Microfinance, micro manage

By Arun Madhu and Akanksha Midha, Phoenix Legal
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Microfinance is not quite so micro anymore and, as the potential to book profits from it grows, so does its potential for scandal. It is the latter that has prompted a scramble to regulate the sector.

Arun Madhu Senior associate Phoenix Legal
Arun Madhu
Senior associate
Phoenix Legal

After a failed attempt in 2007 by parliament to pass the Micro Financial Sector (Development and Regulation) Bill (MF Bill), the Andhra Pradesh government recently undertook an initiative to regulate the industry. The state had been plagued by a spate of borrower suicides that was allegedly linked to unbridled lending and strong-arm recovery tactics by microfinance institutions (MFIs). So in an attempt to keep things in check the state government on 15 October passed the Andhra Pradesh Microfinance Institutions (Regulation of Money Lending) Ordinance, 2010.

This ordinance requires all MFIs in Andhra Pradesh to register with a state government-appointed authority. A majority of MFIs are non-banking financial companies (NBFCs), which are already regulated by the Reserve Bank of India (RBI). As such, the new ordinance has resulted in an overlap of jurisdictions.

Leave it to the experts

Given the RBI’s expertise in policy making in the financial services sector, and the fact that it already monitors NBFC MFIs, it may be more effective to bring regulation of MFIs within the RBI’s mandate rather than adding the state government authorities into the mix. In fact, the RBI may be a more effective choice than NABARD, which is the proposed regulator under the MF Bill.

A key concern for both policymakers and MFIs themselves is multiple lending to the same borrower and excessive geographic concentration of micro loans. This results in sub-prime lending, the dangers of which have never been clearer.

Seeking solutions

Although MFIs have attempted self-regulation on this count through the recently formed Microfinance Institutions’ Network (MFIN), its efficacy is limited by the voluntary nature of membership and the vested interests of its members. Given that Andhra Pradesh has the highest penetration of micro credit in the country, the problem of loan-pushing and excessive lending is acute in the state. As one would expect, the Andhra Pradesh ordinance seeks to address this issue by stipulating that no person shall be a member of more than one self-help group, which is the collective of borrowers who guarantee each others’ loans. Multiple loans to the same borrower now require prior regulatory approval.

While such streamlining is no doubt required, it could have been done in phases. This would have given borrowers some lead time to repay the multiple loans already obtained. Unfortunately, this provision is effective immediately, forcing borrowers to either default on repayment or lead to breach of the ordinance.

Akanksha Midha Associate Phoenix Legal
Akanksha Midha
Associate
Phoenix Legal

Bringing transparency

Another aim of the Andhra Pradesh ordinance is to prevent the exploitation and harassment of borrowers by MFIs. To this end, it has capped the interest payable to an amount equal to the principal amount borrowed, imposed disclosure requirements in respect of interest rates and recovery mechanisms adopted, imposed penal provisions on the directors and officers of MFIs for coercive recovery tactics and prohibited procurement of security for micro loans in any form including pawn or pledge. However, the definition of coercive action is fairly wide and there is a concern that it may also include existing practices where is there is no coercive intent.

Knee-jerk reactions

Since the promulgation of the ordinance, collections have fallen from over 90% to nearly 30%. The ordinance and its effects thus far have made banks and other financers of MFIs wary, choking off the debt and equity fund flows which keep the capital hungry microfinance industry up and running. The stock price of SKS Microfinance, India’s largest MFI, tanked in the aftermath of the ordinance and other players are also worried, with their credit ratings having been adversely impacted.

Thus far, the Indian policy framework has been structured to encourage micro lending with both micro borrowers and MFIs, helping to meet priority sector lending targets set by the RBI for banks. However, if Andhra Pradesh’s regulatory attempt is anything to go by, the industry must prepare itself for uncertain growth and irrevocable change.

While it is clear that regulation of the microfinance sector is the need of the hour, perhaps Andhra Pradesh’s experiment has been somewhat hasty. Despite its stated objectives, the ordinance is by and large considered a knee-jerk reaction to check unhealthy practices followed by some MFIs. As such, it fails to facilitate holistic financial inclusion by encouraging or incentivizing micro savings, micro investments and increased penetration.

Arun Madhu is a senior associate and Akanksha Midha is an associate at Phoenix Legal in Mumbai. They can be reached at arun.madhu@phoenixlegal.in and akanksha.midha@phoenixlegal.in.

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