Regulation in microfinance, a work in progress

In a previous post I already emphasized the importance of the regulatory framework for a healthy development of the microfinance sector. In India, the question of policing the industry has taken an acute human dimension in the wake of the Andhra Pradesh crisis .

The Reserve Bank of India is responsible for regulating the financial sector.

After the wake-up call of this crisis in 2010, a commission was formed to reflect on the matter and make recommendations to the Reserve Bank of India (“RBI”), the regulator. This resulted in the publications last December of guidelines for a new type of financial institutions: the Non-Banking Financial Companies – Microfinance Institutions, or NBFC-MFI. MFIs would have to comply in order to qualify as recipient of priority lending, an important factor when looking for funding in India. A bill laying out a comprehensive regulation of MFIs was presented to the parliament and is expected to be voted as law before the end of the year.

It is common place to say that regulations are like pendulums: when a crisis results from them being too loose, they swing to the other extreme and become too stringent, or the other way around. And indeed the December guidelines for MFIs could appear quite constraining. It imposed a margin cap at 12% and an interest rate cap at 26%. Revenues of clients, amount of loans, maturities and other features would make a loan qualify as a microloan. In order to be considered an MFI, an institution had to have 85% of its portfolio qualifying as such. Moreover, 75% of loans had to specifically be used for productive, i.e. business purposes, excluding housing, health and education expenses that often also yield investment returns in the form of rent, increased work force, and better prospects.

Outside the RBI in Mumbai.

Such limits were problematic for many MFIs. 26% interest rate might sound like a lot, but once you account for cost of finance (MFIs have to borrow the money they ultimately lend to microborrowers, and interest rates on such corporate loans run in the double digits) and the cost of operations, it was difficult for many MFIs to break even.

Quite logically, MFIs conveyed their worries to the RBI. And quite rapidly (and surprisingly some would say), they were heard. On August 3^rd the RBI issued new guidelines that dismissed some provisions of the December version, clarified others, and added some new ones. Constraints of portfolio composition and modalities of provisioning Andhra Pradesh losses were eased. The margin cap stayed, being even lowered to 10% for large MFIs, but the fixed interest rate cap was removed and replaced by a more flexible floating mechanism that allows MFIs to translate higher financing costs to their pricing while obliging them to pass the benefit of lower costs to their customers.

It is too early to say what good and bad the guidelines and future law will do to the sector. But what is definitely good is to see that there is an ongoing dialogue between the regulator and the regulated, with a level of flexibility and realism on both sides. That alone is a strong signal for the future stability of the market, and the prosperity of both microlenders and microborrowers.