RBI’s proposal for regulation of the Microfinance sector- Explained, pointwise

Introduction

Recently, the Reserve Bank of India has released a Consultative Document on Regulation of Microfinance sector. The document aimed to address the concerns related to the over-indebtedness of microfinance borrowers and empowering them. The document proposes that there should be no prepayment penalty and collateral for all microfinance loans. The introduction of regulation is much needed, as the Microfinance Institutions loan portfolio has reached Rs 2.31 lakh crore at the end of FY2020, touching the lives of 5.89 crore customers.

The microfinance sector has grown rapidly in India over the past few decades. Currently, the microfinance sector is serving around 102 million accounts (This includes banks and small finance banks) of the poor population of India. But still, there are certain inherent challenges associated with the Microfinance sector.

What are Microfinance Institutions?

These are organizations that offer financial services to low-income populations. They provide services such as micro loans(all loans that are below Rs.1 lakh), micro-savings, and microinsurance.

Microfinance Institutions provide small loans to people who do not have any access to banking facilities. Their area of operation includes rural areas and among low-income people in urban areas.

The Non-Banking Financial Company -Micro Finance Institutions (Reserve Bank) Directions, 2011 of the Reserve Bank of India (RBI) is regulating all the Non-Banking Finance Company (NBFC)-MFIs in India

Salient provisions of RBI document on Regulation of Microfinance sector

The suggested framework in the Document is intended to be made applicable to the microfinance loans provided by all entities regulated by the Reserve Bank. After the consultation, the RBI will release the overall guidelines for the regulation of the Microfinance Sector.

1. A common definition of microfinance loans: there is no common definition for microfinance loans available from various microfinance entities in India. The document aims to provide one common definition for all regulated microfinance sector entities.
2. Capping the outflow on account of repayment of loan obligations of a household to a percentage of the household income. Further, borrowers can determine the period of repayments as per their requirements.
3. A Board approved policy for household income assessment.
4. There should be no pre-payment penalty; no collateral requirement, and greater repayment frequency for all microfinance loans.
5. Alignment of pricing guidelines for NBFC-MFIs with guidelines for NBFCs.
6. Introduction of a standard simplified fact sheet on the pricing of microfinance loans. Further, MFIs need to display minimum, maximum and average interest rates charged on microfinance loans on their websites for greater transparency.
7. Aligning pricing guidelines for NBFC-MFIs with guidelines applicable to NBFCs

Need for RBI document on Regulation of Microfinance sector

1. Decade-old rules and regulations: At present, Microfinance Institutions are governed by NBFC-Micro Finance Institutions (Reserve Bank) Directions, 2011. So the new document is much needed to govern the growth and misuse of Microfinance Sectors.
2. Increased share of banks and small finance banks: After 2015 the banks and small finance banks started increasing their operations in Microfinance Sector. At present, only 35% of the Microfinance sector lies with the MFIs, the rest are with banks and small finance banks. This resulted in the following difficulties,
   • The RBI’s 2011 directions did not cover around 70 percent share in the microfinance portfolio.
   • This created a non-level playing field among the Microfinance Sector.
   • The issue of Over-indebtedness and Multiple Lending: small borrowers are able to get multiple loans from several lenders, contributing to their over-indebtedness.

So, for creating a level playing field and cover all the regulated entities (REs) engaged in the microfinance sector, a new regulation is necessary.

Significance of RBI document on Regulation of Microfinance sector

1. Provides a new interest rate regulatory system for MFIs: The regulations provide a more market-based interest system. Further, the transparent pricing mechanism will provide competition among players in the microfinance sector to bring down the interest rates.
2. The centrality of the borrower: Further, the new document places the borrower (i.e Customer) at the center of the microfinance sector. It empowers the borrowers to make an informed decision, the framework.
   • At present, with the rise in competition in the microfinance sector, the interest rates are not getting lower.
   • The document also protects the microfinance borrowers from over-indebtedness (As the document mentions that the payment of interest/loan will not exceed 50% of monthly income)
   • No prepayment penalty: This will aid the borrower(low-income households) and provide greater flexibility in repayment of the loan.
3. Venture into other types of loans: As the consultative document removed the time limit of the loan, the institutions in the microfinance sector now can provide other types of loans. Such as affordable housing loans, loans for renewable energy, sanitation requirements, etc.
4. Provides overall growth of the microfinance sector: With these guidelines, more and more small finance banks and banks can venture into the microfinance sector and provide benefits to a rural and low-income population.
5. Facilitates financial inclusion: The borrower will have a wide variety of institutions to cater to his/her needs specifically. This will help in financial inclusion.

Challenges with the microfinance sector in India

1. Sustainability of MFIs: MFIs generally lack access to capital. Many Microfinance  Institutions are socially-oriented institutions and have little access to financial capital. So, they charge high rates of interest to attain sustainability. This was passed on at higher interest rates from their clients (who are “interest insensitive”).
2. Impact on profits: The SLR and CRR requirements of Microfinance Institutions hampers short-term profits of microfinance sectors. Along with the operating expenses, their profit margin is very less.
3. Impact of COVID-19 pandemic: The pandemic has impacted the microfinance sector more compare to other credit institutions. Their loan collections have taken a hit, and loan disbursals are yet to observe any meaningful growth.

Suggestions to improve the microfinance sector

The consultative document provides holistic reform in the microfinance sector. Along with that, certain measures can be taken to improve the sector further. Such as,

1. Introduction of Digital technologies: Like regular banking, the MFIs also have to embrace complete digital formats for providing loans. This will improve digital literacy also among the public as MFIs focus on the low-income population.
2. Creation of Social Impact Scorecard: The RBI should encourage all the entities in the Microfinance sector to create a Social impact scorecard and to update it regularly. This will be helpful to measure the societal change and also help in framing government policies for the low-income populations based on their specific needs.
3. Creation of authenticated customer data: If the consultative policy turned into policy, then the MFIs cannot charge payment of interest/loan exceeding 50% of monthly income. Since the MFIs function for the low-income population, the field officers might face challenges in calculating the exact income of the household. So, apart from approving the household income, the board should also create an authenticated data of households, by including all revenue sources of low-income populations.
4.  Verification after loan: Many times people will get the loan and use them for commercial purposes like buying mobile phones, paying interest to the moneylender, etc. The MFIs have to verify and update the loan has been properly used for the stated purpose and not for any other purpose.

Conclusion

The RBI’s Consultative Document on Regulation of Microfinance sector alters the complete functioning of the microfinance sector in India. The guidelines provide much-needed reforms and pave the way to recover the microfinance sector from the dreadful Covid-19 pandemic. But along with that, the RBI may introduce other suggestions to ensure the smooth functioning of MFIs.