Last month the Reserve Bank of India (RBI) released a consultative document on regulation of microfinance, aimed at harmonising MFI rules across various classes of microfinance lenders i.e. for banks, small finance banks (SFBs), and non-banking finance company - microfinance institutions (NBFC-MFIs). The RBI has been trying to regulate the microfinance sector and the recent move is one more step ahead in that direction. However, there may be challenges in the implementation of the proposed guidelines (if passed in the current avatar) such as subjectivity in assessed income, no repercussions for large ticket loans and non-inclusion of non-MFI loans.
The guidelines in this consultative paper come a decade after the Malegam Committee report (2011) which laid down the platform for microfinance regulation. The committee report had revealed that high interest rates, coercive recovery methods and excessive lending to undeserving clients had led to a crisis in the MFI sector in 2010. The new proposals include a collateral-free loans system and a complete waiver on prepayment penalties.
“The primary objective is to address the concerns related to the over-indebtedness of microfinance borrowers and to enable the market mechanism to bring the interest rates downward in the microfinance sector,” RBI said.
As of now, RBI’s microfinance regulatory framework – such as pricing caps, ceiling on loan amounts and limit on the number of lenders – is applicable only to finance companies classified as pure play NBFC-MFIs which accounts for just about 30% of loans to the microfinance market size of Rs 2.47 lakh crore. This means, currently, regulation does not apply to almost 70% of the microfinance lenders. As a result of this, small borrowers are more likely to get multiple loans from various lenders which leads to their over-indebtedness. This in turn exposes them to questionable recovery practices and pushes them into a vicious cycle of debt.
Under current regulations, micro borrowers can borrow up to Rs 125000 from NBFC-MFIs while there is no limit on borrowing from universal banks and small finance banks.
“This compromises the essential objective of protection of small borrowers enshrined in the NBFC-MFI regulations which do not permit more than two NBFC-MFIs to lend to the same borrower,”the RBI said.
The key proposals put forth by the RBI in its consultative paper are :
(1) Capping borrower indebtedness (payment of interest and repayment of principal of all outstanding loans) at 50% of household income,
(2) Removal of the maximum-of-2-lenders rule and
(3) Removal of the 10% spread cap on NBFC-MFIs
(4) Collateral-free loans system
(5) Waiver of pre-payment penalties
(6) All guidelines to be lender agnostic
The most important difference (as compared with the current regulation) is that these rules (if proposed rules are accepted) would be applicable to all the regulated entities – banks, SFBs and NBFC-MFIs (vis-a-vis just NBFC-MFIs under current rules).
The consultative document has put the onus on institutions and their boards to act responsibly to address the issues such as over-indebtedness. The linking of borrowing to household income may reduce credit flow to an individual borrower.
The discussion paper is open for public comments until the end of July 2021. It is not a final guideline, which may take a different form.
The proposed regulations are much more relaxed as compared to what the market had expected.
Currently, there is a margin cap of 10% over cost of funds for MFIs with Rs 100 crore outstanding loans or more. For the rest, the margin cap is 12%. While a separate formula using the average base rate of five largest public sector banks can also be used, there is a cap there too. These restrictions were imposed in 2014.
The RBI’s rationale for removing the pricing caps is based on two observations. First, it was being used as a benchmark rate by banks / SFBs with lower cost of funds to price their own loans. Second, actual operating expenses for MFIs have turned out to be higher than envisaged, necessitating a higher spread cap.
‘Assessed income’ based caps have been imposed on all lenders, instead of absolute indebtedness caps being extended to banks/SFBs. This is negative from the industry’s perspective in the long term (since the limits of Rs 1.25 lakh for rural and Rs 2 lakh for urban households could limit the average ticket size growth).
Given the low savings of such households, at least half of their income should be available to meet their other expenses, according to the RBI. Hence, the banking regulator has suggested that the payment of interest and repayment of principal for all outstanding loans of the household at any point in time shall be capped at 50% of the household income.
While the RBI’s intent of trying to cap indebtedness at 50% of maximum assessed income of Rs125000 / Rs200000 – i.e. Rs62500/Rs 100000 is indeed commendable but if one checks the ground-reality, nothing can possibly prevent lenders willing to give larger ticket loans from doing so. Hence, implementation criteria would also need to be tightened.
There are a few challenges to effective implementation of proposed rules.
1) Subjectivity in assessed income: Microfinance borrowers tend to be largely self-employed with mostly minimal formal or documented income. It is quite likely that lender X might ‘assess’ income of a certain customer at Rs 4 lakh per annum while lender Y might ‘assess’ it to be Rs 2 lakh per annum. The question then arises, what will be the borrower indebtedness limit?
The document mentions that each lender must have a board-approved policy to assess income, but this means it is almost impossible to have a standardised approach to assess income.
Assessing individual household income and introducing a cap on the EMI-income ratio would require microfinance lenders to allocate significant human and financial resources. It could end up increasing the cost of lending, which would eventually be passed on to the customers.
2) No repercussions for large ticket loans: ‘Assessed income’ of more than Rs125000/ Rs200000 per annum in rural / urban areas, respectively, means the underlying loan will not be a "qualifying asset".
However, banks and SFBs have no compulsion to have any "qualifying assets", unlike NBFC-MFIs. Banks/SFBs are free to assess incomes exceeding above prescribed limits and give bigger loans with absolutely no repercussions. These loans would not be called ‘group MFI’ loans, but ‘individual loans/ MSE loans/ personal loans’ etc.
3) Inclusion of non-MFI loans: The definition of indebtedness in the final guidelines is important and must include small-ticket non-MFI loans like 2- wheeler loans or consumer durable loans, which are common for this customer segment. The consultative paper is silent on such loans. It is also not practical to include self-help group (SHG) and informal loans, since they are not reported to credit bureaus.