Local level supervision is critical to ensure consumer protection in microfinance

Self-regulation in the microfinance business has not worked for various reasons. Most importantly, it involves the distribution of small sums, almost totally in cash, to people who are vulnerable, and in areas so widely spread out that it is quite impossible to ensure fairness on a day-to-day basis

Just after the microfinance crisis of 2005-06 in Krishna district of Andhra Pradesh, when around 50 branches belonging to two of the then largest microfinance institutions (MFIs) were shut down by the state administration, I heard several microfinance industry stalwarts arguing that a code of conduct, together with competition, would ensure protection of low-income consumers. However, as the events of the last few years have shown, that has sadly not happened and there have been serious violations with regard to the rights of microfinance consumers.

Two aspects are noteworthy here: (1) Neither has competition between many MFIs been able to fully address consumer protection issues on their own, and (2) nor have codes of conduct for responsible lending (often cited as a substitute for regulation) been able to improve the business practices of many MFIs.

One, as far as I have seen, in many places in India (Andhra Pradesh included) competition has merely ensured that some MFIs repeatedly provided a rather limited group of consumers with a flood of standardised loansi resulting in over-lending, multiple-lending, etc. Further, practices surrounding the delivery/distribution of these financial services, including access to transparent information, have always been under question. Therefore, much more than competition is required to ensure efficient and fair markets, especially with regard to delivery of microfinance services to low-income people. This is because MFIs are indeed selling the most attractive product (money) on the face of this planet to a large set of vulnerable people, who are struggling even for their day-to-day survival.

Two, in the Indian microfinance sector, self-regulation, through such voluntary codes of conduct, has not worked because of several reasons: (a) The institutional capacities of industry associations (MFIN or Sa-Dhan) have often been limited. (b) Microfinance markets are highly concentrated and dominated by a small number of large MFIs, as a result of which conflicts of interest are also very high. (c) The legal framework for microfinance services is underdeveloped and perhaps even flawed, as it does not take into account the special nature of microfinance. And, (d) the available laws and regulations (like the Reserve Bank of India's code of conduct for NBFCs) are not enforced due to lack of sufficient (local level) supervision and oversight.

In fact, when the Sa-Dhan code of conduct was introduced in 2006-07, I had a very open mind and felt that it may act as a useful first step, particularly if the regulator (or supervisor) oversaw the implementation of this code and reported on its ground level effectiveness. However, that did not happen and it is clear that mere paper codes are not sufficient to improve business practices and the operational model of MFIs. If only the Sa-Dhan code of 2006-07, or MFIN code of 2009-10 had been implemented on the ground, then, we would not have had the 2010 (and ongoing) microfinance crisis at all.

Hence, it is imperative for the Government to consider introducing special consumer protection provisions (in its regulatory architecture) for microfinance and this must be backed by appropriate (local level) supervision so that the relevant laws and provisions are actually enforced on the ground. I was naïve to think that good central level regulation and supervision (either through the RBI or any other body designated by the Ministry of Finance) would alone be enough to ensure responsible microfinance business. However, based on the lessons from the 2010 crisis, I am now fully convinced that local level supervision is a must to ensure client protection in real time.

Let us try and understand the nature of microfinanceii and the kind of financial assets that it creates. Microfinance loan assets have several peculiarities that need to be carefully considered while devising regulation and supervisory arrangements, especially related to consumer protection-irrespective of whether MFIs (different legal forms) or business correspondents (various types of legal entities) are involved in the last mile financial intermediation. There are four major peculiarities:
> Microfinance loan assets tend to be predominantly small in amounts, but large in number.
> While the transactions are also small, they are, however, numerous (repetitive) and most often, predominantly cash oriented; this makes it difficult to trace the source as well as end use.
> The geographic diversity is huge and these assets tend to be spread over large tracts of remote rural areas and/or thickly populated urban slums which make it rather difficult to physically locate them.
> While many of the lenders ask for KYC documentation, it must be noted that what is provided is far from accurate. Therefore, it is very easy to show the same assets for different lenders and re-deploy the (surplus) funds in other activities, especially given the fact that different people can have the same names and initials in remote villages, whose names can also have been duplicated.{break}
All of these make supervision of micro-finance rather difficult as even establishing the identity of the micro-finance borrower and, hence, the loan asset is rather difficult. This is a very critical issue to be noted. Therefore, unless and until the supervisor has the presence and clout, especially at the local point of sale and collection, which all state governments have, it would be next to impossible to identify the real microfinance clients on the ground and provide them the necessary protection. Make no mistake about this.

Given this scenario, I am fully convinced that neither the RBI nor any other body (with peripheral presence in the states) can provide real protection to low-income microfinance consumers. Without any doubt, given the above physical and other special characteristics of microfinance, it is clear that only the state governments have the wherewithal to supervise microfinance locally and ensure protection on the ground in real time.

That said, let us hereafter try and look at who should supervise microfinance from the perspective of what any consumer protection legislation should do on the ground?

I think that all of us would agree that the focus of any consumer protection legislation must be on the relationship and interaction between a low-income customer and MFI/equivalent delivering various financial services. In broad terms, it must ensure that vulnerable (low-income) clients are not exploited and/or treated unfairly. Again, this calls for close monitoring of the MFI-client relationship and this again can be done only locally, either in the villages or urban slums. Again, this is an aspect that neither the RBI nor any other equivalent body will be able to accomplish effectively. This again is something that only the state governments can possibly do.

The case for state governments to supervise consumer protection in microfinance becomes even stronger when one considers the substantive features of any such consumer protection legislation. To be effective, any consumer protection legislation should ensure that MFIs provide low-income people (consumers) with:

  •  Transparent information - by providing full, plain, adequate and comparable information about the prices, terms and conditions (and inherent risks, if any for the new savings and mutual fund type products) of various microfinance products and services.
  •   Choice of products and services - by ensuring fair, non-fraudulent, non-coercive, legally valid and responsible/reasonable practices in the selling, advertising and marketing of microfinance products and services, and collection of payments, etc.
  •   Appropriate redressal mechanisms - by providing inexpensive and speedy mechanisms to address complaints and resolve disputes in a fair and transparent manner and especially at the local level.
  •  Privacy aspects - by ensuring control over access to personal financial information and its non-use for other (not-so-legal) purposes.

Now this requires local presence, especially at the point of sale and collection. Again, neither the RBI nor any other central institution can monitor this on a day-to-day basis, especially given the scale, remoteness and huge levels of decentralisation prevalent in the Indian microfinance business.

Therefore, the case for having state governments perform the supervisory role, especially with regard to consumer protection aspects, is very strong and cannot be dismissed. Using any other arrangement including regional/state level RBI offices, state level microfinance councils and/or offices of any other central supervisory institution is surely a recipe for disaster. Mark my words, if that were to happen, we will surely be facing a larger microfinance crisis in a few years to come and that is certainly a risk that we simply cannot afford to take.

i Mostly consumption loans and some small production loans
ii As an illustration, I use microfinance loans and the same logic can be derived for other kinds of products. Also, much of Indian microfinance has been really micro-credit.

(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.) 

Nagesh KiniFCA
1 decade ago
Yes, Mr. Arurnachalam is absolutely right in calling for a more effective local level supervision on the MFIs.
They have been doing a great job in accessing and funding the hitherto unpenetrated sector in rural india.
The outreach of the Regulator, the RBI is good enough, needs to be enhanced with a result oriented mechanism set up by their own DBOD and with the ICAI.
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