complete report here.