Short Note on Microfinance Institutions Bill, India

A Amarender Reddy

Unregulated growth of microfinance institutions

Microfinance industry is growing at faster rate in recent years with about 62% per annum in
terms of numbers of borrowers and 88% per annum in terms of credit over the past five
years. India had the world's largest microfinance market by number of borrowers, at 2.56
crore, and ranked fourth in terms of loan portfolio (Rs.20,000 crores) as on March 2010. It
exceeds the number of borrower accounts served by the Regional Rural Banks by as much
as 50% and represents 40% of the total number of micro-borrower accounts (of value less
than Rs 25,000) in the entire Indian financial system. This represents more than 10 % of the
total number of 22 crore families in the country and about 15 % of the 60% of the
population that is thought to be financially excluded (M CRIL, 2010). The microfinance
penetration in India is merely 3.6 per cent, and 60 per cent of the portfolio is concentrated in
the southern states of Andhra Pradesh, Tamil Nadu and Karnataka. The Indian micro
finance industry (MFI) would cross 11 crore borrowers and Rs 135,000 crore in loan
portfolio by 2014 and will require a huge capital inflow both in debt and equity, according
to a latest report by Intellecap (2010). The proposed new Micro Finance Bill (2011) came in
the right time, which suggested a single regulator as it gives more clarity and uniform rules
to all MFIs functioning across states. MFIs provide financial services to poor women and
low income households, who are excluded by formal financial institutions and at the mercy
of the money lenders. They are playing important role in the financial inclusion plan of
government of India. The growth of microfinance is much faster after the entry of private
MFIs, whose role cannot be underplay. There many issues which needs to be addressed
urgently in rural finance which is suffering from over exploitation of rural poor (Reddy
2005; Reddy 2006; Reddy and Malik, 2011; Reddy, 2012)

Keywords: Microfinance, India

Citation: Reddy, A A (2012) Short note on Micro Finance Institutions (MFI) bill, India. Financial
Regulation International. pp. 1-5.

In the past few years, the microfinance sector has witnessed fast unregulated growth.
Initially not-for profit organisations were active in the sector, however after seeing the huge
business and profits in the sector many for-profit organisations started business in this
sector. Many of the not-for profit organizations (NGOs) were switched over to micro-
finance business and taken loans/funds from different sources (including banks,
international donors) to expand microfinance operations for the sole purpose of making
money as business proposition. It is observed that, between 2008 and 2011, loan disbursals
of SKS Microfinance , India's largest and only listed operator, jumped from Rs. 1680 crore
to Rs. 7830 crore (increase of 366%in 3 years). With the entry of commercial MFIs into
microfinance business, one can expect that there will be increased competition and
reduction in margins and interest rates and the benefits of competition would reach to
borrowers in terms of lower interest rates. But in the last few years, the benefits of this
competition were not percolating to the borrower, interest rates were not decreased.
Moreover, potential borrowers were encouraged to take multiple loans without considering
their repaying capacity. During the recovering loans the MFIs used coercive practices which

Electronic copy available at: http://ssrn.com/abstract=1986880

resulted in number of suicides in Andhra Pradesh. With the proliferation of MFIs, the
common complaints against microfinance institutions are (i) high interest rates exceeding
30%, (ii) coercive recovery practices and the aggressive tactics of for-profit MFIs, (iii) over
borrowing, multiple lending (iv) concentration in only few states like Andhra Pradesh and
Maharashtra and complete neglect of other states like Uttar Pradesh, Bihar, Rajasthan and
north eastern states etc where banking density is low and expected profits to MFIs are low.

The Andhra Pradesh MFIs (Regulation of Money Lending) Act, 2010

Many suicide cases were registered in Andhra Pradesh in response to high interest rates, multiple loans
beyond repayment capacity and aggressive loan recovery practices of MFIs. In response to this, Andhra
Pradesh government issued an ordinance on October 15, 2010 with the intention to regulate microfinance
activities in the state. This Ordinance was ratified two months later on December 15, 2010 by the
Andhra Pradesh assembly. The key features of the Bill are: (i) All MFIs should be registered with
the district authority (ii) No person should be a member of more than one SHG (iii) All MFIs shall
make public the rate of interest charged by them on the loans extended (iv) Penalty on the use of
coercive action by the MFIs and (v) Violation of the bill shall be punishable with imprisonment for
a period of 6 months or a fine up to the amount of Rs 10,000, or both.

The demand for a cap on the interest rates charged by the MFIs for the loans extended to the SHGs
was rejected during the ratification. The ordinance has severely curtailed the activities of
microfinance lenders in the state, which had been their largest single market in India. The passage of
the bill hampered the operations of microfinance lenders in the state. Collection rates in Andhra
Pradesh have fallen to 20% from 95% since the ordinance took effect. The stringent rules in AP act
has turned the opinion of the public and, more importantly, funding bodies against MFIs. The
uncertainty in regulatory and political environment towards microfinance institutions has caused
bankers/donors to play safe and not increase their exposure in microfinance.

As a first step toward resolving the jurisdictional breach caused by the AP government’s purported
regulation of NBFCs, the RBI set up the Malegam Committee to study the issue and make
recommendations. In its draft report, the Malegam Committee legitimized MFIs and the private
sector’s involvement in microfinance and called for continued priority sector lending support to
MFIs. Some recommendations include (i) Loan limits. A limit on loans of Rs 25,000 to borrowers
with household income of less than Rs 50,000. (ii) A cap on interest rates and margins (iii)
Provisioning norms: The report recommends much higher provisioning norms than are currently in
place. The RBI accepted the committee recommendations with some modifications. In continuation
of reforming MFI regulation, Government of India comes up with the MFI (Development and
Regulation) bill, 2011 for discussion.

Microfinance Institutions (Development and Regulation) Bill 2011

The area of operations of many major MFI’s has been extended to more than one state. In
such cases, facing different MFI regulations in different states may hinder the MFI
performance. Therefore, keeping the objective of financial inclusion, poverty reduction and
reasonable competitive environment and uniform regulation and clarity, Microfinance
Institutions (Development and Regulation) bill 2011 was put up by the Finance Ministry,
which proposes to override all other laws, including legislations passed by states like
Andhra Pradesh, with an aim to protect the consumers.

The Act empowers all the regulatory powers to Reserve Bank of India to take disciplinary
action and act as on ombudsman for MFIs and overrule all existing state acts. The key feature of
this Bill is that it will bring all microfinance services under one regulator – the Reserve Bank of
India. All microfinance companies must first register with the RBI before they begin operation.
The Bill also directs all MFIs to set up a reserve fund which cannot be used without RBI's
permission. All MFIs will also be required to submit their balance sheets to an RBI approved

Electronic copy available at: http://ssrn.com/abstract=1986880

auditor. The bill has proposed that any entity, other than banks, which provides microfinance
services, would be treated as a micro finance institution (MFI) and come under the RBI's
regulatory oversight. The RBI will have sweeping powers to determine upper limits for margins
besides fixing prudential norms. The Bill also proposes setting up of centre and state level
councils to advise the government on policies for the development of the sector. The central
council will consist of officers from Finance and Rural Development Ministries, the RBI,
SIDBI, NABARD and NHB besides six experts. Draft MFI Bill is materially positive for all
microfinance institutions. The state advisory councils will have representatives from the state
microfinance sector, the RBI and banks. They will advise on lending, recovery methods and
grievance redressal mechanism. If activities of MFIs are found to be hurting the interest of
clients, the regulator can issue 'cease and desist' order and can even cancel the registration.
If the MFI is not satisfied with RBI's actions, then it can appeal to the central government,
which will have the final say. Among other things, the regulator will have a say on how
much loans can be disbursed by the MFIs, the number of borrowers who can avail these
loans and also the areas where they can operate. The RBI can also delegate an inspecting
authority to look into the books of MFIs to NABARD.

Key Issues in the bill

Main competitive advantage of MFI activities lies in their reach and spread among remote
villages, which are unreachable by traditional bank staff. Keeping this in mind, it is doubtful
whether RBI/NABARD will be successful in regulating them with their meagre presence in
rural/remote areas. It is also doubtful, keeping the low cost structure followed by most small
scale MFIs, whether they are able to maintain the accounts/records as prescribed in the bill. It is
general convention that RBI is the regulator for all organised money lenders like banks and
NBFCs. The Money Lenders Act which is covered by Constitution, which is part of state
subject and applies to unorganised sector where money lending is being done. Even though
MFIs are alternatives to banks in financial inclusion objective in rural areas, in terms of loan
disbursal and recovery practices, interest rates and book keeping they are closure to money
lenders with local presence, low cost structure, high penetration to remote areas although with
high interest rates and coercive loan recovery practices.

Even if the RBI becomes the sole regulator of the sector, the fallout of coercive recovery
practices and resulted suicides becomes a subject of state. Some state governments including the
AP state government criticized the act in terms of (i) why the issue of interest rate has been left
untouched. The bill talks about capping margin, when the problem is with the interest rate.
There are MFIs charging about 40% interest but showing just 6% margin over cost. (ii) It is
mentioned in the bill that the MFIs are ‘extended arms of the banks’, many times it may not be
true. MFIs acts as independent for-profit organizations with their own objective of profit
maximization with more emphasis on increasing profit margins with little or no interest in
farmers welfare, financial inclusion, reduction of poverty etc. Consequently, the lending
practices, interest rates, recovery practices of the MFIs are more coercive and different from
banks and (iii) Further MFIs also take funds from different other sources, whose objectives may
not be in line with banks objectives and welfare of the poor.

The bill defined ‘Micro finance services” as one or more of the following services involving
small amounts to individuals or groups: (i) providing micro credit, (ii) collection of thrift,
(iii) remittance of funds, (iv) providing pension or insurance services and (v) any other
services as may be specified. The new draft Bill says microfinance is not money lending
and therefore not under the state governments' jurisdiction. However, the facts indicates that
big microfinance institutions get a larger share of income from interest income from micro-
lending, and more likely share of interest income is increasing for even small microfinance
institutions (M-CRIL, 2010). It may be kept in view that the crisis in AP precisely arose out
of the coercive lending and recovery practices of MFIs, calling for regulation of their
money lending activities. This justifies that the MFIs should be treated as money lenders.

Finally, the draft proposes to allow MFIs to collect the thrift from the poor. Thrift is the
money of the members of the self-help groups, used for internal rotation to meet the
emergency credit needs. It is a good proposition and inculcates and encourages habit of
thrift among rural people at their door step. As until now only banks are allowed to collect
deposits from the ordinary people.

Conclusions and Suggestions

At present the micro finance institution is in a transient phase. With too much proliferation
of profit oriented MFI in the rural market charging high interest rates and exerting coercive
forces for recovery. This has created an uncertainty regarding the functioning of micro finance
institution in the rural credit market. Many MFIs complained that the existing AP MFI Act
(2010) is over empowered local administration, which jeopardized their microfinance
operations. The recovery rate of MFI’s has come down drastically which is even effecting the
functioning of not-for-profit MFI’s which are really making a change in the lives of people by
encouraging them to take up livelihood projects. For Example: It is observed in a case study of
National Institute of Rural Development (NIRD/Hyderabad) that BASIX has been providing
small loans through Joint Liability Groups to the farmers in Parbhani district of Maharashtra to
purchase dairy animals. Besides this, it is also providing veterinary services and marketing
services to the farmers by helping them to organize into dairy cooperative societies. The
livelihood of the people in the area has been improved. While it is very much necessary to
curtail the fraudulent and exploitative functions of MFI’s, it is equally important to nurture and
support the activities of those institutions that are serving the people. The following are some of
the suggestions which may be worth exploring.

1. The birth of developing institutional networks like MFIs is rooted in helping rural
population to get timely and hassle free loans at reasonable rates of interest with minimum
processing/procedures and minimum documentation without collateral security. Under these
situations, recovery of loans is a complex task. The lending and recovery of most of the
MFI’s is through Joint Liability Groups which empowers local women/poor households and
act as vehicles for many developmental activities. The Joint Liability Groups/ Self-Help
Groups should also be responsible for not taking multiple loans from different sources and
also oversee the recovery practices and interest rates of MFIs.

2. Sufficient flexibility to MFIs to design their products in terms of loan amount and
tenure, while retaining measures that protect borrowers.

3. As most of the previous problems with MFI’s came from coercive and unlawful
practices in recovery of loans, major role should be given to state advisory committees
to frame rules and manage grievance redressal mechanism.

4. Accountability and time frame needs to be put in place for any grievance redresses
mechanism.

5. Even though the last word regarding the MFIs may be rest with RBI, there is a need for
delegation of many powers to local administration such as district collector, state level
banking committee and even district level banking committee to be formed to oversee
unlawful MFI operations.

6. The failure of grass root level functioning institutions, in implementation and

 enforcement of law, is a pointer towards failure of governance which demands some
degree of urgency. Panchayat Raj institutions should have a role with checks and
balances in the implementation of the bill.

7. We cannot expect MFIs could cater to the financial needs of ultra-poor, as they don’t
have necessary income sources to repay their loans. Invariably there is a need for public
sector banks and regional rural banks to cater them with subsidized schemes.

8. Part of what got Indian microcredit firms into trouble was borrowers who took out
multiple loans from different sources, with a large chunk of funds used for luxurious
consumption, like buying TV sets or paying for private parties and weddings and unable
to repay at the end. There is a mention of complementarities between the livelihood
projects taken up through microfinance and increase in income of the people in many
studies. Livelihood projects help borrowers to start and maintain an income-generating
activity, such as rickshaw-pulling, street-selling or making jewellery, which greatly
enhances repaying capability of borrowers of microfinance. Limiting the extent of
finance to consumption loans and taking a livelihood approach in the provision of loans
may lead to a win –win situation for both for MFIs as well as that of beneficiary.

References

Intelcap (2010) Indian Microfinance Crisis of 2010: Turf War or a Battle of Intentions?
http://intelcap.com/assets/82/intellecap_Microfinance_White_Paper_Oct_%20%202010_. pdf

M-CRIL (2010) M CRIL Microfinance Review.

Microfinance Institutions (Development and Regulation) Bill 2011

Reddy 2012. Structure of Indebtedness of Households in Semi-Arid Tropics of India | Show Abstract | Download |
Agricultural Economics Research Review, Volume 25, 3, pp. 473-483

Reddy AA 2005. Banking Sector Deregulation and Productivity Change Decomposition of Indian Banks, Finance
India, Vol. 19 (3) , pp. 983-1001, September 2005

Reddy AA and DP Malik 2011. A Review of SHG-Bank Linkage Programme in India, Indian Journal of Industrial
Economics and Development, Vol. 7, No. 2, pp. 1-10, 2011

Reddy AA 2006. Productivity Growth of Regional Rural Banks, Economic and Political Weekly, Vol. 41, No.11,
pp. 1079-1086, March 2006

The Andhra Pradesh MFIs (Regulation of Money Lending) Act, 2010

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