Before allowing MFIs to become banks, the Reserve Bank of India must ensure that these institutions are equipped with adequate due diligence and sound KYC policies and procedures

The idea of microfinance institutions (MFIs) converting to banks is an intrinsically attractive one, and without question those MFIs that meet the requirements set out by the Reserve Bank of India for a banking licence should consider applying for it. This will help carry the sustainable delivery of a wide range of need-based financial services to low-income people across the country, thereby enhancing the cause of financial inclusion.

That said, let us look at what a banking licence would mean for the crisis-ridden MFIs.

First, this will enable them tap public deposits, which are the cheapest source of non-subsidised capital. It will also allow MFIs to offer a wide range of savings-related services to low-income people, for savings is a much-needed financial service which is the first insurance that enables people to cope better with crisis situations and emergencies.

Second, it would reduce considerably the total cost of servicing the last mile (especially in remote rural areas, as many MFIs have branches there) and this may make it possible for many of them to have a lower, but sustainable cost of financial services delivery for low-income people. That would be no mean achievement by any standards!

Well, given these aspects and that the cause of financial inclusion is likely to be enhanced, the Reserve Bank of India (RBI) must seriously look at providing banking licences to MFIs that meet the stipulated criteria. On its part, the RBI must take into account the following characteristics that are peculiar to micro-finance.

•  Microfinance loan assets tend to be predominantly small in amounts, but large in number.
•  While the transactions are small, they are numerous (repetitive) and most often, predominantly cash-oriented, which makes it difficult to trace the source of the funds as well as the end use.
•  The geographic diversity is huge and these assets tend to be spread over remote rural areas and/or urban slums that make it difficult to physically locate. Therefore, establishing the identity of the microfinance borrower and, hence, the loan asset is difficult.
• As a result, the KYC documentation can be far from accurate.

Therefore, establishing the integrity of micro-finance assets becomes important and given the 2010 experience with multiple, ghost and over-lending in Indian microfinance, this is an aspect that needs to be closely considered by the RBI, prior to granting a banking licence to any MFI. Thus, the RBI would need to seriously focus on ensuring implementation of KYC norms in a rigorous manner by all MFIs that desire to transform and become banks.

This would call for:

• Customer acceptance, customer identification and record-keeping standards to be implemented with consistent policies and procedures throughout the MFI, according to standards laid down by the RBI for banking companies.
   
•  Each branch office of an MFI should maintain and transparently monitor information on its accounts and transactions, using a standardised process recognised and approved by the RBI. This local monitoring should be complemented by a robust process of information sharing between the head office and its branches and especially, regarding accounts and activity that may represent heightened risk.

•  MFI internal auditors (reporting independently to the board or audit committee) should verify that appropriate internal controls for KYC are in place and that the MFI is in compliance with the supervisory and regulatory guidance for them to become banking companies. The audit process would have to be according to the minimum standards set by the RBI and it should include not only a review of policies and procedures, but also a review of customer documentation and records, along with sampling of a significant number of random accounts. The role of the auditors is particularly important in the evaluation of adherence to KYC standards on a consolidated basis. The RBI should ensure that appropriate frequency, resources and procedures are established in this regard and that they have full access to any relevant reports and documents prepared through the audit process.

•   Some MFIs do have multiple (related) institutions and many MFIs share clients. Customer due diligence here poses issues that may not be present for a single entity. Thus, the RBI should ensure that there are systems and processes in place to monitor and share information on the identity of customers and account activity of the entire group (with all related institutions) as also other MFIs.

To summarise, while granting banking licences to MFIs is a welcome aspect and must be actively and seriously considered by the RBI, there is a need for the central bank to ensure client-related controls at MFIs which desire to transform into banks accessing public deposits.

These controls would emphasise and ensure that: (a) MFIs know the clients they are dealing with. (b) There is adequate due diligence on new and existing clients. (c) There are sound KYC policies and procedures that go beyond simple record-keeping, with the transforming MFIs having a customer acceptance policy and a tiered client identification programme that involves more extensive due diligence and proactive monitoring across headquarters and branches. Without this client-level due diligence, transforming MFIs could become subject to reputational, operational, legal and political and concentration risks, which could result in significant financial cost for the financial sector. The lessons from the 2010 Andhra Pradesh microfinance crisis should not be forgotten.

Therefore, it is imperative that the RBI closely examine the KYC procedures in place at MFIs, draw up (appropriate) standards applicable to all MFIs that desire to transform into banks, and most importantly, handhold and build the capacity of MFIs which desire to transform into microfinance banks.

Without question, the time has finally arrived for microfinance banks in the country, and the RBI needs to put in place a rigorous enabling transformation programme that will facilitate MFIs to become real torchbearers of financial inclusion, through the delivery of a wide range of need-based financial services to low-income people in India.

(The writer has over two decades of grassroots and institutional experience in rural finance, MSME development, agriculture and rural livelihood systems, rural/urban development and urban poverty alleviation/governance. He has worked extensively in Asia, Africa, North America and Europe with a wide range of stakeholders, from the private sector and academia to governments).