Microfinance 2.0: to provide a level playing field

The Reserve Bank of India (RBI) released a Consultative Document on the Regulation of Microfinance in June 2021 in an attempt to revamp the regulatory policy for microfinance institutions – essentially non-banking financial companies (NBFC-MFIs) – which had been unchanged for almost a decade. The consultation paper focuses on customer indebtedness and highlights two critical factors that contribute to it. First, the policy of the RBI which regulates microfinance activities of NBFC-MFIs covers only 30% of all microfinance financial institutions in India, meaning that the remaining 70% (banks including small finance banks; non-profits etc.) are not subject to policy restrictions such as loan caps and lender limit norms. Second, lending rates for microcredit remain high despite some NBFC-MFIs and banks having achieved scale and having low expenditure. This blog is an attempt to anlayse the key issues in the consultation paper.

A brief analysis of the RBI’s policy changes

A sweeping change that has been proposed by the consultation paper is to apply a uniform policy regime to all entities regulated by the RBI which undertake microfinance. In other words, the RBI aims to create a level playing field between NBFC-MFIs and other financial entities engaged in microfinance. These proposed changes highlight the RBI’s intention to set NBFC-MFIs free from the exlusive regulatory fetters imposed on them through the regulatory policy in the last decade.

A prima facie review of the paper tells us that the major changes which have been proposed are as follows:

• First, the RBI proposes that the overall permissible indebtedness limit is linked to the repayment capacity of the borrower at a household level i.e. the limit should not exceed 50% of the household income. This applies to a rural household with an income of not more than INR 1.25 Lakh as well as an urban or semi-urban household with an income of not more than INR 2 Lakh. This is a departure from the current policy, which permits a total indebtedness of an absolute value of INR 1.25 Lakh (excluding education and medical expenses), irrespective of the geographical location of a household. For example, under the current regime, a rural household with an income of INR 1.25 Lakh could take on a loan of another INR 1.25 Lakh, whereas under the proposed regime, the same household can take on a loan which is half its income i.e. INR 0.625Lakh. While this change will result in reduced flows of credit to rural borrowers (and all borrowers in general), it will on the other hand, act as a self-regulatory mechanism for regulating indebtedness within the limits of the household income.

• Second, the RBI proposes to do away with the restriction on a borrower being able to borrow from only two lenders. The rationale for the current two lender norm is to prevent customer over-indebtedness and to make tracking of loans easier. However, this purpose is not served as borrowers are able to take loans from multiple lenders in the informal sector. The consultation paper clarifies that the limit is no longer required in light of the total customer indebtedness limit which is applicable for all regulated entities of the RBI, and not just to NBFC-MFIs. This move appears to be in line with the 2013 report by the RBI on small businesses and low-income households, wherein it was recommended that if total indebtedness is being tracked, then the need to impose a limit on lenders becomes less important and can be gradually removed. Moreover, this move may also divert the borrower away from informal lenders.

• Third, the RBI proposes to remove the restriction that 50% of the loan issued by NBFC-MFIs shall be for income generation purposes, along with the removal of the sub-limits and tenure for such loans. The RBI’s rationale for removing the need for specifying a purpose while giving a loan is that in the Indian context, there are many other purposes, other than income generation, for which a microfinance loan may be taken. These purposes include, but are not limited to repaying money lenders, paying for one’s (or one’s family’s) education, paying medical bills, acquiring property, etc. All of these reasons are possibly just as important as income generation and should not disqualify a future borrower from acquiring a loan. Hence, this proposal appears to be a step towards aligning the policy with ground reality that most of the microfinance loans are used for non-business purposes. However, because loans may now be open-ended, they also deviate from the policy’s original purpose of providing microfinance opportunities to women, to uplift them and build their entrepreneurial spirits.

• Fourth, the RBI proposes to do away with the interest rate cap on microfinance loans. Fixing of interest rates for NBFC-MFIs has had the unintended consequence of creating a benchmark for the industry, even if it may have achieved economies of scale with banks having lower cost of funds. The removal of the cap appears to be more of a breather to banks, than to the NBFC-MFIs, who may not have to adhere to a cap on interest rates with the policy being made uniform for all. Further, it will also make the market more competitive and promote innovation, and industry experts predict that interest rates will dip. However, the consultation paper does not recommend an absolute ceiling, even for usurious interest rates. This opens up avenues for abuse as borrowers may be charges disproportionately high interest rates, and only time will tell whether the safeguarding conditions of adhering to the fair practice code and board-approved policy are enough to prevent abuse.

Conclusion

The proposals relating to linking customer indebtedness with income, and removing the lender limit norms as well as interest rate caps may be a step towards making the regulatory policy more borrower-friendly. However, the proposal removing the restriction that 50% of the loan shall be for income generation purposes appears to be counter-intuitive to the very purpose of microfinance loans. The proposals in the consultation paper also indicate RBI’s intent of upholding and acknowledging the relevance of NBFC-MFIs and giving them a level playing field in the financial system. The RBI’s consultation paper touches upon various regulatory aspects, and the draft guidelines which will be released by the RBI in due course of time will be crucial to determine its merits holistically.

About the Authors

Shreya Garg

Shreya is a Senior Resident Fellow, and leads the work at the intersection of law, finance and development at Vidhi. She is currently focusing on independent research work relating to financial inclusion, tech and corporate governance. She has worked on several engaged projects with the International Financial Services Centres Authority, Ministry of Corporate Affairs and the Insolvency and Bankruptcy Board of India. Shreya completed her LLB from National Law University, Jodhpur in 2012 and LLM from Queen Mary, London on a Chevening scholarship in 2019. She also worked with the European Bank for Reconstruction and Development, London in 2019. Prior to joining Vidhi in 2014, she worked as an Associate at Luthra & Luthra Law Offices, New Delhi.