Linking the implementation of norms and safeguards to availability of priority sector lending can minimise the risk of failure while improving the protection of the interests of clients and investors

While we are on the topic of the microfinance bill, I would like to bring up the aspect of incentives which are very crucial in any regulatory/supervisory framework.  Indeed, incentives are very necessary in a nascent industry like microfinance and their impact is likely to be phenomenal, provided they are well structured and appropriately implemented. Accordingly, I suggest some incentives for the proposed microfinance bill and hope that the Reserve Bank of India (RBI), as the regulatory/supervisory authority, would try and implement this on the ground.

For microfinance institutions (MFIs)

Dividend and bonus share issue capⁱ 

The bill and its regulatory framework would have to specify a permanent specified cap on dividends (it could be 10%-15% on shareholder equity and decided through consensus among industry stakeholders) and issue of bonus shares for any MFI that wants to be registered with the proposed authority as per provisions in the bill.

Registration, in turn, will provide such MFIs with access to priority sector loan funds from banks, the complete freedom to act as banking correspondentsⁱⁱ  and immunity from state level usury laws. Additionally, the MFI will be required to meet certain minimum standards with regard to governance, systems (human resources, portfolio management, MIS, finance and accounting, internal audits, internal controls, and so on), client protection/literacy and other aspects as per the suggested framework that have been outlined in an earlier Moneylife article.

It also goes without saying, that the framework will utilise various means (on-site and off-site supervision, etc) to ensure that these non-negotiable minimum standards are indeed met in a dynamically changing microfinance environment, quarter-on-quarter, year-on-year.

Compensation caps

All stakeholders (from senior management, right up to field level staff and directors/board members, if appropriate) at registered MFIs, would have to adhere to compensation caps as per the suggested framework. At any cost, the compensation should not exceed that of similar positions in public/private sector banks, whichever is higher. Further, for salaries/compensation above a certain limit (to be fixed in the suggested framework) and certain key positions (like managing director, CEO, CFO, etc), the registered MFI would have to take necessary approvals from the authority.

Disclosure by promoters/directors/senior management of their personal assets and shareholding in MFI

Promoters, directors and senior management at all registered MFIs would have to provide yearly statements of their assets and liabilities, as also transparently list their and their family/friends' investment in the MFIs. This would be mandatory as part of the suggested framework.

If any MFI does not want to accept the dividend cap, bonus share issue cap, compensation cap and disclosure norms, then they would be free to raise funds from banks and/or other sources at commercial rates to carry on business. In such a case, the loan will not be from a bank's priority sector quota. So, a bank can lend to an MFI at a higher interest rate after factoring in the appropriate risks for the sector. Thus, such MFIs that are not eligible to register under the legal framework offered by the proposed microfinance bill, will not (a) gain access to priority sector funds, (b) be able to act as banking correspondents, and (c) enjoy the benefits and/or immunity provided by this framework against state level usury laws.

For banks

Focus on all kinds of MFIs

Encourage banks to lend to large and small MFIs (with different models) so that overall risk for the banking sector is minimised. Also, no MFI becomes too big to fail. Thus, it will also minimise the material impact on a bank's balance sheet in case a large MFI fails. This is a very important lesson from the present crisis.

Meeting the standards

Loans made to MFIs that have a dividend, bonus share issue and compensation cap in place, that have agreed to certain minimum standards with regard to governance, systems and client protection and provide the mandatory disclosures as per the proposed framework, will come under priority sector targets. That these loans have to be reasonably priced follows naturally. As noted earlier, banks would be free to set a true risk-based price for loans made to MFIs that do not have a dividend, bonus share issue and compensation cap in place, reflecting the level of operational and other risks (including political risks).

If we get these incentives right, here is what I foresee for each of the players.

For banks

•  Their systemic risk would be considerably reduced as their lending would be spread across a much bigger portfolio of MFIs-different types, sizes, scale, etc.
   
• Political risk would also be reduced somewhat-especially for MFIs operating as part of the proposed framework.

For MFIs

•   Some large MFIs may borrow from banks under priority sector lending, while others may not. But that is a choice that each MFI will have to make, based on its vision and mission and the perceived benefit of operating under the proposed framework.
   
•  Large MFIs that do not accept dividend, bonus share issue and compensation caps are likely to become pure play financial institutions. They will be able to give reasonable returns to their investors but they may be more prone to operational and political risks. However, that is something that they may choose to live with.
   
•  Large MFIs who have accepted a dividend, bonus share issue and compensation cap, and who remain pure financial institutions, will start getting surpluses. This can then be ploughed back for the development of the microfinance industry at large. Thus, they will be able to build their reserves and, over a course of time, will be able to offer cross-subsidisation across different kinds of products to clients. For example, an income generating loan at 24% or less, education loan at 8%, etc.
   
•  Socially focused MFIs will now get adequate funding and will become true livelihood finance and support institutions, where credit would be just one of the products on offer. They may also offer additional support like health advisory services. Thus, these organisations will be able to work on poverty reduction as well as financial inclusion and, thereby, contribute meaningfully to the inclusive growth agenda in India.

For clients

•  Their interests will be protected. They will have true choice. If they want only credit they will perhaps get it from a large registered MFI at a relatively lower rate. If they want livelihood support with credit they will get it from a socially focused MFI.
   
•  If they want to increase their loan size slowly, they can approach a socially focused/small MFI. If they want to increase a loan size faster, they can go to larger MFIs.

For investors

•  They will now have wider choices. They can either invest in truly commercial for-profit MFIs or they can invest in and/or support MFIs that have capped dividends, bonus share issue and compensation and those which avail priority sector funding, and can act as banking correspondents.  It would entirely depend on their social and commercial goals.
   
•  Investors who believe that all problems can be solved only commercially, can invest in non-dividend capped MFIs. Investors who believe in the double bottom line can invest in dividend capped MFIs. Donors can support NGO MFIs.

I hope that I have been sufficiently clear in outlining my incentive proposals. I strongly believe that a crisis should never be wasted, but rather converted into a learning opportunity instead. I also believe that microfinance will not die, irrespective of whatever happens now with regard to the on-going crisis. It is my optimism that makes me seek a proper regulatory/supervisory framework, one that can enable MFIs to grow and flower, one that can protect clients and one that can safeguard public and people's money (loans which are public deposits). All three are important and there can be no compromise on that. I hope the powers that be understand this and attempt to help the microfinance industry with such a clear enabling regulatory/supervisory framework as part of the proposed microfinance bill. It is not too late even now.

 ⁱReturn on Assets and Return on Equity caps are possible but there will be workarounds to that by bundling products along with the loan. Thus, the MFIs will be able to show that their revenues are now coming from other income streams. If these caps are in place, then the existing caps on interest rates and margins can be done away with.
  ⁱⁱDividend capped NBFC MFIs, with their primary social orientation, should be allowed to become banking correspondents since there is minimised conflict of interest. Further, they should be encouraged to open savings bank accounts with banks and eventually the loan size to the borrower by the MFI should be linked to the savings of the borrower with the bank (perhaps the supervisory authority can come out with prudential guidelines for ratio of loan to savings). This, in essence, will: (a) Encourage savings for clients; (b) Simplify regulation: One will be able to allow savings to clients without creating deposit taking MFIs in the short and medium term; and (c) Reduce chances of over indebtedness by linking loan size to savings amount.

(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.)