VIVEKANANDA COLLEGE OF EMPOWERMENT

RESEARCH PROJECT

TOPIC – MICROFINANCE

BATCH – MBA 2nd Semester

FACULTY – KUNAL CHATTOPADHAY & RUMA SAHA

STUDENT – KALLOL DAS

What is Microfinance?Microfinance is the provision of financial services such as loans, savings, insurance, and training to people living in poverty. It is one of the great success stories in the developingworld in the last 30 years and is widely recognized as a just andsustainable solution in alleviating global poverty.

The industry began by providing small loans to emerging entrepreneurs to start or expand businesses. Opportunity International was one of the first nonprofit organizations to recognize the benefits of providing capital to people struggling to work their way out of poverty. Over the years, with Opportunity leading the way, the microfinance sector has expandedits financial service offerings to better meet client needs. Along with providing more flexible loan products and business andpersonal development training, Opportunity offers savings and insurance to help clients effectively navigate the daily hardships they face. Without these services, clients are continually at risk of slipping back into poverty because of unforeseen circumstances.

Microfinance organizations make it a priority to serve the particular needs of women, since a staggering 70 percent of all those living in extreme poverty are female. Women are often excluded from education, the workplace, owning property and equalparticipation in politics. They produce one half of the world’s food, but own just one percent of its farmland. 93 percent of allloans are made to women. While Opportunity gladly extends loans to men, the organization believes the greatest opportunity for interrupting cycles of extreme poverty come from microfinance programs that target female entrepreneurs. When women improve their circumstances, they also improve the lives of their

children. By investing in nutrition and education, they help to create a better future for their children and their communities.

Despite the success of life-transforming microfinance services, the World Bank says that the industry is not close to meeting thedemand. Five hundred million people living in poverty could benefit from a small business loan and only one-third of the world’s population has access to any kind of bank account. The lack of access is particularly severe in sub-Saharan Africa wherethe World Bank estimates that microfinance is reaching only a small percentage of the economically active population. In sub-Saharan Africa’s poorest countries, less than 10 percent of the population has an account with a financial institution. In response, Opportunity has committed to building scalable, sustainable and accessible banks throughout the developing world to provide loans, training, savings and insurance products tailored to the specific needs of each region.

As the microfinance industry continues to mature, there is a danger that it will drift toward a more secure client base. It iscritical that microfinance organizations continue to focus on those with the greatest needs–those who have been displaced, those in rural areas, those who traditional institutions considerunbankable–the most marginalized people. Maintaining that focus, microfinance can help create a world in which the underserved have fair access to economic opportunities and the hope to move beyond poverty.

RISKMicrofinance institutions (MFIs) essentially act as financialintermediaries, bridging the gap between mainstream financialinstitutions and low-income households for a specific type ofcredit need that is short-term and unsecured. The concept of risklies at the heart of any such financial intermediation.

Systematic Risks

Systematic risks that face the entire sector, such as rainfallfailure, impact the livelihoods of a large numbers of clientssimultaneously and cannot be eliminated, but can be mitigated bypurchasing insurance at a portfolio level, or diversifying acrossregions. However, a significant systematic risk that has emergedin recent times and which has impacted MFIs severely is politicalrisk.

As MFIs deal with low-income households, their operations aresubject to scrutiny by State governments and local powers, inaddition to formal regulators. Recent experiences of politicalinterference bring out the vulnerability of MFIs to these risks:In 2006, 50 branches of two major MFIs were closed by authoritiesin Krishna district of Andhra Pradesh; in 2009, repayments almostcame to a grinding halt in Karnataka’s Kolar district; and in2010, the Andhra Pradesh Government introduced a law that reducedMFI repayments dramatically.

Clarity on regulatory framework, and jurisdiction of Stategovernments vis-à-vis non-bank financial institutions is criticalin mitigating political risk. At the institutional level, thiscan be managed by building a closer connect between theinstitution and customer groups so that there is resistance tolocal political interference that constrains the businessactivities of MFIs.

Idiosyncratic Risks

Idiosyncratic risks are internal to an entity and compriseprimarily operations and credit risk. In microfinance, these twoare deeply intertwined and are potentially among the primaryreasons why MFIs fail.

In the Joint Liability Group (JLG) model, typically followed byMFIs to disburse credit, as “credit decisions” are taken by thegroup on the basis of its access to private information abouteach member, the quality and robustness of the group formationprocess becomes crucial in credit risk management. The mechanism

of group cross-guarantee, if implemented as per the rules thatgovern group formation, will result in positive selection ofmembers. It is important, however, that the under-writing processbe undertaken by the group and not by the MFI.

Dilution of group formation and meeting norms are early warningsigns of process deterioration that should trigger concerns aboutcredit quality. Outstanding MFIs pay a great deal of attention tofactors such as length of the group formation process, regularityof group meetings and attendance rates.

Operational Risks

Microfinance is an operations-intensive model and weak processesaffect internal control and manifest as fraud and otheroperational failures. Detailed mapping of the processes and sub-processes will help MFIs identify risks, as also the weak linksthat pose a greater threat of fraud. To detect fraud early andtake action, MFIs should have a risk-scoring model, giving eachbranch a risk score. Taking a holistic view, the model should bebased on diverse parameters. Branches with history of fraudshould be penalised in the risk-scoring model and the frequencyof audit linked to the risk score. This helps understand two keyquestions: Which branch has poor portfolio quality? Is the branchwitnessing fraud?

Cash movement

As all MFI disbursements and collections are cash-based, theinstitutions face high risk due to movement of cash. This isexacerbated for institutions operating in remote geographies. Ifmovement of cash is not tracked and checked against demand andcollections, it can result in fraud.Such fraud can be mitigatedby MFIs setting cash retention limits for branches, withdeviations approved and recorded. Reconciliation of cash throughMIS in the branches’ bank accounts is important in scrutinisingfloat and idle cash at each level. Risks such as burglary duringcash movement can be mitigated through insurance for cash-in-transit; cash-in-safe and branch; and fidelity insurance.

Interest rate volatility

Interest rate volatility is among the key risks MFIs face today.Changes in interest rates at which they borrow impact spreads,especially in the short term. Most MFIs do not explicitly manageinterest rate risk. Increase in cost of funds severely squeezesmargins, impacting profitability and operational self-sufficiency.

With increased competition and pressure to cut interest rates,MFIs are also not in a position to pass on interest rateincreases to clients. With proposed regulations on cappingmargins, interest rate risk will continue to be one of the keythreats for MFIs.

Long-term borrowing, with hedging and diversification of fundingsources, will enable MFIs to mitigate interest rate risk. Giventhat MFIs typically have positive duration of equity (liabilitiesare longer dated than assets), their asset-liability managementstrategies have also to take into account scenarios arising frominterest rate movements that impact profitability.

As with any other financial institution, risk management iscritical to the success of MFIs. The unique context of MFIoperations that involve under-writing by client groups anddealing in large amounts of cash outside branch locations createspecific risk management needs. MFI boards, lenders and investorsshould be cognisant of these features.

ANOTHER KIND OF RISK

These transactions are typically of smaller amounts and shorter tenure than corporate loans and target small business owners or commercial clients whose operations are generally small.

The environmental and social risks associated with microfinance are typically low partly due to the small size of the operation and the industry sector. However, in some cases clients may be

involved with handling dangerous substances such as pesticides that can pose health or environmental risks, but frequently they lack the necessary environmental and social management capacity to do so safely.

Although at the individual transaction level the environmental and social risks associated with microfinance are low, given the smaller size and shorter tenure of transactions, there are creditor liability risks for the microfinance institution in cases where environmental and social issues, such as an accident, affect a micro-entrepreneur’s ability to repay a loan. Microfinance institutions often consider the environmental and social impacts associated with their transactions in the context of the developmental role they play in their communities and are therefore concerned with reputational risks. In addition, many see the promotion of good environmental and social practices as part of their role in the community.

Risk and Relevance: The 2012 Microfinance BananaSkins SurveyPresenting the most pressing risks facing microfinance today, and whatwe can do to manage them.

What are the greatest risks facing microfinance today and how well prepared are we to handle those risks? 

The Centre forthe Study ofFinancialInnovation(CSFI) askedthose questionsto microfinanceprofessionalsaround theworld. Thesurvey drew 360responses from79 countriesand resulted inthe MicrofinanceBanana Skins2012 report,produced byCSFI inpartnershipwith the CitiFoundation and CGAP .

The Top Ten

The theme ofthe 2012 reportis, "stayingrelevant." While the previoustwo reports(2009 and 2011)found creditrisk to be thegreatest threattomicrofinance,

Microfinance Banana SkinsTop Ten 2008 - 2012

20081. Management quality2. Corporate

governance

3. Inappropriate regulation

4. Cost control

5. Staffing

6. Interest rates

7. Competition

8. Managing technology

9. Political interference

10. Credit risk

20091. Credit risk2. Liquidity

3. Macro-economic trends

4. Management quality

5. Refinancing

6. Too little funding

7. Corporate governance

8. Foreign currency

9. Competition

10. Political interference

20111. Credit risk2. Reputation

3. Competition

4. Corporate governance

5. Political interference

6. Inappropriate regulation

7. Management quality

8. Staffing

9. Mission drift

10. Unrealisable expectations

20121. Overindebtedness2. Corporate

governance

3. Management quality

4. Credit risk

5. Political interference

6. Quality of risk management

7. Client management

8. Competition

9. Regulation

10. Liquidity

the latest report finds over-indebtedness to be the number one risk. And the voting was clear with 60% of respondents scoring it4 or 5 on a scale of 1 to 5. Rounding out the top five are corporate governance, management quality, credit risk, and political interference. The table shows how this list compares topast surveys.

Considering recent headlines, this year’s top risks may not be surprising. Questions about the impact of microfinance threaten its reputation as a poverty alleviation tool. The crisis in Andhra Pradesh shook the Indian market and rattled others around the world. Reports of over-heated markets with multiple borrowing, over-indebtedness, and decreasing portfolio quality called into question the entire model of micro-lending. 

How well prepared are MFIs to deal with these risks? Not well, according to the respondents. On a scale of 1 to 10, responses averaged only 5.49. The results indicate a sentiment among microfinance professionals that significant work is required to strengthen the sector.

A Closer Look at the Results

Over-indebtedness was not an option on previous surveys making itdifficult to compare to previous years.  Because over-indebtedness and credit risk are closely related, it is possible that this year's high ranking of over-indebtedness is simply a better articulation of people’s continued concerns about “credit risk” from prior surveys. But what is driving the concern about over-indebtedness?

Over-indebtedness may be a threat on the horizon in some markets,but as the report points out, “over-indebtedness is widely seen to be symptomatic of deeper difficulties in the industry: an excess of lending capacity…, a lack of professionalism within MFIs, and an emphasis on growth and profit at the expense of prudence.”

The report also points out that 8 of the top 12 risks are considered institutional risks, or “ones under the direct control

of the MFIs themselves.” The risk seems to be that over-indebtedness could be a manifestation of what might go wrong if the other risks aren’t addressed. 

Managing Risk to Stay Relevant

Acknowledging today’s risks – management quality, corporate governance, internal controls and policies, and client management– is the first step in mitigating them and "staying relevant."

Survey respondents pointed out a number of opportunities to address some of the most pressing risks. A number of these are summarized below:

Credit registries could reduce over-indebtedness by helping lenders identify clients with loans from multiple institutions.

Credit bureaus would help reduce credit risk by addressing the information asymmetry between borrowers and lenders and helping lenders make more informed decisions.

Introducing products better matched to client needs would alleviate over-indebtedness and multiple borrowings.

Funders and MFIs should prioritize portfolio quality over quantity, it would benefit both the institution’s credit risk and the client’s risk of over-indebtedness.

Corporate governance impacts all aspects of an institution. Ensuring that governing bodies are comprised of knowledgeable people who understand the business and are subject to sound governing principles would have positive impact on all aspects of the institution from human resources to strategic growth plans.

Capacity development focused on both staff and management would result in improved decision-making at all levels.

These are just a few of the opportunities identified in the survey report.

Regulating Microfinance in India: IFMR Trust’s feedback on the Malegam Committee’s report

The Malegam Committee’s (referred to hereinafter as the“Committee”) recommendations to increase the supervisory capacityof the RBI, to make MFI regulation consistent at the nationallevel, to promote good corporate governance and to increase banklending to MFIs are welcome.

At the same time, many of the tactical and operationalprescriptions made by the Committee require to be examined in thecontext of (a) broadening the RBI’s financial inclusion agenda,(b) regulatory approaches to pursuing this agenda (c)operationalising the recommendations in an effective andinclusive manner and (d) ensuring sustainable development andorderly growth of the industry by limiting externalities anddeveloping a series of best practices.

Definition of the Sector

1. Under 2.1 of the Committee’s report, the Committee has definedmicrofinance as “an economic development tool whose objective isto assist the poor to work their way out of poverty. It covers arange of services which include, in addition to the provision ofcredit, many other services such as savings, insurance, moneytransfers, counselling, etc.”

2. At the same time, the Committee has confined itself to “micro-credit” for the purpose of the report.

3. The Committee has subsequently defined a separate category –NBFC-MFIs – for NBFCs operating in the microfinance sector, andstated that, in such firms, over 90% of assets must comprise of“qualifying assets”. At the same time, the Committee suggeststhat NBFCs should either allocate over 90% of assets to“qualifying assets” or less than 10%

4. We suggest that it is counter-productive to limit micro-creditor the supervision of micro-credit to NBFCs in the fashion asdescribed above for the following reasons:

a) These recommendations, if accepted, would prevent thetransformation of microfinance into full service finance forrural customers.

a. One of the main reasons for becoming an NBFC is that theentity is then able move beyond traditional JLG lending, andgradually start to offer larger loans, individual loans,enterprise loans, crop loans, equipment loans, etc. whilecontinuing to offer the original JLG product.b. This allows the entity to meet completely the requirements ofthose borrowers that need larger amounts as well as use the widerproduct-scope to spread its cost structures over a much largerpool of assets and bring its lending rates down, eventually wellbelow even the caps specified by the Committee for thetraditional JLG product.c. Entities operating in this space would have to grapple withlow value of transaction and still remain viable. Multiplesources of revenue would provide such viability to such entities.

b) The 90/10 recommendations (Clause Numbers 5.9 and 5.10), ifaccepted, would essentially freeze the sector to permanently stayin its current form since nobody else would even be allowed toaddress the needs of this sector and no other business modelswould evolve.

a. And for this reason, there would also then be no impetus forinterest rates to come down further below the caps specified bythe Committee. Costs of operations, using new technologies andeconomies of scope and scale can be brought down to as much lowerlevels relatively quickly.b. This would also take away the entities’ incentive to investeffort in working in a challenging environment.

c) The recommendations would leave out significant microfinanceproviders from the regulatory framework

a. It is quite possible that Banks may emerge as substantialproviders of micro-credit and other forms of microfinance, butmicrocredit (as defined by the committee) may not form 10% oftheir assets. This will leave out a significant institution-typefrom the regulatory ambit. The proposed regulation must cover allmicrofinance providers

i. However, it may be argued that microfinance, at present, isbeing provided by multiple non-profit entities that are notwithin the regulatory ambit of the RBI. Recognising this, wepropose that microfinance regulation must cover at least allexisting forms of entities regulated by the RBI, i.e. Banks andNBFCsii. The microfinance operations of such entities, be in micro-credit, micro-savings, distribution of micro-insurance etc., mustbe reported separately as an SBU to the RBI, to permit efficientinformation dissemination, transparency and effective regulationiii. For entities outside RBI’s regulatory ambit, regulationcould make the principals (in case of business correspondents)and lenders (in case of microcredit) to the providers aware ofthe importance adherence to client protection standards by theproviders. These principals and lenders should be activelyencouraged to broaden their due diligence and monitoringprocesses to ensure that the providers are not just maintainingfinancial discipline but also adhering to ethical standards ofclient protection.RBI must also actively use such measures toenforce covenants on entities not regulated by RBI to create alevel playing field and uniform standards.

d) Further,

a. If entities were forced to concentrate over 90% of theirassets in the microfinance sector, lack of diversification withintheir asset portfolios could emerge as a significant systemicrisk.b. In India, portfolio protection for institutions providingservices to low income rural households against the vagaries ofsystemic and catastrophic losses, i.e. rainfall reduction,weather variations, crop losses, floods and other events etc. arestill not available on a large scale

5. Hence, we recommend that the definition of microfinance beapplied at a functional level, rather than at the entity level.This would imply that entities providing microfinance would berequired to create separate business units, tailor internalpolicies to provide efficient service delivery and at the sametime be able to leverage internal financial, technology andprocess strengths in this regard.

6. Ensuring complete access to finance for every individual andevery enterprise in India will require continuous innovations infinancial products, delivery channels, and human resourcemanagement by a wide array of strong firms competing with eachother to do business with the low-income household in aresponsible manner. By opening up the sector to multipleinstitutions will enhance competition and meet the regulator’sobjectives

Capital adequacy requirement

7. The committee has not offered any rationale for the Rs. 15crore minimum capital requirements even for pure non-deposittaking NBFCs despite recommending very conservative loan limitsand being aware of the very low default rates that have beenobserved for this sector in India for over a decade.

8. Such a requirement clearly favours the established largemicrofinance providers, which making it even more difficult forsmaller, locally focused entities to emerge.

The issue of “Qualifying Assets”

9. The Committee has defined a low income household as one withannual household income less than Rs 50,000

10. IFMR Trust’s experience is that though a large number ofmicrofinance clients belong to households with less than Rs.50,000 annual household income, there are also a very largenumber of households with higher incomes who can and do benefitfrom microfinance mechanisms.

a) This happens mainly because of limitations of the creditappraisal methods of traditional financial providers. Many ruraland urban low income households cannot access credit throughthese mechanisms – their assets cannot be easily collateralised;their incomes are hard to estimate; and their past repaymentrecords are not recorded in accessible databases. b) So, though most poor are financially excluded, manyfinancially excluded households have household incomes exceedingRs 50,000. Much of urban microfinance caters to such clients.Restricting microfinance to the poor will make the financiallyexcluded non-poor more vulnerable.

11. We believe that it would be detrimental to the interests of alarge section of the population to define low income householdsin the manner as recommended by the Committee. Further, thisdefinition implies that originators (and perhaps their lenders)have the wherewithal to collect information regarding householdincome, which is unlikely and expensive

12. The Committee has also stated that credit to individualclients be limited to Rs 25,000 per member

13. This is not clear and raises the following questions

a) What are such households to do when their credit needsoutstrip Rs 25,000 per individual member?b) Shouldn’t the committee focus on “regulating the lender”rather than “regulating the household’s debt needs”?c) Is it not wasteful for such a household to approach multiplelenders, rather than avail of a single “one-stop shop” solutionfor financial needs?d) Effect of inflation on household credit requirements are notfactored in

14. Given the above negative effects on a household’s creditaccess, we find it difficult to believe this is the Committee’sintention. We suggest that it is up to the household to determineits own debt needs and requirements, and for the provider todetermine the creditworthiness.

15. Given that the objective is to regulate the originators, wesuggest the following approach

a) The Committee has opined that multiple loans given to a singlehousehold may increase the risk of non-repayment and amplifiessystemic riskb) At the same time, it is the objective of the committee toensure that the maximum number of households come under thecoverage of financial inclusionc) Therefore, to incentivise organisations to enhance coverageand limit multiple lending to a single household it is proposedthat a higher capital charge be levied upon institutionsproviding the third or further loan to a single household (at thetime of providing the loan)

a. Therefore, the first loan to a household could attract acapital charge of 75%, the second loan 100%, the third loan 125%and so onb. This could be tracked by stipulating the use of biometricauthentication, and a credit bureau

16. It is useful to note that the group-based method (followed atpresent by MFIs as well as SHGs) ensures that each borrower isforced to assess his / her co-borrowers before forming a group.The ability of this methodology to impose credit discipline iswell-documented. Even during the current crisis, IFMR Trust hasmonitored repayment behaviour in over 200 districts across thecountry outside Andhra Pradesh, where repayment behaviour hasbeen flawless1

Our experience tells us that, contrary to popular belief, lowincome households are rational and well able to take complexfinancial decisions. Rather, such households are limited by thequality and depth of the financial instruments that they haveaccess to. This evidence is bolstered by the book “Portfolios ofthe Poor” and a recent impact study2 conducted in Hyderabad byMIT researchers.

17. The committee seems to be taking a view that it not onlyneeds to regulate the lenders, but also the households’ financial

lives. It should focus on regulating the lenders and developingways to indirectly reduce the risks of over-leveraging andsystemic risks. Therefore, credit discipline on lenders throughusage of capital charge, is a better risk management tool thatwill also form an effective check on over-lending, rather thanimposing an external limit on the borrowing ability ofhouseholds.

18. Further, it is incorrect to assume that rural households haveno collateral at all to provide for raising debt. Banks are knownto have substantial exposure to the agricultural sector that iscollateralised through land holdings, household gold and farmequipment

a) We had earlier made the argument favouring using microfinanceproviders for delivery of multiple services for efficient servicedelivery at lower costb) Though much of microfinance has focused on credit, it shouldinclude other services as well. IFMR Trust’s experience withremote rural households across three states (Tamil Nadu,Uttarakhand and Orissa) shows the benefits clients can get fromsuch complete offering, and how such a multi-service approachhelps the institutions improve efficiency by leveraging economiesof scope, which can be tapped in the context of financialservices.c) Therefore, we submit that organisations should be permitted tooffer a complete suite of financial services to low incomehouseholds viz.

a. Loans – both secured and unsecured. Secured loans that requirea high penetration of distribution include crop loans, loansagainst warehouse receipt, MSME loans etc.b. Distribution of savings, either through Banks or throughmutual fundsc. Distribution of insurance – life, cattle, weather, crop,accident, health etc.d. Remittances

d) It is necessary that such organisations develop the breadth ofknowledge and understanding that is necessary to understand low

income household needs and prevent mis-selling. This is somethingthat can be periodically audited by the RBI

Pricing of Loans

19. The Committee feels that “Given the vulnerable nature of theborrowers, it becomes necessary to impose some form of interestrate control to prevent exploitation”

20. Evidence from other countries however shows that pricing capshave historically hurt the poor3 . Pricing caps and margin capsincentivise originators to expand only to easily serviceablegeographies and ignore remote areas and lower income clients.

21. Further, the sharp increase in financing costs for MFIs postthe AP Ordinance has indicated that originators are not insulatedin any manner from high borrowing costs during either (i) aliquidity crunch or (ii) a credit situation / event risk

22. IFMR Trust has, on several occasions, opined that the currentinterest rates and margins charged by MFIs are high and there isroom for reduction. However, at the same time, we believe thatcompetition and transparency should pave the way for reduction ofrates rather than impose a hard cap. This is indeed the view RBIhas taken on pricing of services offered by banks throughbusiness correspondents, allowing banks to decide the price theywant to charge, but requiring them to have the pricing approvedby the boards, and transparently communicate it to RBI and otherstakeholders.

23. Suggestions to this effect include enhancing competition,imposing transparency in pricing (already recommended by theCommittee) and monitoring the originators by tracking reductionin interest rates over a period of time

a) Further, originators could be encouraged to augment lendingrevenues through fee based income achieved through distributionof specially tailored products for low income households, e.g.livestock insurance, low ticket savings and remittances. Thiswould permit originators to reduce costs on lending products

b) Originators that provide other forms of secured products,together with unsecured loans, could also avail of cheaperfunding from lenders that could be used to reduce lending ratesfor the unsecured loans

Purpose / end use of the Loan

24. The Committee believes that microfinance should largely focuson income generating purposes, and has opined that a minimum of75% of microfinance loans should be for “income generatingpurposes”

25. This topic needs to be examined from three aspects:

a) What exactly is an “income generating loan”?b) What are the current purposes for which borrowers are usingloans?c) Loans used for functions that other services usually fulfil

26. What exactly is an income generating loan? Evidence showsthat loans are used by low income households for a variety ofpurposes including:

It is difficult to opine that households should be restrictedfrom using external financing for any of the above activities,especially when the middle-class and the rich are permitted toborrow for all of the above purposes and have access to funds aswell

27. It is clear from studies that low income households haveutilised MFI loans for a variety of purposes. Recent evaluationof an MFI’s urban microcredit programme in Hyderabad revealed avariety of uses for the loans:

While such percentages vary widely across households, it is clearthat each household is faced with a specific set of economic,social and risk variables that require a certain course ofaction. It is counterproductive to impute (or impose) a specificend-use pattern to a household.

28. Loans used for functions that other services usually fulfil:Since most of these households may not have a savings facility,they might be using a short-term loan to “save-down”, instead of“saving-up” as one does using a savings bank account. Someresearchers have also posited that microfinance helps because itacts as a disciplining device for people to save, and they canuse the discipline of weekly repayments to help bind themselvesinto putting money aside, which they otherwise would not havebeen able to do5 . Transformation of small amounts into lump sumsis an important function for households6 , and in the absence ofother mechanisms (like savings account, recurring deposits),microfinance serves as a mechanism to help make thistransformation. These other purposes (consumption smoothing bytransforming small amounts of money into lump sum; reducing cashoutflows by repaying expensive old debts; etc) can be and oftenare welfare enhancing

29. Traditionally the low income household is only familiar withcredit as a tool for financial needs and have developed copingmechanisms based on access to credit. While other financialproducts would clearly be useful to such households, they wouldneed time to adapt to such tools.

30. While financing for certain end-use could be encouraged (i.e.through the priority sector guidelines), it is counter-productiveto impose end-use restrictions on households when no suchrestrictions exist on higher income households. It is conceivablethat, through disincentives on multiple-lending, originatorswould take greater care in ascertaining the repayment capabilityof the household, as well as diversify into products that wouldbe directly linked to business activities, e.g. retailer loans,crop loans, small business loans etc.

31. The view the Committee eventually takes on the manner inwhich poor women conduct their financial lives and their maturityand sagacity is deeply disturbing. Microfinance plays multipleroles in the lives of low income households including seasonalcash management (so that school fees can be paid even during theseasonal troughs); asset transformation from small savings tolarger valued assets (such as higher quality roofs and beds);refinance of high cost loans from money lenders; and as asubstitute for good commitment-savings products. This is alsoacknowledged by the Committee but while making itsrecommendations it surprisingly reaches an opposite conclusionwithout citing any research or offering any rationale foroverlooking its own earlier observations or suggesting anyalternative solutions.

32. These recommendations of the Committee along with thoserestricting the amounts she can borrow and severely limiting thechoice of providers that she can access, constitute aninfringement of the rights of the low income household,particularly women, to conduct their own financial affairs asthey think best fit. Similar stipulations, if imposed on middleand upper income households would be resisted very strongly, buthave been recommended for imposition on poor women without anyevidence that they are in any way less rational than high andmiddle income customers and good evidence that the opposite isactually the case.

Incentives for Orderly Growth

33. The Committee has recommended the creation of a Credit Bureaufor ensuring orderly sharing of information. We wholeheartedlysupport this initiative and believe that fully functional (andcompeting) credit bureaus are essential for the orderlydevelopment of the sector

34. Further, and very critically, the Committee has suggestedthat a single regulator is necessary and sufficient to monitormicrofinance activities. This is extremely important, especiallyin the context of the AP Ordinance, and will go a long waytowards dispelling uncertainty on the legal and regulatoryenvironment

35. We also have a few other suggestions regarding the role thatthe RBI can play in facilitating orderly growth. These include:

a) Ensuring incentive alignment of stakeholders to enable market-based regulation –

a. Use of the priority sector guidelinesb. Securitisation

b) Ensuring continuity of servicec) Promoting healthy competition amongst originators

36. Incentive alignment

a) The priority sector guidelines can be used very effectively bythe RBI in controlling and at the same time incentivisingoriginators and lenders to behave responsibly. The Committee hasrecommended continuation of priority sector for microfinanceadvances and we are in support

Some additional steps that could be brought in the priority sector guidelines:

a. Unsecured loans provided to a household could attract a higherpriority sector weightage than secured loans (the RBI has alreadymoved a step in this direction by stating that gold loans madefor agricultural purposes may no longer be treated as direct orindirect agricultural advances)b. First and second unsecured loans given to a household couldhave a higher weightage than subsequent loans – tracked through acredit bureau

b) Securitisation and other capital market transactions:traditionally, originators of financial services to low incomehouseholds have been far too dependent on bank borrowings (theCommittee estimates that 75% of loans to MFIs are from banks)

IFMR Trust has been working closely with high quality originatorsto assist them in availing capital market financing throughsecuritisations and bond issuances. We strongly feel that theadditional transparency imposed by a capital market transactionis very beneficial in incentivising originators to “raise thebar” in MIS, reporting, operational processes and systems, so asto be able to meet the scrutiny of rating agencies and investors

37. Continuity of service: Continuity of service delivery shouldbe seen from the perspective of “who is taking risk on whom”,because based on this the importance of and strategy for ensuringcontinuity of service delivery will be determined.

Clients taking risk on the institution (Savings, Insurance,Investment, Remittance): For services like savings and insurance,there is a strong case for high level of prudential regulation toprevent failure of institutions, because of the need to protectclients’ savings and insurance. For these services, theregulation should continue on the path of letting prudentiallyregulated, well-capitalised, well-diversified institutionsprovide microfinance through agent-led models, like the businesscorrespondent model. To ensure continuity of these services, thecontinuity of both the principal and the agents is necessary.

The principal institutions (banks, insurance companies, assetmanagement companies, etc) are already governed by detailedprudential norms, which are meant to minimise the risk offailure. For such agent-led models, the regulator should make theprincipal financial institution (eg. banks appointing thebusiness correspondent) responsible for ensuring continuity ofservice delivery to the clients, with penalties if an acquiredclient is not able to access the service continuously for acertain period of time. These principal institutions should thendraft their own due diligence and monitoring criteria to ensurethis.

At the same time, the model should ensure that every originator(who serves as an agent) has sufficient risk participation toprevent the risk of moral hazard.

Institution taking risk on the clients (Loans): Considering thefact that most of the microfinance providers (except banks) inIndia do not mobilise public deposits, we believe that the RBIneed not take further steps towards regulating such institutionsexcept defining basic prudential norms on institutions that arenon-systemically important.

However, we strongly believe that the RBI should focus onensuring that a microfinance originator’s practices do not havenegative externalities for other originators. IFMR Trust’sexperience is that maintaining high quality field processes is amust for microfinance. Hence, regulation that is focused onreducing negative externalities will be immensely useful. Somesuggestions:

a) Develop an external audit mechanism through third parties:Such third parties auditors could (i) verify through samplechecks the quality of origination and reported profiles ofcustomers, (ii) define process standards for processes inorigination, collection, risk management etc7 and audit the same,(iii) provide feedback to the institution on their findings, (iv)provide inputs to the lenders of such originators

b) Use differentiated capital charge, as outlined earlier, toprevent multiple lending

Client Protection

38. The Committee has recommended certain steps with regard to client protection including

a) Prevention of coercive collection practicesb) Customer protection codec) Transparent pricing

39. We are in agreement with the broad line of thinking and offera few suggestions regarding the same

a) While it is fair to state that borrowers of group-basedlending are not to be visited for non repayment at theirresidence, the same is not true for borrowers of individual loans/ business loans / crop loans etc. The RBI should make adistinction between loans where group liability serves as acushion against individual default, and individual unsecuredloans

b) Where security is available to the originator (property, gold,movable assets), the originator should have clearly defined,board-approved, policies regarding any appropriation, auction anddisposal of such assets. Such policies must follow the FairPractices Code and every such incident of recovery from securitymust be monitored at the highest level in the originator’sorganisation

c) IFMR Trust’s stringent underwriting guidelines stipulate thatno originator should use the services of or incentivise thirdparties to originate and service the loan clients. While it hasbeen observed that originators use group leaders or centerleaders for such purposes, this must be completely stopped

d) Transparent pricing to clients must be enforced, displayed inloan agreements, explained during customer interactions etc. TheRBI could consider prescribing standard communication componentswhich cover various methods of calculation of interest (Upfrontfees, flat rate, reducing balances rate etc.) and also variousrepayment cycles (Equated, ballooning, variable) to bring them to‘effective cost to client’ numbers so that clients can makeinformed decisions

e) Prevent mis-selling: Regulation should prescribe fairorigination practices by microfinance providers. Some activities

that should be actively discouraged are: compulsory bundling ofproducts, miscommunication about product features and givingwrong advice to clients. Explicit confirmation from the clientsthat such practices have not been indulged in should be obtainedby external process auditors to create pressure towards adherence

f) Mechanism for redressal of grievances: All originators must berequired to have in place timely and responsive mechanisms forcomplaints and problem resolution for their clients. Thisrequires ensuring that clients are able to contact a person whocan then address their grievances effectively and in a time-boundmanner. Apart from this the regulator must make availablemechanisms outside of the institutional framework to addressunresolved queries or queries of larger magnitude. The bankingombudsmen with enhanced capacity would be best placed to performthis function without conflict of interest

g) Privacy of client data: The privacy of individual client datamust be respected in accordance with the existing laws andregulations, and such data cannot be used for other purposeswithout the permission of the client. Explicit regulations aroundwhen and how information sharing is possible should be notified.Severe implications must be notified to ensure that originatorsdo not overstep on this requirement

IFMR Trust believes, and has learnt through experience, thatsmall, local financial institutions are best placed to understandthe financial needs of low income households and deliverfinancial services to their doorstep. It is critical to avoid asituation where regulation favours large players over smallerones. Several provisions of the Committee’s report that may havethis unintended consequence are:

➢    Interest rate/Margin cap➢    Allowing only 2 lenders per household➢    Minimum networth

These recommendations favour the largest existing originators,are likely to drive smaller MFIs out of businesses, and createentry barriers for any new players. The larger originators

benefit from economies of scale and will be more easily able tocomply with the increased capital requirements.  They will bemore easily able to build the infrastructure recommended and movefaster into the market place where they could corner the maximummarket share thereby preventing the entry of smaller or newerMFIs in that market.

We strongly feel that such measures will be detrimental to thefinancially excluded and will not serve the RBI’s motive offinancial inclusion. Permitting only larger originators toflourish will imply an oligopolistic situation, lesser productinnovation, poor customer service and ultimately choking thehousehold’s credit requirements.

We believe that there is an important role for the regulator toplay in making sure that innovation is encouraged amongresponsible players in a manner that benefits low incomehouseholds, and we are hopeful that the RBI will agree with ourview when it reviews the Malegam Committee’s report.

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