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Can microfinance institutions lower their loan rates?

Posted on 07 November 2011,    
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India’s Parliament is expected to take up a Bill for discussion in the ensuing winter session that will govern microfinance institutions (MFIs). When it becomes law, the Micro Finance Institutions (Development and Regulation) Bill will give more powers to the Reserve Bank of India (RBI) to regulate lenders that give tiny loans to poor borrowers at an interest rate much higher than what commercial banks charge. They do so as banks do not reach out to all micro borrowers.

The most critical part of the Bill is that MFIs registered with the Indian central bank won’t be treated as moneylenders. This essentially means they will be kept out of the purview of a state law, which has restricted the operations of microlenders.

Roughly a quarter of the Rs.20,000 crore industry is concentrated in Andhra Pradesh, India’s fifth largest state, where MFIs are seeing a rise in bad assets as many borrowers have stopped repaying loans. In October 2010, the state promulgated a law, which many say is draconian, following reports of coercion in recovering loans that allegedly led to suicides by a few borrowers. With the rise in bad loans, most banks have stopped giving money to MFIs. Typically, MFIs borrow from banks at around 12% and lend to tiny borrowers charging at least double the interest rate. Under norms, banks are required to give 40% of their loans to agriculture and small industries, among others, under the so-called priority sector tag, and banks’ exposure to MFIs is also treated as a priority sector loan.

There are two types of MFIs—one set operates as non-banking finance companies (NBFCs), and others as trusts. The trusts, though large in number, do not have sizable assets, and profit-making NBFC-MFIs need strict regulation. Early this year, RBI issued regulations to govern MFIs operating as NBFCs, based on the recommendations of an expert committee, headed by chartered accountant Y.H. Malegam.

The Bill is modelled on some of the recommendations of this committee. It has recommended capping the interest rate MFIs can charge at 26% and made a minimum two-year tenure mandatory for all loans above Rs.15,000. It has also recommended systemically important MFIs’ registration under the Companies Act. Besides, it has proposed the setting up of a Microfinance Development Council that will advise the government on policies and programmes required for the development of the sector, and state advisory councils for close coordination between the states and the Centre in this space. Among others, it has also envisaged a Microfinance Development Fund to be set up by RBI for giving loans, refinance, grants, seed capital or any other financial assistance to any MFI. Finally, it seeks to empower RBI to ask MFIs to cease their activities and even cancel registration if the central bank’s inspection team is not happy with their accounts.

In this context, it will be interesting to note some of the recommendations of an RBI working group that never saw the light of the day. Headed by V.K. Sharma, an executive director of the central bank, it submitted a report in August 2010 and I don’t know why it was given a silent burial. The working group took a close look at the key financial parameters such as return on assets (RoA), return on equity (RoE), net interest margin (NIM), and equity multiplier or leverage of banks, non-banking finance companies and MFIs.

NIM, or the difference between interest earned and interest expended as a percentage of total assets, for the banking sector in 2008-09 was 2.4%, but for MFIs it varied between 10% and 14%. If one subtracts RoA from NIM, one gets an idea about the intermediation cost for delivery of loans. For banks, it was 1.4%, but for MFIs it is 7-10%. This means the credit delivery cost of MFIs is five-seven times that of banks. They can reduce it by looking for a lower RoA, but they do not do so because they are more concerned about rewarding shareholders than spreading a credit culture.

The Sharma working group report also debunked the theory that MFIs have greater penetration than the banking industry’s reach through self-help groups (SHGs). It said that 33,000 rural bank branches have covered at least 100,000 villages, and in 2009 the banking sector lent Rs.22,700 crore through SHGs, while MFIs lent about Rs.15,000 crore in 2010.

The group was in favour of covering the unbanked tiny borrowers through the banking channel. This could be done through four ways—by giving banks freedom to open branches in centres with less than 50,000 population without RBI authorization; setting up brick-and-mortar branches in 73,000 villages by March 2012; allowing banks to arrange for doorstep banking services through banking correspondents in villages with a population below 2,000; and removing any ceiling on interest rates for small loans.

While the ceiling on interest rates has already been removed, most other issues are being addressed. A recent finance ministry note has also said that by September 2012, there must be at least one bank branch in villages with 5,000 population. RBI has identified 296 districts across the nation where there is less than one branch for 14,000 people, and the ministry note has asked public sector banks, which account for 70% of the industry, to open one branch every 80 sq. km in each of the 296 under-banked districts.

The working group had suggested that unless MFIs cut the cost of intermediation and eventually the cost of loans, banks should stop giving them money as a part of their exposure to priority sector. It had suggested a conditional sunset period till March 2012, and had MFIs not shown any progress in paring loan rates, they should be denied this facility. Banks, of course, can continue to give money to MFIs as commercial loans. A good idea that found no taker.


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