Tackling informal collateral and collateral substitutes in Indian microfinance

The RBI must ensure that informal collateral and/or abusive collateral substitutes do not contaminate microfinance in the future. It should also seriously think on incentives/disincentives that can be set up to eliminate use of informal collateral and/or abusive collateral substitutes, where they exist

Recently the Reserve Bank of India (RBI) issued a circular defining NBFC–MFIs. According to the circular, an NBFC-MFI is defined as follows:

“An NBFC-MFI is defined as a non-deposit taking NBFC (other than a company licensed under Section 25 of the Indian Companies Act, 1956) that fulfils the following conditions:

i.    Minimum net owned funds of Rs5 crore. (For NBFC-MFIs registered in the North Eastern Region of the country, the minimum NOF requirement shall stand at Rs2 crore).
ii.    Not less than 85% of its net assets are in the nature of ‘qualifying assets’.

For the purpose of ii above, ‘Net assets’ are defined as total assets other than cash and bank balances and money market instruments. Thus qualifying asset shall mean a loan which satisfies the following criteria:-
a.    loan disbursed by an NBFC-MFI to a borrower with a rural household annual income not exceeding Rs60,000 or urban and semi-urban household income not exceeding  Rs1,20,000;
b.    loan amount does not  exceed Rs35,000 in the first cycle and Rs50,000 in subsequent cycles;
c.    total indebtedness of the borrower does not  exceed Rs50,000;
d.    tenure of the loan not to be less than 24 months for loan amount in excess of Rs15,000 with prepayment without penalty;
e.    loan to be extended without collateral;
f.    aggregate amount of loans, given for income generation, is not  less than 75% of the total loans given by the MFIs;
g.    loan is repayable on weekly, fortnightly or monthly instalments at the choice of the borrower

iii.   Further, the income an NBFC-MFI derives from the remaining 15% of assets shall be in accordance with the regulations specified in that behalf.
iv.    An NBFC which does not qualify as an NBFC-MFI shall not extend loans to the microfinance sector, which in aggregate exceed 10% of its total assets.” (Source: http://www.rbi.org.in/scripts/BS_CircularIndexDisplay.aspx?Id=6857)

While in a series of articles, I look at the above RBI circular and outline its implications, the first in this series concerns a very fundamental aspect identified in the aforementioned circular—that of mandatory non-collateralized lending as a condition for an NBFC’s assets to be classified as qualifying assets—which again is very critical for the NBFC to be recognized as an NBFC MFI.

Through the years leading to the 2010 Andhra Pradesh (AP) microfinance crisis, I have come across a phenomenon at the grass-root level that startled me somewhat. All along, we have known typical microfinance to be non-collateralized lending and that is why we have the RBI using the same to define qualifying assets for MFIs and also defining NBFC-MFIs. And it remained as such until perhaps the Krishna crisis. However, in the recent years, I have come across several instances where informal collateral and/or (abusive) collateral substitutes have been used for making loans and/or collecting repayments from low income clients. And given that the RBI has listed non-collateral lending as one of the conditions for classifying a microfinance asset as a qualifying asset, it becomes important to understand ways in which informal collateral (and/or abusive collateral substitutes) are being used in Indian microfinance

Here are some examples:
1.    At the time of making a loan, especially large multiple loans, ration cards are sometimes taken as a form of collateral security. This is mostly done by agents/field workers
2.    Ration cards, are also provided by clients for other clients on a fee per loan basis—thus, the loan becomes a sort of benami loan as it is made in the name of the person who has given the ration card, although the actual borrower is someone else
3.    Pattas, or village/slum land title deeds are often re-possessed in case of clients being delinquent. They are also taken as collateral security for larger loans and/or clients who are over leveraged
4.    Plus several other examples

The implication of all of this is that any instrument—by which low income clients’ access government subsidies/services—can become informal collateral for MFIs. In the future, UID cards and/or other such technology-based arrangements are perhaps easy fodder for such prey. This aspect needs to be recognized by the RBI and other stakeholders.

This apart, I have seen collateral substitutes as well—often, called as peer pressure in the good old days of microfinance pilots, such current day practices seem to have degenerated to forcibly taking over household utensils, small assets (including cows, pigs, goats etc.) and sometimes, even children as the Leo Hornack’s (http://www.independent.co.uk/news/world/asia/why-the-dream-of-microfinance-is-turning-sour-2280814.html) and other stories suggests.

That said, what then are the key questions for the RBI?
1.    How widespread is the use of informal collateral (and/or abusive collateral substitutes) in microfinance?
2.    Under what circumstances are informal collateral and/or abusive collateral substitutes used?
3.    When microfinance is synonymous with non-collateral lending, then, how and why is this happening?
4.    Are agents in the decentralized microfinance model primarily responsible for this? Or is the drive for better operating results in wake of supply led disbursements (in the commercial model) responsible for this unique phenomenon?

So, what then are the key issues here? First, the RBI must surely clarify on how it will ensure that informal collateral and/or abusive collateral substitutes do not contaminate microfinance in the future. Second, the RBI must seriously think on incentives/disincentives that can be set up to eliminate use of informal collateral and/or abusive collateral substitutes, where they exist. Three, the RBI must specify detailed guidelines for its supervisors (and examiners) on how to unearth this informal collateral and abusive collateral substitute menace and take swift action against the erring agents, field workers and concerned institutions.

Surely, without tackling this problem of informal collateralization of microfinance loans, no policy drive for financial inclusion will provide meaningful results on the ground. Let us be clear on that as what is often told to us in microfinance (by MFIs and other stakeholders) is very different from what is actually happening on the ground. And I do hope that the forthcoming Microfinance India summit, to be held at Hotel Ashok, New Delhi on 12th and 13th December, will look closely at critical and practical problems like these rather merely discussing rhetorical paradigms in theoretical obscurity…

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