Team Reference Number: GIMRM022 Topic: Regulatory Framework for MFIs in rural India

Introduction
Microfinance services can be defined as providing financial assistance to an individual or an eligible client, either directly or through a group mechanism for:

i. an amount, not exceeding rupees fifty thousand in aggregate per individual, for small and tiny enterprise, agriculture, allied activities (including for consumption purposes of such individual) or ii. an amount not exceeding rupees one lakh fifty thousand in aggregate per individual for housing purposes, or iii. such other amounts, for any of the purposes mentioned at items (i) and (ii) above or other purposes, as may be prescribed.

Further, MFI can be defined as an organization or association of individuals including the following if it is established for the purpose of carrying on the business of extending microfinance services:

i. a society registered under the Societies Registration Act, 1860, 88 ii. a trust created under the Indian Trust Act, 1880 or public trust registered under any State enactment governing trust or public, religious or charitable purposes, iii. a cooperative society / mutual benefit society / mutually aided society registered under any State enactment relating to such societies or any multistate cooperative society registered under the Multi State Cooperative Societies Act, 2002 but not including:   a cooperative bank as defined in clause (cci) of section 5 of the Banking Regulation Act, 1949 or a cooperative society engaged in agricultural operations or industrial activity or purchase or sale of any goods and services.

MFIs are uniquely positioned to facilitate financial inclusion and provide financial services to a clientele poorer and more vulnerable than the traditional bank clientele. MF in India is synonymous with microcredit this is because savings, thrift and micro insurance constitute a miniscule segment of the

MF space. It is however that around 12o million households in India continue to face financial exclusion which translates into a credit demand of around Rs 1.2 trillion.

MFIs are the main players in the MF space in India, their primary product being microcredit. Other players that extend microfinance services in addition to their core businesses include banks and insurance companies, agricultural and dairy cooperators, corporate organizations such as fertilizer companies and handloom houses, and the postal network. Additionally, there are specialized lenders called apex MFIs that provide both loans and capacity building support to support MFIs. The apex MFIs of India includes National Bank for Agriculture and Rural Development (NABARD), Small Industries Development Bank of India (SIDBI), Rashtriya Mahila Kosh and Friends of Women s World Banking.

With respect to legal structure, MFIs may be classified as follows:

Not-for-profit MFIs o o Socities (such as Rashtriya Seva Samithi, Bandhan and Gram Utthan) Public trusts (such as Shri Kshetra Dharmasthala Rural Development Project and Community Development Centre) o Non-profit companies (such as Indian Assosiation for Savings and Credit and Cashpor Micro Credit)

Mutual benefit MFIs o Co-operatives registered under State or National Acts (such as Pustikar Laghu Vyaparik Pratisthan Bachat and Sakh Sahkari Samiti Limited) o Mutually-aided co-operative socities (MACS; such as Sewa Mutually Aided Cooperative Thrift Socities Federation Limited)

For-profit MFIs o Non-banking financial companies (NBFCs; such as Share Microfin Limited, SKS Microfinance Limited and Spandana Sphoorthy Financials Limited) o o Producer companies(such as Sri Vijaya Visakha Milk Producers Co Limited) Local area banks (such as Krishna Bhima Samruddhi Local Area Bank)

MFIs would like to provide financial services to low-income clients with the objectives of providing financial services to large numbers of low-income clients, and ensuring long-term sustainability. Though many innovative initiatives have been undertaken by Indian MFIs over the past five to seven years, their efficacy has been limited and their operations hamstrung by the absence of a supportive regulatory environment. The problems of these MFIs are manifold. While societies and trusts provide an initial

breakthrough to start microfinance operations these structures are not appropriate for supporting the scaling-up of operations. MACS and producer companies may offer better options, but their lack of professional governance structures raises serious doubts in the minds of investors. Mobilising equity support for such institutions is also a problem. These factors hamper the scaling-up of operations as these entities would find it hard to mobilise the substantial volumes of funds required for expansion. NBFCs and cooperative banks have also been facing certain issues RBI has been extremely reluctant to provide fresh licenses to cooperative banks and registration to new NBFCs for one reason or the other, compounding the problem of raising the substantial capital requirement of Rs. 2 Crore. However, the RBI has recently shown some willingness to provide registration to NBFC established by MFIs. A summary of the issues affecting the choice of institutional form by MFIs is contained in the Table below.

Source: Sa-Dhan The Association of Community Development Finance Institutions

Recent Initiatives in the Field of Microfinance Regulation

A number of recent initiatives have dealt with the issue of microfinance regulation Below, some of the most important initiatives are briefly summarized: 1. The NABARD Task Force In the late 1990s, it was felt that a suitable national policy framework was essential for the orderly development of the microfinance sector in the country. Various critical issues such as ways to scale up microfinance programmes in India, the division of roles between existing mainstream financial institutions, development banks and newly emerging microfinance institutions (MFIs) and the need for an appropriate policy and regulatory framework for their operations were engaging the attention of microfinance practitioners, the Government and the RBI. It was at this juncture that in November 1998 a high-powered Task Force on Supportive Policy and Regulatory Framework for Microfinance (henceforth referred to as the Task Force) was set up by NABARD at the instance of RBI. The Task Force comprised senior officials from GoI, RBI, NABARD, banks and chief executives of prominent NGOs implementing various microfinance models in the country. The objectives of the Task Force were, among others, to come up with suggestions for a regulatory framework that brings the operations of the MFIs into the mainstream, to assess the possible role of self-regulatory organisations and to explore the need for a separate legal framework for microfinance. The Task Force (1999) made various recommendations, based on which RBI issued a number of important instructions to microfinance practitioners. With regard to the hitherto unregulated microfinance NGO sector, setting up a system of self-regulatory organisations (SROs) features prominently among the recommendations. The Task Force recommends a classification of MFIs according to the question of whether deposit facilities are offered or not and if so, what kind of facilities these are. The strong reliance on self-regulation even for NGOs mobilising deposits from the public does not go in line with more recent recommendations from other international experts, who stress the enforcement problems of a self-regulatory framework and the potential conflicts of interest of the SROs. 2. Other Working Groups on Regulatory Issues Following a meeting at the Prime Minister s Office in October 2001, seven working groups comprising government, NGOs and banking sector representatives were set up, one of them with the mandate of

exploring the legal and regulatory challenges currently faced by the microfinance sector in India. One of these groups provided clear recommendations regarding how to make the current legal framework more microfinance-friendly. Some of these need immediate attention; some are for the longer term. Major recommendations of these informal working groups are to create a separate category of nondeposit taking NBFCs with a lower capital requirement of Rs. 2.5 million (US$ 56,000), and to require NGOs and federations of SHGs either to wind up their savings business and transform into Section 25 companies or to transform into NBFCs or MACS. 3. Recent Regulatory Amendments for Microfinance Due to the increased attention to regulatory issues for microfinance, several legal and regulatory changes were initiated over the recent years. The most important changes are a number of instructions issued by the RBI, which for the first time specifically deal with microfinance.

4.

Mainstreaming of SHG-Bank Linkage Model

A Working Group on NGOs and SHGs set up by RBI in 1995 looked into various aspects of the linkage between informal SHGs and banks. According to the model, formal banks lend either directly or through an intermediary such as an NGO or an SHG federation to groups of poor people, mostly women. Based on the recommendations of the Working Group, RBI in 1996 issued instructions to the banks to treat the SHG-bank linkage model as part of their mainstream lending. Over the years the linkage program has made very good progress.

5.

Allowing More Flexibility for Banks Offering Microfinance Services

th

In a circular letter to the banks dated 18 February 2000, RBI recognized the definition of microfinance as proposed by the Task Force. The central bank advised that for mainstreaming microfinance and to enhance the outreach of microfinance service providers, banks are free to choose their own model for extending microcredit. Further, microcredit extended by banks to individual borrowers directly or through any intermediary would be taken as part of their priority sector lending.

A Self-Regulatory System for MFIs Has Not Found Sufficient Support

There were some initiatives from the microfinance sector to build a consensus among the industry and to advocate for putting in place a broad-based system for regulation of the microfinance sector and, more particularly, the MFIs in the country. In the recommendations of the informal group set up by RBI, SROs do not figure at all.

The Way Forward

The question on how to regulate microfinance institutions (MFIs) continued to vex the Reserve Bank of India (RBI), NABARD and the finance ministry. They were not satisfied with the previous options before them, namely, regulating MFIs' conduct through interest rate caps, priority sector lending norms, NBFC norms or the draft microfinance bill. Earlier this year, RBI issued regulations to govern MFIs operating as NBFCs. The new rules capped the interest rate MFIs can charge at 26% and made a minimum 2 year tenure mandatory for all loans above Rs 15,000. The Micro Finance Institutions (Development and Regulation) Bill, 2011 (Bill) is the most timely initiative of the GOI -MOF and will be meeting the long outstanding demand of MFIs and practitioners for a formal statutory framework for its financial activities. The government recently released the draft of the new bill which if approved in its entirety will have a far reaching impact on this sector. The regulations of this bill have been drafted in line with the recommendations of Malegam Committee but go well beyond that to provide comfort to the sector. The Bill gives more powers to the RBI to regulate micro-lenders. It includes all forms of microfinance institutions, providing a comprehensive legislation for the sector. The new regulation includes:
y

The Reserve Bank of India is the sole regulator for all microfinance institutions, with power to

regulate interest rate caps, margin caps, and prudential norms. All institutions must register with RBI.
y

Formation of a Micro Finance Development Council, which will advise the central government

on a variety of issues relating to microfinance

y y

Formation of State Advisory Councils to oversee microfinance at state level Creation of Micro Finance Development Fund for investment, training, capacity building, or

other expenditures as determined by RBI

The draft Bill also proposes the setting up of a Microfinance Development Council, which will advise the government on policies and programmes required for the development of the sector. The members of the council will represent the industry, the government, RBI, the National Housing Bank, the National Bank for Agriculture and Rural Development (Nabard) and the Small Industries Development Bank of India. The council will also look into establishing credit information bureaus for the creation of a database of clients who avail of microfinance services from various agencies. The draft legislation proposes to establish state advisory councils for close coordination between the states and the Centre with regard to the working of the industry. The Bill also envisages a Microfinance Development Fund to be constituted by RBI to provide loans, refinance, grants, seed capital or any other financial assistance to any MFI and to which all government grants received and fees payable for this sector will go. The Bill will also empower RBI to ask MFIs to cease their activities if warranted upon inspection of the accounts. It will also be able to cancel registration granted to the MFI. It also gives RBI the option of delegating its powers to Nabard in respect of any MFI or class of MFI. The earlier draft of the Bill had envisaged Nabard as the regulator for smaller MFIs, a move that was opposed by RBI.

Impact of The Micro Finance Institutions (Development and Regulations) Bill 2011
The industry welcomed the draft saying it offers more clarity to the future of India s 20,000 Crore microlending sector. The designation of RBI as the sole regulator is a huge step forward for the sector. Though the specifics of regulation are yet to be determined, having one respected regulatory who is acknowledged as in charge of all aspects of the sector should lead to a great reduction of regulatory uncertainty if the bill is passed. Some of the possible impacts of the Bill are discussed below: The grievance redressal procedures, mandatory enrollment to credit bureaus and code of conduct enforcement through industry associations will improve customer protection. y The creation of national and state councils should provide wider sector participation in policy making.

The proposed microfinance fund that would not only provide grants but also bulk finance to MFIs is a very welcome proposition.

The refinance facility (whether offered by RBI or arranged through financial institutions) would be a significant step forward for the resource starved sector.

The bill has chosen to implement margin caps rather than interest rate cap which are supposed to be anti-market and introduce rigidities in the system.

Recommendations and Conclusion

The setting up of a strong advisory council at the national level, as proposed in the bill, is a welcome step. However, the council should be vested with a role in regulation and supervision. It should be asked to consider periodic reports prepared by the regulator on the state of practice in the sector and compliance with regulation by the institutions. In addition to other functions described in the bill, the council could perform the functions that Board of Supervision performs in respect of banks. The State councils are a good way of involving the state governments. But the councils should be linked to the national council and given a role with content rather than just creating them. The tough task of ensuring depositor protection still remains unexplained. The bill could have gone a step further and mandated coverage of MFI mobilized thrift under deposit insurance as is the case in some other countries. The strong customer protection content reflects a significant change in stance on part of the government that even borrowers are entitled to protection. The actual measures indicated in the

proposed legislation mostly take in to account potential abuses in pricing, competition, and irresponsibility on the part of lender. The bill requires implementation and enforcement in some cases. The regulatory capacity has to be ramped up and the small and medium MFIs capacity to comply with regulation would also need to be beefed up. The bill is an important first step; several more steps in translating the bill to action are required before we reach a stage that restores the vitality of the sector.

Annexures

Trend in Operational Self Sufficiency (based on legal structure)

References
Emerging Scenarios for Microfinance Regulation in India, B R Bhattacharjee & Stefan Staschen Existing Legal and Regulatory Framework for the Microfinance Institutions in India: Challenges and Implications, compiled by Sa-Dhan Microfinance Resource Centre www.nabard.org http://www.crisil.com/pdf/ratings/CRISIL-ratings_india-top-50-mfis.pdf http://indiamicrofinance.com/microfinance-institutions-development-regulation-bill-2011draft.html http://articles.economictimes.indiatimes.com/2011-07-07/news/29747758_1_mfis-coerciverecovery-finance-institutions