Representation to the Malegam Committee on microfinance

Representation to the Malegam Committee on microfinance, Microfinance Focus, December 27, 2010:

Dear Chairman and members of the committee,

You have been entrusted with a challenging task; you must be faced with different and often conflicting expectations from several quarters.  As a sector observer, I have a few comments to make for your consideration.

Microfinance institutions took roots in the crags and fissures of the formal financial sector – they never had a clear policy space.  (For example, dormant companies registered with RBI as NBFCs were bought and retooled for commencing business as MFIs – because it was difficult to register a new NBFC with RBI!) The result is that they grew haphazardly and in a manner that is not altogether appealing.  They struggled for survival and did anything to secure their future.  And what they did was not always good.

The formal financial sector’s efforts to meet the demand for financial services had not been entirely successful – and left a market void which the MFIs have tried to occupy.  Even with the MFIs and the larger SHG movement in place, the demand for financial services is nowhere near being satisfied.  A complete appreciation of the extent of the market and design of strategies for meeting the market demand in a given timeframe are required – the committees work in proposing a policy relating to microfinance and MFIs is just one part of this larger effort.  Actions such as in AP should be stopped through a central legislation.  Such actions might be disastrous in other states where MFIs serve more excluded people (Karnataka for example) and might cut the only link to finance they have (even if the link is a sub-optimal and extortionate one).

1.    Fragmentation of regulatory effort and each state having a regulatory regime will cost the sector dearly and provide wrong precedents that might affect the larger financial sector in future.  The resultant regulatory arbitrage is something that the sector can do without.

2.    What is good as a solution for today need not necessarily be good in the long run. Today’s problems which necessitated the set up of this committee may not be the real ones to solve in microfinance.  If the customers’ interests are to be served, we should look at the causes – not the symptoms.

3.     The sector direly needs a well articulated rural and microfinance policy rather than just microfinance regulation. What do the government of India and RBI think of delivery of financial services to the excluded?  Are the financial inclusion efforts that exclusively focus on banking system the only means of achieving inclusion?  If so we need not bother too much about the temporary arrangements such as MFIs or SHGs. The can be told the future picture and asked to conform or quit.

4.    Systemic stability considerations that underlie prudential financial sector regulation are not relevant in microfinance sector with its tiny foot print in terms of financial volumes.  Customer protection is a more legitimate and relevant concern in regulating Microfinance.

5.    The principles that would serve microfinance regulation well are – social mission, transparency, fair practices, inclusive processes and social audit by customers:
Social mission:  Institutions that want to enter microfinance should have a clear social mission that prioritizes customer interests.  Institutions that do not have a social mission should be denied entry.

Transparency: Relates to placing in public domain information on prices, product features, ownership of the MFI, executive remuneration, regulatory action faced, violation of any law pointed out and pending investigations  of any kind and regulatory/audit reports.  The information on interest rate, effective price paid by the customer and product features should be provided to each concerned customer in a form and manner suitable and understandable.

Fair practices: Relates to sales and marketing of products and services (avoidance of mis-selling, cross selling, bundling of unwanted products such as insurance), recovery practices (avoidance of stressful coercion), customer based loan appraisals (including lender’s liability for wrong credit decisions that result in excessive debt), avoidance of use of agents, centre leaders, etc., in credit processes and incentivizing responsible staff behavior.

Inclusive processes: Enabling participation of customer groups in credit decisions to group members in group based lending methods, grievance handling procedures that have customer groups as part of the redressal mechanisms at block/district levels, annual meetings in each branch of MFI to provide information about performance of the institution in that branch and invite customers’ observations and reactions.

Social Audit: Annual audit of the MFIs operations by a group that comprises select customers and also renowned NGOs to get a customer perspective of the MFI’s effectiveness and relevance.

Regulation should consider setting limits on extent of private ownership, limits of profits (in terms of ROE and ROA), restriction  on accessing capital markets for equity in the initial years (say 7 years) and limits on executive remuneration. The enforcement of these should be through funding banks.  The transparency in disclosure could be implemented through organizations such as Microfinance Transparency which is working on pricing transparency in the country.

What regulation should not do.

Regulation should not introduce interest caps, prefer some institutional forms over others, encourage state sponsored microfinance programmes or engage in micro-regulation.

Enforcement of regulatory guidelines

Given that more than 80% of funds deployed by MFIs are borrowed from the banking and financial institutions, the guidelines can be made financing conditions and monitored through the lending institutions.  A board of supervision of microfinance can be set up.  This body should not engage in micro-regulation, but should reviews the annual reports given by lending banks.  The board should take up cases of those MFIs that are reported as being ‘non-compliant’ or ‘deviant’. The principal lending bank should be charged with providing an annual report on all their borrower MFIs describing compliance with regulatory guidelines and conclusions of the social audit exercise.  This might require some specialization within the banking sector which could be created and sustained with ongoing training.  As a further measure, rating agencies could be asked to include “quality of compliance with regulatory guidelines” in their standard reports.

Other matters

The microfinance sector should be formally represented in the SLBC and DLCCs.  Their performance (and problems) should be part of the review in these bodies.
Governments should provide a level playing field for the MFIs.  There is no point in highlighting the fact that MFIs charge high interest rates even when banks are provided subsidies to keep interest rates low to farmers, SHGs, etc., and permitted to charge separate service charges in they engage BCs to deliver services to customers.
MFIs could be used for delivery of government programmes on the same terms as that of banks.
Well run MFIs should be allowed to function as business correspondents so that costs of financial intermediation come down for banks, MFIs and customers.