Implementing Best Practice Regulatory Principles and Proportionate Regulation

Implementing Best Practice Regulatory Principles and Proportionate Regulation to Support MSME Access to Finance Regulatory and Supervisory Issues Arising from the Andhra Pradesh Micro Finance Crisis Sanjay Saxena Managing Director 1

Background It is self-evident that in the actual life of man intellectual, social, political, moral we can make no real step forward without a struggle, a battle between what exists and lives and what seeks to exist and live and between all that stands behind either. — Sri Aurobindo Ghosh 2

Types of MFIs in India # Types of MFI Not for Profit (NGO) MFIs 1 NGOs – Societies 2 NGOs – Trusts Mutual Benefit MFIs 3 Mutual benefit MFIs – Mutually Aided Cooperative Societies (MACS) Legal Registration Society Registration Act, 1860; Indian Trust Act, 1880 State Co-operative Societies Act Mutually Aided Co-operative Societies Act Multi State Cooperative Societies Act Not For Profit NBFC MFIs 4 Non-Banking Financial Companies (NBFCs) Section 25, Indian Companies Act, 1956 Reserve Bank of India Act, 1934 For Profit NBFC MFIs 5 Non-Banking Financial Company. Indian Companies Act, 1956 Micro Finance Institution Reserve Bank of India Act, 1934 (NBFC-MFI) A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956 and is engaged in the business of loans and advances, acquisition of shares/ stock / bonds / debentures / securities issued by Government or local authority or other securities of like marketable nature, leasing, hire-purchase, insurance business, chit business but does not include any institution whose principal business is that of agriculture activity, industrial activity, sale / purchase / construction of immovable property. A non-banking institution which is a company and which has its principal business of receiving deposits under any scheme or arrangement or any other manner, or lending in any manner is also a non-banking financial company (Residuary non-banking company). 3

Priority Sector Lending • RBI directive (since 1974) requires all PSU banks to allocate a% of their • loan portfolios to invest in specified priority sectors, at a rate lower than the Prime Lending Rate (PLR) of the Banks. While for local banks, both the public and private sectors have to lend 40 % of their net bank credit (NBC) to the priority sector as defined by RBI, foreign banks have to lend 32% of their NBC to the priority sectors, which currently are: – – – Agriculture (Direct and Indirect finance) Small Scale Industries (Direct and Indirect Finance) Small Business / Service Enterprises Micro Credit Education loans Housing loans • MFI lending is considered priority sector lending. Number of priority sectors • 4 reduced recently -> greater dependence to meet priority lending norms. Domestic banks having a shortfall in lending to priority sector/ agriculture allocated amounts for contribution to the Rural Infrastructure Development Fund (RIDF) established in NABARD. In case of foreign banks operating in India, which fail to achieve the priority sector lending target or sub-targets, an amount equivalent to the shortfall is required to be deposited with SIDBI for one year

Accepting Deposits • Only NBFCs and Cooperatives are permitted to accept deposits, • • 5 though NBFCs must adhere to more stringent regulations and Cooperatives are only permitted to accept deposits from their members, not the general public. The deposits limit for NBFCs is linked to the size of an institution's Net Owned Fund (NOF). No NBFC MFI currently accepts deposits because regulation requires that institutions must obtain an investment grade rating. Uncollateralized loans are considered more risky by rating agencies, making it extremely difficult for them to obtain such rating. NMFC MFIs’ excessive reliance on Banks for capital – 75% finance of NBFCs provided by Banks ->prevents a balanced portfolio of products and revenue sources for MFIs – Micro-credit as opposed to Micro Finance

Funding for MFIs • NBFCs can receive both equity and debt investments. • The main sources for domestic capital are currently SIDBI and NABARD in • • • 6 addition to the commercial, rural and cooperative banks. Recently local microfinance focused funds have also entered the market. NBFCs can raise foreign equity investment, though a minimum investment USD 500, 000 restriction applies. Stringent foreign investment rules, make it hard for international investors (specially social investors) to invest in India. RBI’s Foreign Investment Promotion Board (FIPB) has mandated the following minimum capitalization norms for fund based NBFCs: – i) For FDI up to 51% - US$ 0. 5 million to be brought upfront – ii) For FDI above 51% and up to 75 per cent - US $ 5 million to be brought upfront – iii) For FDI above 75% and up to 100% - US $ 50 million out of which US $ 7. 5 million to be brought upfront and the balance in 24 months NGOs are prohibited from becoming shareholders in NBFCs

The SHG-Bank Linkage Model • • • 7 Self Help Group Bank Linkage (SHG-BL) model pioneered by NABARD in 1992 15 -20 women form a Self Help Group (SHG) and regularly contribute small savings, typically on a weekly basis Savings are lent by the group to members, and are later supplemented by loans provided by banks for income-generating activities and other purposes for sustainable livelihood promotion Weekly / monthly meetings at which new savings come in, and recoveries are made from members towards their loans from the SHGs, their federations and banks NABARD provides grants, training and capacity building assistance to Self Help Promoting Institutions (SHPI), which in turn act as facilitators/ intermediaries for the formation and credit linkage of the SHGs 4. 5 million SHGs receiving credit nationwide, with 97 million rural households, through 7. 46 million SHGs, representing 58% (Rs. 312 billion) of the total loan outstanding portfolio of MFI sector in India

Progress of SHGBank Linkage Model 8

The NBFC Model • NBFCs encourage villagers to form Joint Liability Groups (JLG) and • • • 9 give loans to the individual members of the JLG Loans are jointly and severally guaranteed by the other members of the Group Many of the NBFCs operating this model started off as non-profit entities typically providing micro-credit services to the poor, but being unable to raise financing for rapid growth, they converted themselves into ‘for-profit’ NBFCs Others entered the field directly as for-profit NBFCs seeing this as a viable business proposition Significant amounts of private equity funds too have been attracted to this sector Till 2010, NBFC MFIs were expanding at an average annual rate of 80% reached 27 million borrowers and represented 34% (Rs. 137 billion) of the total loan outstanding portfolio of MFI sector in India

Progress of MFI-Bank Linkage Model Significant conversion of NGO MFIs into NBFC MFIs in the years preceding the AP crises of 2010 10

Background • Government’s active support for SHG-BL led to its success • In Andhra Pradesh (AP), the SHG program received substantial funding • • • 11 from the World Bank SHGs also provide an excellent platform for vote bank politics AP Govt. acts both - as a Regulator as well as a provider. Indian Government’s indirect support for MFIs through Priority Sector Lending quotas - large loans to MFIs with insufficient due diligence Phenomenal growth of MFI sector in AP However, state governments’ ambivalent stance toward interest rates and margin caps and occasional politically-motivated exhortations for loan waivers

Current MFI Regulation National Level Regulation • Currently there is no regulator that oversees NGO-MFIs, Cooperatives and Section 25 s • RBI is the Regulator for NBFCs, which are subject to some prudential regulation, including a minimum capital requirement, a capital adequacy requirement, and foreign investment restrictions. Since NBFCs encompass many types of financial institutions, MFIs operating as NBFCs are subject to no specific regulation relating to lending, pricing, or operations. • Most MFIs in India often voluntarily join an industry association (such as Microfinance Institutions Network (MFIN) and Sa-dhan), which acts as a commitment and guide for self-regulation. State Level Regulation • The Money Lending Act; and • The Andhra Pradesh Micro Finance Institutions (regulation of money lending) Ordinance, 2010, in case of AP. The Money Lending Act, though originally intended to restrict the interest rates charged by money lenders, has been applied to MFIs in some states. 12

Andhra Pradesh Crisis • AP in southeast India is the 5 th most populous of India’s 28 states, with a population of 75 million (larger than Iran, Turkey, France, Thailand, UK, Italy, South Africa – If AP was a country it would be the 17 th largest country) • Some of the largest NBFCs are registered in AP. • In AP, the average debt outstanding per household is Rs. 65, 000 as • • 13 compared to a national average of Rs. 7, 700 3% of ALL households in Andhra had more than one Micro-credit loan. The average no. of loans per poor household is>1 AP Govt. an autonomous body called Society for Elimination of Rural Poverty (SERP), which is implementing the SHG based Microfinancing in all the 22 rural districts of AP First crisis (called the “Krishna” crises) in 2005 : District Authorities closed 50 branches of 2 major NBFC MFIs due to allegations of usurious interest rates and forced lending Compromise reached between State Government and MFIs as per mutually agreed terms to improve governance , but MFIs subsequently largely ignored the agreed terms and reverted to ‘business as usual’

Andhra Pradesh Crisis • August 2010 : SKS Microfinance held the first Initial Public Offering • • • 14 (IPO) for an MFI in India, raising USD 347 million and drawing global attention to the potential profits of MFIs Media reports took divergent viewpoints on the IPO Media reports cited links between MFIs predatory lending, usurious interest rates and coercive collection techniques and the numerous suicides in rural Andhra Pradesh. AP Chief Minister promulgates the Andhra Pradesh Microfinance Ordinance 2010 – compulsory registration, numerous restrictions on MFI operations, virtually stopped all repayment collections, prohibited new loans. MFI with exposure to AP suffer significant losses. Banks stopped lending to MFIS all over India – serous liquidity crunch for MFIs The Reserve Bank of India (RBI) responded by appointing an RBI sub-committee know as the Malegam Committee.

Malegam Report (Report of the Sub-Committee of the Central Board of Directors of Reserve Bank of India to Study Issues and Concerns in the MFI Sector – January 2011) and Micro Financial Sector (Development and Regulation) Bill, 2011 & Reserve Bank of India Regulation 15

Malegam Committee – Terms of Reference • Review the definition of microfinance and MFIs for the purpose of • • • 16 regulation of NBFCs and make appropriate recommendations. Examine the prevalent practices of MFIs in regard to interest rates, lending and recovery practices to identify trends that impinge on borrowers interests. Delineate the objectives and scope of regulation of NBFCs undertaking microfinance by the RBI and the regulatory framework needed to achieve those objectives. Examine and make recommendations in regard to applicability of money lending legislation of the States and other relevant laws to NBFCs/ MFIs. Examine the role that associations and bodies of MFIs could play in enhancing transparency disclosure and best practices Recommend a grievance redressal machinery that could be put in place for ensuring adherence to the regulations recommended at 3 above. Examine the conditions under which loans to MFIs can be classified as priority sector lending and make appropriate recommendations.

Definition : Microfinance Services As per the proposed Microfinance Services Regulation Bill “Providing financial assistance to an individual or an eligible client, either directly or through a group mechanism for : • an amount, not exceeding Rs. 50, 000 in aggregate per individual, for small and tiny enterprise, agriculture, allied activities (including for consumption purposes of such individual) or • an amount not exceeding Rs. 150, 000 in aggregate per individual for housing purposes, or • such other amounts, for any of the purposes mentioned at items (i) and (ii) above or other purposes, as may be prescribed. ” 17

Definition : Micro Finance Institution (MFI) As per the proposed Microfinance Services Regulation Bill “An organisation or association of individuals including the following if it is established for the purpose of carrying on the business of extending microfinance services : • a society registered under the Societies Registration Act, 1860, • a trust created under the Indian Trust Act, 1880 or public trust registered under any State enactment governing trust or public, religious or charitable purposes, • a cooperative society / mutual benefit society / mutually aided society registered under any State enactment relating to such societies or any multistate cooperative society registered under the Multi State Cooperative Societies Act, 2002 but not including : • a cooperative bank as defined in clause (cci) of section 5 of the Banking Regulation Act, 1949 or • a cooperative society engaged in agricultural operations or industrial activity or purchase or sale of any goods and services. ” 18

MFI Regulation Status • January 2011: Malegam Committee report containing recommended • • • 19 regulations released May 2011 : Recommendations were 'broadly accepted' by RBI in, though specific regulation was only released regarding which institutions qualify for priority sector lending at this time An updated version of the Micro Finance Institutions (Development and Regulations) Bill 2011 in Parliament, which aims to provide a regulatory structure for all MFIs The Bill has not been passed as yet

Entry Point Norm Malegam Report RBI Directive NBFC-MFIs should have a minimum Net All new NBFC-MFIs except those in the North Eastern Region of the country Worth of Rs. 15 crores. should have a minimum Net Owned Funds(No. F) of Rs 5 crore; Those located in the North eastern region should have a minimum No. F of Rs. 2 crore for purposes of registration. The existing NBFCs to be classified as NBFC-MFIs will be required to comply with this norm w. e. f April 01, 2012. 20

Capital Requirement Malegam Report NBFC-MFIs should be required to maintain Capital Adequacy Ratio of 15% all of the Net Owned Funds should be in the form of Tier I Capital. RBI Directive New NBFC-MFIs shall maintain a capital adequacy ratio consisting of Tier I and Tier II Capital which shall not be less than 15 percent of its aggregate risk weighted assets. The total of Tier II Capital at any point of time, shall not exceed 100 percent of Tier I Capital. 21

Provisioning Norms Malegam Report RBI Directive Aggregate loan provision to be maintained by NBFC-MFIs at any point of time shall not be less than the higher of • 1% of the outstanding loan portfolio or • 50% of the aggregate loan instalments which are overdue for more than 90 days and less than 180 days and 100% of the aggregate loan instalments which are overdue for 180 days or more. 22

Pricing of Credit Malegam Report RBI Directive “Margin cap” of 10% in respect of MFIs which have an outstanding loan portfolio at the beginning of the year of Rs. 100 crores and a “margin cap” of 12% in respect of MFIs which have an outstanding loan portfolio at the beginning of the year of an amount not exceeding Rs. 100 crores. All NBFC-MFIs to maintain an aggregate margin cap of not more than 12%. The interest cost will be calculated on average fortnightly balances of outstanding borrowings and interest income is to be calculated on average fortnightly balances of outstanding loan portfolio of qualifying assets. Interest on individual loans will not exceed 26% per annum and calculated on a reducing balance basis. Processing charges shall not be more than 1% of gross loan amount. NBFC-MFIs to recover only the actual cost of insurance – Administrative charges where recovered, shall be as per IRDA guidelines. A cap of 24% interest on individual loans. Only the actual cost of insurance should be recovered and no administrative charges should be levied. 23

Transparency in Interest Rates Malegam Report RBI Directive a. Only three components in the pricing of a. There shall be only three components in the loan, namely (i) a processing fee, not the pricing of the loan viz. , the interest exceeding 1% of the gross loan amount charge, the processing charge and the (ii) the interest charge and (iii) the insurance premium (which includes the insurance premium. administrative charges in respect there of). b. There should not be any recovery of b. NBFC-MFIs shall not collect any Security security deposit. Security deposits already Deposit/ Margin from the borrower. collected should be returned. c. There will be no penalty charged on c. There should be adequate regulations delayed payment. regarding the manner in which insurance premium is computed and collected and d. There should be a standard form of loan policy proceeds disposed off. agreement. d. There should be a standard form of loan agreement. 24

Transparency in Interest Rates Malegam Report RBI Directive d. Every MFI should provide to the borrower e. Every NBFC-MFI should provide to the a loan card which borrower a loan card reflecting i. shows the effective rate of interest i. the effective rate of interest charged ii. the other terms and conditions attached ii. all other terms and conditions to the loan attached to the loan iii. information which adequately identifies iii. information which adequately the borrower and identifies the borrower and iv. acknowledgement by the MFI of iv. acknowledgements by the NBFC-MFI payments of instalments received and the of all repayments including final discharge. instalments received and the final v. The Card should show this information in discharge. the local language understood by the v. All entries in the Loan Card should be borrower. in the vernacular language. The effective rate of interest charged by the MFI should be prominently displayed in all its offices and in the literature issued by it and on its website. 25 The effective rate of interest charged by the NBFC-MFI should be prominently displayed in all its offices and in the literature issued by it and on its website

Multiple-lending, Over-borrowing and Ghostborrowers Malegam Report RBI Directive i. MFIs should lend to an individual borrower a. NBFC-MFIs can lend to individual borrowers only as a member of a JLG and should have who are not member of Joint Liability the responsibility of ensuring that the Group(JLG)/Self Help Group(SHG) or to borrower is not a member of another JLG. borrowers that are members of JLG/SHG. ii. A borrower cannot be a member of more b. A borrower cannot be a member of more than one SHG/JLG. not more than two NBFC iii. Not more than two MFIs should lend to the -MFIs should lend to the same borrower. c. A minimum period of moratorium between iv. There must be a minimum period of the grant of the loan and the due date of the moratorium between the grant of the loan repayment of the first instalment. The and the commencement of its repayment. moratorium shall not be less than the frequency of repayment. For e. g. : in the case of weekly repayment, the moratorium shall not be less than one week. 26

Multiple-lending, Over-borrowing and Ghostborrowers Malegam Report v. recovery of loan given in violation of the d. Recovery of loan given in violation of the regulations should be deferred till all prior existing loans are fully repaid. All sanctioning and disbursement of loans should be done only at a central location and more than one individual should be involved in this function. In addition, there should be close supervision of the disbursement function. 27 RBI Directive All sanctioning and disbursement of loans should be done only at a central location and more than one individual should be involved in this function. In addition, there should be close supervision of the disbursement function.

Non-Coercive Methods of Recovery Malegam Report RBI Directive i. The responsibility should rest with the MFIs • NBFC-MFIs shall ensure that a Code of and they should be subject to severe Conduct and systems are in place for penalties if coercive methods are used. recruitment, training and supervision of field ii. The regulator to monitor whether MFIs have staff. The Code of Conduct should also a proper Code of Conduct and proper incorporate the Guidelines on Fair Practices systems for recruitment, training and Code issued for NBFCs vide circular CC supervision of field staff to ensure the No. 80 dated September 28, 2006 as prevention of coercive methods of recovery. amended from time to time. iii. Field staff should not be allowed to make recovery at the place of residence or work of the borrower and all recoveries should only be made at the Group level at a central place to be designated. 28

Non-Coercive Methods of Recovery Malegam Report Each MFI must establish a proper Grievance Redressal Procedure. The institution of independent Ombudsmen should be examined and based on such examination, an appropriate mechanism may be recommended by RBI to lead banks. RBI Directive • Recovery should normally be made only at a central designated place. Field staff shall be allowed to make recovery at the place of residence or work of the borrower only if borrower fails to appear at central designated place on 2 or more successive occasions. • All other elements of the Fair Practices Code issued for NBFCs vide CC No 80 dated September 28, 2006 as amended from time to time shall be adhered to. 29

Corporate Governance Malegam Report Every MFI should be required to have a system of Corporate Governance in accordance with rules to be specified by the Regulator. RBI Directive Listed NBFCs which are required to adhere to listing agreement and rules framed by SEBI on Corporate Governance are already required to comply with SEBI prescriptions on Corporate Governance. Detailed guidelines are already available. 30

Improvement of Efficiency Malegam Report MFIs should review their back office operations and make the necessary investments in Information Technology and systems to achieve better control, simplify procedures and reduce costs. 31 RBI Directive NBFC-MFIs shall review their back office operations and make the necessary investments in Information Technology and systems to achieve better control, simplify procedures and reduce costs.

Priority Sector Status Malegam Report RBI Directive Bank advances to MFIs shall continue to enjoy “priority sector lending” status as However, advances to MFIs which do not per the revised guidelines. comply with the regulation should be denied “priority sector lending” status. 32

Money Lending Acts Malegam Report RBI Directive NBFC-MFIs should be exempted from the No directive as yet. provisions of the Money-Lending Acts, especially as interest margin caps and increased regulation are recommended. 33

Credit Information Bureau Malegam Report a) One or more Credit Information Bureaus should be established and be operational as soon as possible and all MFIs be required to become members of such bureau. b) In the meantime, the responsibility to obtain information from potential borrowers regarding existing borrowings should be on the MFI. 34 RBI Directive No provision as yet.

Customer Protection Code Malegam Report RBI Directive Regulator should publish a Client No provision as yet. Protection Code for MFIs and mandate its acceptance and observance by MFIs. Code should incorporate the relevant provisions of the Fair Practices Guidelines prescribed by the Reserve Bank for NBFCs. similar provision should also be made applicable to banks and financial institutions which provide credit to the microfinance sector. 35

Monitoring of Compliance Malegam Report a) Primary responsibility for ensuring compliance with the regulations should rest with the MFI itself and its management must be penalized in the event of non-compliance b) Industry associations must ensure compliance through the implementation of the Code of Conduct with penalties for non-compliance. c) Banks must play a part in compliance by surveillance of MFIs through their branches. d) The Reserve Bank should have the responsibility for off-site and on-site supervision of MFIs but the on-site supervision may be confined to the larger MFIs 36 RBI Directive Recommended a role for industry associations in monitoring of compliance by NBFC-MFIs with the regulations. Separate guidelines in this regard will follow.

Key Points 37

Key Points • RBI as the MFI Regulator for all MFIs (but not Cooperatives) is a • • • 38 major step forward. May delegate any of its powers for some type of MFIs to NABARD RBI–registered MFIs not to be treated as money lenders under State level Acts – major step forward as this will free MFIs from populist actions of state governments Minimum capital + extent of deployment of assets in microfinance is Rs 500, 000 ($11, 000) initially will ensure that MFIs focus largely on micro credit A few very large NGO MFIs will be affected with the requirements of being transformed to an NBFC (or Section 25 Company) Services offered include Micro-credit, thrift, remittance, pension & insurance services - opens the door for MF NBFCs to offer thrift services and enables to move beyond micro-credit No savings passbook, thrift must be in the form of term or recurring deposits – denies clients the flexibility of frequent withdrawals

Key Questions • Do the onerous regulatory provisions pertaining to pricing, • • • 39 profitability and conduct of business amount to micro managing the sector? Does RBI have the bandwidth to supervise all MFIs? Is the development of the MF sector an ideal role for a central bank, or should it be entrusted to a more specialized agency? Has the development function taken a backseat to supervision function? Should the Act be preceded by a Financial Inclusion Policy & Strategy? Should there be universal code of conduct to ensure client protection for ALL MFIs?

Thanks sanjay@tscpl. com Disclaimer : The views expressed in this presentation are those of the author and do not reflect the official policy or position of their respective institutions. Figures quoted in this presentation have been primarily taken from RBI, SIDBI, NABARD and Mo. F reports and documents. Inadvertent errors, if any, are attributable to the author. 40

SIDBI • Setup under the SIDBI Act, 1989 • The preamble to the Small Industries Development Bank of India • • Act, 1989 defines the objective of SIDBI as: "the principal financial institution for the promotion, financing and development of industry in the small scale sector and to co-ordinate the functions of the institutions engaged in the promotion and financing or developing the industry in the small scale sector and for the matters connected therewith or incidental thereto. “ 4 basic objectives set out in the SIDBI Charter 1. 2. 3. 4. Financing Promotion Development Coordination • for orderly growth of industry in the small scale sector. 41

NABARD • Setup under “The National Bank For Agriculture And Rural • • Development Act, 1981” An Apex Development Bank with a mandate for facilitating credit flow for promotion and development of agriculture, small-scale industries, cottage and village industries, handicrafts and other rural crafts. Mandate to support all other allied economic activities in rural areas, promote integrated and sustainable rural development and secure prosperity of rural areas. • • • – – 42 – Providing refinance to lending institutions in rural areas Bringing about or promoting institutional development and Evaluating, monitoring and inspecting the client banks Acts as a coordinator in the operations of rural credit institutions Extends assistance to the government, the Reserve Bank of India and other organizations in matters relating to rural development Offers training and research facilities for banks, cooperatives and organizations working in the field of rural development Helps the state governments in reaching their targets of providing assistance to eligible institutions in agriculture and rural development Acts as regulator for cooperative banks and RRBs