Microfinance in India

On May 2, Reserve Bank will announce its annual credit and monetary policy which will include the changes to be implemented in the microfinance industry in the country. This is expected to enable the industry to come out of the turmoil it is facing on two fronts – sourcing of funds and questions over their own lending activities and practices. When India gained independence in 1947, most of India’s banking sector was nationalized with the focus of inclusive growth. As part of this policy, regional rural banks were set up in the 1970s to promote inclusion while the 1980s saw the emergence of the Self Help Group (SHG) – bank relationships for rural financing and empowerment. NABARD along with the priority sector lending policies enabled the growth of SHG lending. With the economic liberalization in the 1990s, a new breed of organizations emerged – Microfinance Institutions, which originated initially as non-profit but later transformed into for-profit NBFCs came into the arena through increased private sector participation. By 2010, the SHG-Bank linkage model accounted for 58% of loans outstanding. Most of the bigger MFIs are operating as NBFCs and account for 34% of the outstanding loans. These NBFCs are growing at an annual rate of 80% and reaching 27 million borrowers. The balance 8% of loans is extended by trusts and societies. The MFIs are not allowed to take deposits and hence the financing happens through the banks lending to the MFIs, buying their loan books through securitization deals or borrowing from the market. So microfinance institutions mainly rely on funds from banks to disburse microcredit to needy borrowers. While the bigger and more reputed MFIs have been able to raise a major part of their funds from the market, many others depend on institutional bank funds which are refinanced by NABARD. Banks also have to meet their priority sector lending requirements and the way they generally did that was through purchase of MFI loans. Since the MFIs are better in performing the due diligence at the ground level, many a times, the safer option for the banks is to purchase the MFI loans to meet their PSL needs. So when a crisis broke out in Andhra Pradesh leading the Reserve Bank of India to establish the Malegam Committee to study the state of MFIs in the country, most of the microfinance funding was put on hold, forcing the players to look at other options including restructuring. This has put immense pressure on the MFIs as well as for the banks. Most of the microfinance activities came under the purview of the state government and did not have the regulatory clarity of being under the control of the central banks. While NBFCs were already regulated by RBI, the NBFCs in microfinance have to be considered separately as they cater to a vulnerable section of the society and are an important tool of financial inclusion. Also, they compete with the SHG-Bank linkage model and hence the decisions made by the NBFCs have impact on the SHG-Bank model as well. Also, the interest rates charged were unjustified in many cases and there was lack of transparency in the rates charged. Other practices like multiple lending to the same borrower leading to over-borrowing, taking deposits, ghost borrowers, coercive recovery mechanisms were rampant. With the new rules, there will be a centralised regulatory rule and microfinance will come under the purview of Reserve Bank of India. This clarity will enable the future growth of the industry but in a manner protecting the end borrowers. With the recent controversy, the certainties in funding had been lost but with the committee report being put into implementation, the MFI lending will mostly retain its PSL status thereby guaranteeing funding certainty. The Committee advises for the creation of a separate category of non-banking financial companies (NBFC-MFIs) for the MFI sector. This will empower the central bank to bring in some restraint to the unwanted aspects of competition in the industry. The small loans now cannot exceed Rs. 25000 and most importantly, the interest charged should not exceed 24% for individual loans. These, along with other suggestions, will improve transparency in micro-lending and reduce issues related to over-borrowing. While there will be some constraints arising out of these regulations for the participants in the short run, these changes will align microfinance more along the lines of the financial inclusion strategy that has been envisaged for India.