The Regulation of Microfinance in India:
DRAFT: NOT FOR CIRCULATION
70000
India:
The Regulation of Microfinance – An Analysis of Recent Proposals
March 2006
Finance and Private Sector Development Unit South Asia Consultative Group to Assist the Poor
[pic]THE WORLD BANK [pic]
CONTENTS
EXECUTIVE SUMMARY i
I. Introduction 1
II. Overview of Microfinance in India 5
2.1 Introduction 5
2.2 Three Models of Microfinance Delivery in India 6
2.2.1 SHG-Bank Linkage Model 6
2.2.2 Free-Standing MFI Model 7
2.2.3 Bank Agency Model 9
III. Overview of Current Legal and Regulatory Treatment of Microfinance in India 11
3.1 Introduction 11
3.2 Legal and Regulatory Bases of the SHG-Bank Linkage Model 12
3.3 Legal and Regulatory Bases of the Free-Standing MFI Model 13
3.3.1 MFIs Unregulated by the RBI 13
3.3.2 MFIs Regulated by the RBI 15
3.4 Legal and Regulatory Bases of the Bank Agency Model 17
IV. Proposals for and Positions on Regulatory Reform 19
4.1 Introduction 19
4.2 Reform Proposals and Positions Related to the Free-Standing MFI Model 19
4.2.1 Overview 19
4.2.2 Proposals Aimed at Formal Government Recognition of Credit-Only MFIs not Regulated by the RBI 20
4.2.3 Proposals Aimed Primarily at Enhancement of Transparency in the Microfinance Sector 21
4.2.4 Proposals Aimed at Permitting Voluntary Savings Mobilization by MFIs not Regulated by the RBI 22
4.2.5 Proposals Aimed at Easing Eligibility Requirements for Operating as a Deposit-Taking Microfinance NBFC or Microfinance Bank 22
4.2.6 Proposals Aimed at Accomplishing Substantially all the Foregoing Objectives Through New Microfinance-Specific Legislation 23
V. Foreign Experience with Specialized Regulatory Treatment of Microfinance Applied in the Indian Context 27
5.1 Introduction 27
5.2 Regulation of Non-Depository Institutions 28
5.3 Encouraging Formation of and Transformation into Regulated Depository MFIs through Less Stringent Licensing Requirements 32
5.3.1 Lowering Minimum Paid-In Capital Requirements to Encourage Formation of Depository Microfinance 32
5.3.2 Adding Tiers to Banking Regulation to Permit/Facilitate NGO Transformations 36
5.4 ‘Umbrella’ Legislation Imposed Over Existing Heterogeneous Financial System 39
5.5 Parallel Frameworks for Microfinance 41
5.6 Bank Agency Relationships 43
VI. Summary Analysis of Legal and Regulatory Reform Proposals 45
6.1 Introduction 45
6.2 Proposals Aimed at Formal Government Recognition of Credit-Only MFIs Not Regulated by the RBI 46
6.3 Proposals Aimed at Enhanced Transparency in the Microfinance Sector 47
6.4 Proposals Aimed at Permitting Limited Voluntary Savings Mobilization by MFIs Not Regulated by the RBI 48
6.5 Proposals Aimed at Establishing a Form of Specialized Deposit-Taking Microfinance NBFC with Less Stringent Licensing Requirements 50
6.6 Proposals Aimed at Accomplishing Substantially All the Foregoing Objectives Through New Microfinance-Specific Legislation 52
Bibliography 55
Annex 1: Persons Consulted during India Mission 57
Annex 2: Persons Consulted regarding Foreign Experiences 59
ACKNOWLEDGEMENTS
This note was prepared by a team led by Niraj Verma (Finance and Private Sector Development, South Asia Region, World Bank) and Timothy Lyman (Consultative Group to Assist the Poor) and including Kate Lauer (Consultant) and Lee Byrd (Consultant). The contribution of the Indian legal counsel, Trilegal (Consultant), is acknowledged, particularly in terms of ensuring legal accuracy with respect to Indian laws and regulation in the discussion in the note. The peer reviewers were Bikki Randhawa (Financial Sector Operations and Policy Department), Mohini Malhotra (World Bank Institute) and Richard Rosenberg (Consultative Group to Assist the Poor). The report was prepared under the overall guidance of Barbara Kafka (Director, Finance and Private Sector Unit, South Asia Region) and Simon Bell (Manager, Finance and Private Sector Unit, South Asia Region), Priya Basu (Lead Economist, Finance and Private Sector Unit, South Asia Region) and Stephen Rasmussen (Lead Specialist, Finance and Private Sector Unit, South Asia Region). Heather Fernandes and Lizy Mathew (South Asia Finance and Private Sector Development Unit) provided administrative support.
The team expresses its appreciation to all the persons consulted during the primary research mission as well as during follow up consultations. The team would especially like to acknowledge the various discussions with and inputs from the Financial Sector division in the Ministry of Finance, the Reserve Bank of India, the National Bank for Agriculture and Rural Development and the main network for microfinance in India, Sa-Dhan. The note also draws on the growing body of analytical material on the subject of microfinance regulation and supervision that is available on the international stage, as well as on the experience of experts who have been involved with other countries’ consideration of similar issues. The team expresses its appreciation to these persons for the time they spent discussing various countries' experience. And last but not least, funding support from the Swiss Agency for Development and Cooperation is also gratefully acknowledged.
ABBREVIATIONS & ACRONYMS
|AP |Andhra Pradesh |
|BAM |Banque-Al-Maghrib |
|BKD |Village Credit Board |
|BoG |Bank of Ghana |
|BOU |Bank of Uganda |
|BPR |Bank Perkreditan Rakyat |
|BRI |Bank Rakyat Indonesia |
|CBA |Central Bank of Armenia |
|CCI |Cooperative Credit Institution |
|ECB |External Commercial Borrowing |
|FFP |Private Financial Fund |
|FMFB |First MicroFinanceBank |
|GOI |Government of India |
|GTZ |German Gesellschaft für Technische Zusammenarbeit |
|ICAI |Institute of Chartered Accountants of India |
|KYC |Know-your-Customer |
|LAB |Local Area Bank |
|LDKP |Rural Fund and Credit Institution |
|MACS |Mutually Aided Cooperative Society |
|M-CRIL |Micro-Credit Ratings International Ltd. |
|MDI |Microfinance Deposit-Taking Institution |
|MFDC |Microfinance Development Council |
|MFI |Microfinance Institution |
|MIS |Management Information Systems |
|NABARD |National Bank for Agriculture and Rural Development |
|NBFC |Non-Bank Finance Company |
|NB-MFI |Non-Bank Microfinance Institution |
|NCAER |National Council of Applied Economic Research |
|NGO |Non-Governmental Organization |
|PACS |Primary Agricultural Cooperative Society |
|POS |Point-of-Sale |
|ProFI |Promotion of Small Financial Institutions |
|RBI |Reserve Bank of India |
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|RCB |Rural and Community Bank |
|ROSCA |Rotating and Savings Credit Association |
|RRB |Regional Rural Bank |
|SBP |State Bank of Pakistan |
|SEBI |Securities and Exchange Board of India |
|SHG |Self Help Group |
|SIDBI |Small Industries Development Bank of India |
|SME |Small and Medium Enterprise |
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CURRENCY EQUIVALENTS
As of January 31, 2006, US$1 = Rs. 44.07
EXECUTIVE SUMMARY
Background
The Indian microfinance community has been pushing for legal and regulatory reform for several years, motivated primarily by two desires: (i) formal legal recognition and legitimization of the various types of microfinance institutions (MFIs) operating in India and (ii) legal permission to engage in deposit-taking with lower and fewer entry barriers. Members of the microfinance community have engaged with the Government of India in a dialogue regarding the regulation of microfinance service delivery, arguing that there is a need for reform to facilitate expansion of outreach through microfinance to the millions of Indians who currently do not have access to financial services. Various stakeholders have proposed a range of possible reform measures, which vary in their approaches and in their potential effects on the microfinance sector.
Through an analysis and presentation of the pros and cons of various reform proposals, this note aims to provide a tool with which decision-makers can assess these proposals (summarized below) without being prescriptive. And while the note focuses on proposals pertaining to the microfinance sector only, this emphasis is driven by the need for additional input into the on-going dialogue regarding microfinance regulation and is not indicative of a view that regulatory issues are the most significant constraint to scaling up microfinance in India. Indeed, other constraints – specifically, limited institutional capacity and a lack of appropriate financing – may in fact be more fundamental for the microfinance sector and would ideally be addressed before undertaking any regulatory reform. Furthermore, the proposals discussed in this note would affect institutions that currently account for only a small (albeit growing) part of the overall financial sector. There are likely to be future proposals for reform pertaining to the broader financial sector – reducing government ownership of banking institutions, restructuring and revitalizing rural finance institutions, revisiting directed credit schemes – which may have a greater impact on improving access to financial services for the poor and which therefore merit greater attention from policy makers. Nonetheless, the reform proposals discussed in this note have been accorded attention by the Government and are important to examine for several reasons, including the stated rationale for reform (to increase access to financial services for the poor), the fast growth rate of microfinance and its potential for future expansion, and the intensity of the discussions between the Government and the microfinance sector.
There are currently four models for microfinance delivery in India although, as discussed below, the reform proposals focus on only one of the models. The four models are: the direct provision of microfinance by banks, the free-standing MFI model, the self-help group (SHG)-bank linkage model and the bank agency model. The direct provision of microfinance services by banks is by far the most prevalent means of microfinance delivery in India; however, it is not addressed in this note because it does not raise significant legal and regulatory issues and has not been a significant topic in the current dialogue. The note discusses the legal and regulatory framework for the other three models but analyzes only proposals that relate to the free-standing MFI model. The SHG-bank linkage model, which provides microfinance services through India’s vast network of formal financial institutions, operates largely within the existing legal and regulatory framework and currently does not raise any significant regulatory issues and there are no proposals for reform currently being discussed. The bank agency model, pursuant to which banks engage agents to carry out various financial activities, has recently been the subject of a major reform measure – a January 2006 Reserve Bank of India (RBI) circular that permits banks to use Non-Governmental Organizations (NGOs), Self Help Groups (SHGs), Microfinance Institutions (MFIs) and other civil society organizations as agents for conducting such activities on the micro level. In contrast, significant proposals are currently being debated with respect to the free-standing MFI model.
Proposals for Reform
Many stakeholders feel that the free-standing MFI model, which encompasses a wide array of institutional types, including institutions that are unregulated and institutions that are regulated by the RBI, is constrained by significant regulatory barriers that limit outreach and the provision of a comprehensive range of financial services. In particular, there is dissatisfaction among many MFIs with the current regulations that (i) permit only those MFIs registered as non-bank finance companies (NBFCs) to mobilize voluntary deposits from the public and (ii) pose significant obstacles – financial and operational – for MFIs wishing to transform into an NBFC, especially the required minimum entry capital levels, which are perceived to be too high. Other MFIs not interested in deposit-taking are seeking an operating environment in which they have greater, legally recognized legitimacy. These MFIs recognize that increased transparency is also desirable, both to develop a healthier sector and to provide a clearer picture of the sector and its participants to the world at large (including commercial lenders). In response, various stakeholders have proposed reforms addressing one or more of the following topics: i) formal legal recognition of MFIs not regulated by the RBI; ii) enhanced transparency in the microfinance sector; iii) limited voluntary savings mobilization by MFIs not regulated by the RBI; iv) creation of a form of deposit-taking microfinance NBFC, which would be subject to less stringent requirements than those applicable to other NBFCs, and v) adoption of a microfinance-specific legislation encompassing all of the foregoing attributes.
Summary Observations on the Proposals
The following text summarizes the note's observations with respect to the five reform proposal topics listed above:
i. Formal government recognition of credit-only MFIs. Formal government recognition of credit-focused MFIs that are not regulated by the RBI may help to clarify the legal situation of these MFIs and legitimize their activities. However, a few points need to be kept in mind. First, these institutions already have significant access to commercial funds, suggesting that their legal status may not be a significant operational limitation in this respect. In addition, international experience demonstrates that a formal legislative definition of the microfinance sector is rarely, if ever, possible without limiting MFIs' operational flexibility. As a consequence, implementation of the idea in India may result in a trade-off for practitioners: clearer legal recognition of their legitimacy, but diminished operational flexibility. Also, when considering the practical effects of legislative recognition by the central-level Government, it is important to keep in mind that such recognition will likely neither be a sufficient condition to make MFIs impervious to interference by state-level governments (one key concern behind the demand for such recognition), nor will it be a full substitute for increased dialogue and better transparency in discussions with state-level governments. Although overall, there are advantages to such government recognition, it will be important to ensure that the implementing legislation does not unduly impede MFI operational flexibility. It will also be important to minimize possible disharmonies with state-level laws and regulations and to maximize buy-in by state governments.
ii. Transparency. Increased transparency would clearly benefit the microfinance sector by exposing inefficiencies, enhancing competition, improving access to information for investment and, ultimately, expanding outreach. Hence, the ideas behind the transparency-related proposals are well-founded. However, transparency mandated by law or regulation will impose costs on both MFIs (which must pass such costs to clients, if they operate sustainably) and the responsible regulatory body. And although it can be argued that even efforts to improve transparency outside of law or regulation will entail costs, it is nonetheless important that those responsible for setting the standards carefully weigh the benefits of proposed transparency measures against the costs of compliance and validation (these may be high, given the generally limited capacity of MFIs to prepare, analyze and report on their operations, together with the fact that many MFIs are multi-service organizations with mixed accounts, making segregation of data difficult). Nonetheless, a consensus exists in India with respect to the general idea of promoting improved transparency in the microfinance sector and this idea needs to be supported, perhaps initially focused on building MFIs' capacities to collect and report data.
iii. Limited Unregulated Deposit-Taking. Allowing MFIs that are not regulated by the RBI to engage in limited voluntary savings mobilization could extend a much needed service to unserved poor clients. However, this may also place the clients' deposits at risk. In considering the various proposals on this count as well as the regulatory concerns that the RBI may raise, careful consideration should be given to the readiness of the microfinance sector as a whole to respond to such an enabling measure. A majority of Indian MFIs are not profitable and cannot at present safely absorb the additional costs of mobilizing voluntary deposits, especially small balance deposits, which are difficult to offer profitably. (Indeed, this raises a question whether any regulatory reform needs to be preceded by institutional and financial strengthening of MFIs.) Apart from consideration of these issues, an analysis of the benefits of limited deposit-taking MFIs needs to be viewed in light of the January 2006 RBI circular that endorsed the use of bank agents (which may be MFIs) to provide savings services. By allowing deposit collection through MFIs (acting as agents), a key rationale for the microfinance sector's proposal that largely unregulated MFIs be permitted to provide deposit services to the poor may in fact have been satisfactorily addressed. In overall terms, although the intent underlying this proposal is laudable, the potential drawbacks may outweigh the benefits (particularly when the expansion of access to deposit services through the bank agency model made possible under the RBI circular is factored in).
iv. Deposit-taking Microfinance NBFC. Creating a form of deposit-taking microfinance NBFC with relaxed qualification requirements may have the effect of extending access to savings services through the formation of new depository institutions, as demonstrated by certain other countries' experiences. However, international experience also demonstrates that reduced minimum capital requirements may lead to supervisory challenges and a risk of regulatory arbitrage; these potential risks will need to be carefully considered by policy makers before taking a decision. Moreover, the newly created National Bank for Agriculture and Rural Development (NABARD) Microfinance Development and Equity Fund can provide some of the capital, the lack of which has been cited as a critical constraint for MFIs seeking to transition to an NBFC due to the high minimum capital requirement. This fund has the potential to assist MFIs wishing to transition to deposit-taking NBFCs without requiring changes to existing regulations. Finally, as mentioned above, the RBI's endorsement of the use of bank agents to provide savings services may substantially address the unmet demand for such services. Given the closely balanced arguments in favor of and against this proposal, the final decision should probably hinge on whether there is willingness and capacity on the part of the RBI to assume the larger supervisory responsibilities that would be entailed and whether the risk of regulatory arbitrage can be satisfactorily addressed.
v. Central-level Microfinance Legislation Addressing All Issues. The adoption of central-level microfinance-specific legislation aimed at addressing all of the foregoing topics would carry each of the potential advantages and disadvantages described above, as well as potentially more significant harmonization challenges with existing central- and state-level legislation. Consequently, existing concerns may be better addressed through targeted proposals that do not pose such harmonization challenges. And if the Government elects to propose such more targeted legislation addressing a limited menu of the foregoing issues, then the salient considerations will depend upon the content of the legislation: specifically, the issues covered and the approaches for addressing them. If the legislation is intended to bestow increased legal legitimacy upon MFIs, then this must be handled with due concern not to limit unnecessarily their operational flexibility. The significant arguments against permitting even limited deposit taking by small, unregulated or lightly regulated MFIs counsel against including this in the proposed legislation (particularly in light of the new opportunities for MFIs to mobilize deposits as agents for banks under the January 2006 RBI circular). Finally, if the Government is intending that the legislation create a new apex body for the microfinance sector, then before vesting such a body with regulatory and supervisory responsibilities, the Government should carefully consider the potential downsides of adding another regulatory body to the variety of financial regulators currently operating in India. Instead, it may be more prudent – especially given the large number of financial regulators already operating in India – to establish an apex institution that primarily serves a developmental and policy coordination role for promoting the microfinance sector.
I. Introduction
There is an increasing body of literature, including by the World Bank,[1] demonstrating that access to financial services is an effective instrument in the fight against poverty and that inclusive financial systems are associated with higher growth and better income distribution. Over the last few decades, and in particular over the last ten years or so, microfinance -- the provision of a range of financial services to the poor -- has been making increasingly important contributions towards improving access to financial services for the poor. The Indian microfinance sector, despite as yet being small in comparison to the formal banking system,[2] has witnessed very rapid growth, particularly during the last few years, and is now starting to assume more significant proportions (Figure 1).
With the rapid growth of microfinance in India, it is perhaps not that surprising that regulation of microfinance service delivery to India’s poor has emerged as a topic of significant debate, especially since the late 1990s. The debate has originated from the microfinance sector which has produced various proposals for reform, primarily motivated by the two issues of legitimization and deposit-taking. The former factor is viewed as important by the microfinance sector to give recognition to microfinance practitioners and also perhaps to protect them from interference from state governments, while the latter is viewed as necessary to satisfy demand for savings products as well as provide Microfinance Institutions (MFIs) with a needed source of funds for onlending.[3] The sector has consistently underscored its view that regulations should serve to increase access and that existing regulations pose barriers to this objective through high entry (minimum capital) barriers that prevent microfinanciers from transforming into entities that are able to accept deposits from their clients. To provide additional input and an analysis of the pros and cons of various proposals in the on-going microfinance regulation dialogue, this note focuses on these proposals made by the microfinance sector.
However, this note's emphasis on microfinance regulation does not imply a view that regulatory reform in microfinance is the most significant constraint to scaling up microfinance in India nor that such reform is the most fundamental financial sector reform that policy makers need to consider. Indeed, perhaps more fundamental constraints, including institutional capacity constraints of microfinanciers and a lack of appropriate financing, would ideally be addressed before undertaking any regulatory reform. Furthermore, this debate regarding microfinance regulatory reform needs to be viewed in the larger context of financial sector reform, because the proposals discussed in this note relate to institutions that currently account for only a small (albeit growing) part of the overall financial sector. There are likely to be future proposals for reform pertaining to issues related to the broader financial sector – reducing government ownership of banking institutions, reforms of rural finance institutions, review of directed credit schemes – which may have a greater impact on improving access to financial services for the poor and which therefore merit greater attention from policy makers. Indeed, there is considerable literature that demonstrates a link between such broader financial sector reform and impact on access to financial services and poverty alleviation.[4] Nonetheless, the microfinance reform proposals discussed in this note have been accorded attention by the Government and are important to examine for several reasons, including the stated rationale for reform (to increase access to financial services for the poor), the fast growth rate of microfinance and its potential for future expansion, and the intensity of the discussions between the Government and the microfinance sector.
Discussion of regulatory issues related to microfinance has gained considerable momentum following the February 2005 Budget Message of the Minister of Finance in which the Minister outlined a commitment to consider specialized regulatory treatment of the microfinance sector, which was reasserted in the Minister’s February 2006 speech. In this past year alone, the Reserve Bank of India (RBI), the National Bank for Agriculture and Rural Development (NABARD, an apex rural development financial institution owned by the RBI and the Government of India, GoI) and Sa-Dhan (India’s foremost network of MFIs), among others, have made significant pronouncements on the topic of specialized microfinance regulation. And, as discussed in more detail below, following the Minister's speech in 2005, an internal working group of the RBI had conducted a study of the sector, recommended reform supportive of the bank agency model and, in January 2006, issued a circular permitting banks to use Non-Government Organizations (NGOs), Self Help Groups (SHGs) and MFIs as agents to conduct various financial activities on the micro level.[5] However, each pronouncement has evinced an importantly different idea of the scope of specialized microfinance regulation and the objectives that such regulation might serve.
Notwithstanding the complexity of the existing legal and regulatory picture and the heterogeneity of the actors and interests involved, there is value in an impartial disentangling of the issues and possible avenues of regulatory reform. Without this, there is a risk that debate may evolve based on incorrect comparisons and misunderstandings among the variously interested parties. Moreover, separating out the issues at play and the facts regarding the current legal and regulatory picture for the development and operation of microfinance in India makes it possible to draw analogies to, and learn from, the experiences of other countries that have experimented with microfinance-related regulatory reform.
This note[6] aims to make just such a practical contribution to the discussion of specialized regulation for microfinance in India:
• Sections II and III explain the major models currently used to carry out microfinance in India, the actors involved in each of the models and the salient features of the existing legal and regulatory picture for the major legal forms carrying out microfinance in India, with an emphasis on significant regulatory constraints they face currently in delivering the full range of financial services that poor people need;
• Section IV summarizes the key features of the major reform topics, including both formal proposals and issues under discussion by relevant stakeholders;
• Section V identifies specific issues of key importance to the proposals summarized in Section IV and describes various foreign countries' experiences with those issues;[7] and
• Section VI analyzes the reform proposals for India summarized in Section IV, informed, to the extent applicable, by foreign experiences but also fully considering features of the Indian situation that may defy convenient analogies to other countries (Section VI).
The objective of this note, therefore, is to provide a tool for stakeholders interested in microfinance-related legal and policy reform and is not intended to be prescriptive. Moreover, this note does not intend to suggest that existing regulatory barriers are the most important limitation to outreach and the provision of financial services by MFIs or that the topics underlying the various reform proposals are necessarily the most important factors in increasing access to financial services for India's poor.
This note builds on a significant volume of previous analysis of regulatory issues facing microfinance in India.[8] Experienced Indian legal counsel has been engaged to assist in updating and fleshing out these previously developed sources.[9] The note also draws on the growing body of analytical material on the subject of microfinance regulation and supervision that is available on the international stage, as well as on the experience of individuals who have been involved with other countries’ consideration of similar issues.[10]
II. Overview of Microfinance in India
2.1 Introduction
Since the early years of independence, the GOI has actively sought to alleviate poverty through the provision of access to financial services. Government-led measures to broaden and deepen financial access have included: (i) the promotion and development of the cooperative system during the 1950s and 1960s; (ii) the requirements, imposed after the nationalization of 14 major private banks in 1969 (which was followed in 1980 by the nationalization of six more banks), that commercial banks open branches in rural areas and lend to specified priority sectors, primarily, agriculture and the poor; and, (iii) the creation in 1976 of a new form of banks focused on rural areas – the Regional Rural Banks (RRBs) which are majority government owned. As evident from these measures, India has used a multi-agency approach with particular emphasis on rural finance to meet its policy objectives of increasing access to finance for the poor. And although these measures have resulted in an unusually extensive financial system with a network of branches throughout India, they have also had several unintended consequences for the financial sector, including an inefficient distribution of credit and, especially among cooperatives and RRBs, high numbers of non-performing loans and weak institutions.
As a result of the Government's active role in financial sector policy, state-owned institutions dominate the financial system.[11] Notwithstanding this, in recent years the Government has begun to liberalize financial sector policy and, for example, has deregulated interest rates and eased priority sector lending requirements. Partly as a result of these reforms, competition has increased and many new actors have entered the market.
Despite India's past efforts to extend financial services to the poor through its vast branch network,[12] demand from the poor for financial services remains largely unmet.[13] To address this continuing problem, the Government, together with the microfinance sector and the private sector, for several years has supported developing new and innovative models of microfinance service delivery to the poor. The results of these efforts can be grouped into four broad categories: (i) provision of financial services to the poor directly by banks; (ii) the SHG-bank linkage model; (iii) the free-standing MFI model and (iv) the bank agency model.[14]
The first category involves the direct provision of financial services by banks, particularly rural branches of public sector banks, RRBs and cooperative banks, to individuals – this includes, amongst other kinds of small financing, agricultural credit. Although this is by far the most prevalent model,[15] it is not addressed in this note because provision of microfinance services by these banks does not by itself raise significant legal and regulatory issues[16] and has therefore not been a significant topic in the current dialogue regarding legal and regulatory reform for microfinance. Instead, this note addresses the legal and regulatory issues pertaining to the remaining three categories, each of which is described below,[17] and in particular emphasizes the free-standing MFI model, which has been the focus of proposals for regulatory reform.
2.2 Three Models of Microfinance Delivery in India
2.2.1 SHG-Bank Linkage Model
SHGs in India. SHGs in India are informal groups mostly of between 10-20 members, typically of women, that act as a channel for savings and credit services for their members. SHGs are the most common channel for the provision of microfinance in India, and the Government hopes to extend their reach further. These groups are assisted by "promoters" which help to organize, train and strengthen the capacity of SHGs. Various types of organizations, including government agencies and banks, act as promoters, but promoters are most commonly NGOs.
Increasingly, SHGs aggregate into larger networks. Typically, SHGs join into "clusters" of 15 to 30 SHGs, which in turn join into federations of 5 to 15 clusters. Federations are intended to help member SHGs build capacity, develop governance and internal control mechanisms and access and manage external financial resources with better economies of scale. In addition, these federations, particularly when formed as cooperative institutions, potentially allow SHGs to pool savings on a large scale.[18]
SHG-Bank Linkage Model. Since 1992, the GOI, largely through NABARD's SHG-bank linkage program, has sought to promote linkages between SHGs and banks (commercial banks, RRBs and cooperative banks) in order to link SHGs with the formal financial system. Under this program, NABARD offers refinancing of bank loans to SHGs and provides technical support to participating banks.[19] In addition, the RBI (i) allows participating banks to treat loans to SHGs as part of their priority sector lending requirement (pursuant to which banks are required to direct a certain percentage of their net bank lending, currently 40%, to specified sectors) and (ii) allows an SHG to open a group savings account with a participating bank. Banks typically lend to an SHG after assessing its operations, discipline and capacity. Less commonly, a bank itself acts as the promoter of the SHG and forms and trains the partner SHG prior to extending a loan.
As of end-March 2005, NABARD data reported that cumulatively, since 1992, 1.6 million SHGs, [20] estimated to include 24 million women members, had been linked with banks through a credit account. As many as 573 banks had cumulatively extended loans totaling approximately Rs.69 billion (approximately US$1.6 billion). In 2005 alone, banks disbursed approximately Rs.29 billion (US$680 million) to SHGs.
2.2.2 Free-Standing MFI Model
Various types of institutions broadly characterized as free-standing MFIs provide microfinance services in India. In terms of both number of clients and the outstanding microfinance loan portfolio, the outreach of free-standing MFIs is around one half the outreach of the SHG-bank linkage program, although the difference between the outreach of the two models has been declining over time.[21] These MFIs are formed (i) at the state level as societies, public trusts, and Mutually Aided Cooperative Societies (MACS)[22] and (ii) at the central (or national) level as public trusts,[23] NBFCs, Section 25 companies and Local Area Banks (LABs).[24] Following is a general description of each type of free-standing MFI and the extent and nature of their involvement in providing retail microfinance services in India.[25]
• NGO MFIs. MFIs formed as societies and trusts (NGO MFIs) primarily provide credit services to their clients. However, quite a few also engage in at least some deposit-taking. Estimates by a well-established microfinance rating agency, Micro-Credit Ratings International Limited (M-CRIL), indicate that of those NGO MFIs that accept deposits, approximately 80% of the deposits held by them are compulsory deposits (or "forced savings") that serve as collateral for loans. The balance represents voluntary savings, which are not strictly permitted under the RBI Act, 1934 (RBI Act).[26]
• MACS. MACS are incorporated bodies and are used in practice to carry out a wide variety of financial transactions, including deposit-taking.[27] MACS are permitted to accept term and demand deposits from members and term deposits, but not demand deposits, from non-members. MACS are widespread within particular states that have enacted MACS legislation, particularly in Andhra Pradesh (AP), which has approximately 200-250 MACS[28] according to NABARD data.
• NBFCs. NBFCs are registered with the RBI. Although an NBFC may accept term deposits upon meeting certain requirements (including having a specified minimum investment grade rating from specified credit rating agencies), no microfinance NBFC is currently mobilizing deposits from the public.[29] Approximately ten NBFCs are now engaged in microfinance.
• Section 25 Companies. Section 25 companies are non-profit companies formed under the Companies Act. Section 25 companies engaged in microfinance activities are NBFCs for purposes of the RBI Act, but are exempted from several requirements of the RBI Act provided that they have met certain conditions.[30] Importantly, Section 25 companies that wish to take advantage of these exemptions are not permitted to accept deposits. Only an estimated ten Section 25 companies are providing microfinance services currently.
• LABs. LABs are private banks permitted to operate in three contiguous districts. They are able to deliver credit and provide savings and insurance. Currently, only one LAB, established by BASIX, provides microfinance on a significant scale.
Free-standing MFIs lend directly to individual clients and to SHGs. They typically receive external funding for their lending operations from donor organizations, apex institutions (including, among others, the Small Industries Development Bank of India (SIDBI), which has for many years promoted and funded MFIs, NABARD and Friends of Women's World Banking), as well as from public and private banks.[31] Onlending by MFIs of this external funding is referred to by some, including the RBI, as "bulk lending."[32] Given the large number of apex institutions and banks and the fact that the RBI allows banks to treat such lending to NGO MFIs as part of their priority sector lending requirement, both wholesale and commercial borrowing are now widely available to MFIs – even unprofitable ones – for onlending. In fact, much of the growth of MFIs over the last few years has been funded through borrowings from commercial banks.
In terms of numbers, according to estimates by NABARD, there are approximately 800 free-standing MFIs in India at present. Approximately 250-275 of these MFIs are formed as cooperatives and MACS and approximately 500 are formed as state-level societies or trusts. The remaining MFIs are NBFCs and Section 25 companies, except for one that is a LAB. The great majority of the societies and trusts originated as civil society organizations and have various socially-oriented programs that are complemented by small but often growing microfinance programs. Of the estimated 800 free-standing MFIs, only an estimated 30 to 40 are profitable[33] and, of these, a substantial number are formed as RBI-registered NBFCs, Section 25 companies and LABs. In this context, a few commercially-oriented MFIs, most of which now operate as RBI-regulated institutions (having mostly evolved or transformed from NGO MFIs), have grown extremely quickly and have come to dominate the sector. Today, the eight largest free-standing MFIs serve more than 50 percent of microfinance clients.
2.2.3 Bank Agency Model
A third broad model for microfinance delivery – the "bank agency model" – has gained increasing importance in recent years. Pursuant to this model, organizations – primarily free standing MFIs – act on behalf of banks to facilitate their microfinance operations. Banks in India have been using this model for several years, although primarily to provide credit services. Pursuant to this model, an MFI evaluates, recommends and originates loans, helps in disbursal and subsequently tracks and collects on loans. The MFI receives a service charge and typically provides a first loan default guarantee to the bank. This model differs from direct lending in that banks utilize MFIs as agents in order to reduce bank transaction costs. It also differs from "bulk lending" (to MFIs) in that the loans sit on the books of the bank rather than the MFI, as they would if the MFI were borrowing from the bank in question for onlending.
In January 2006, the RBI issued a circular (described further in Section 3.4) specifically permitting banks to use the services of NGOs, SHGs, MFIs and other civil society organizations as intermediaries for banks in providing a wide range of microfinance services. As stated in the circular, the RBI's objective in supporting the bank agency model is to extend banks' outreach to microclients.
III. Overview of Current Legal and Regulatory Treatment of Microfinance in India
3.1 Introduction
India's financial system is complex and includes a large number of different institutional types and thousands of institutions. This complexity creates significant regulatory challenges for the RBI, which is primarily responsible for regulation of the entire financial system, including banks and NBFCs. In recent years, particularly in the 1990s, India's financial system has experienced the failure of a number of significant NBFCs of different types[34] as well as fraud under micro-deposit schemes.[35] As a result, the RBI has implemented reforms aimed at strengthening prudential regulation of NBFCs and increasing the attention given to the prevention of fraud in retail deposit-taking.[36] The RBI also has been an active party in the current dialogue over proposals for microfinance related legal and regulatory reform, as is evidenced, for example, by the appointment of an internal working group charged with examining regulatory issues raised by each of the models for microfinance delivery discussed in this note and the issuance in January 2006 of a circular permitting banks to use NGOs, SHGs and MFIs as agents.[37]
The RBI has broad responsibilities for the safety and development of the Indian financial system. However, it must share some of its powers with state-level authorities because India's federal system of government allows for state-level legislation that impacts institutions that provide financial services and thereby allocates to state-level institutions some control over financial system policy and supervision.[38] Central and state-level legislation often overlap, and this sometimes creates ambiguity with respect to jurisdiction. This overlapping authority at times creates opportunities for regulatory arbitrage.[39] It also complicates the dialogue surrounding microfinance-related legal and regulatory reform, as several important legal and regulatory issues under discussion involve issues of both central-level and state-level legislation and regulation.
The following discussion outlines the principal legal and regulatory bases for each of the three models of microfinance delivery described in Section 2: the SHG-bank linkage model, the free-standing MFI model and the bank agency model.
3.2 Legal and Regulatory Bases of the SHG-Bank Linkage Model
As discussed in Section 2.2, the SHG-bank linkage model is designed to take advantage of India's existing formal financial system. The result is that the most significant regulatory issues are already addressed in the existing central level regulatory infrastructure for the financial system.
Banks. Pursuant to the RBI Act and the relevant banking acts (collectively, Banking Acts), the RBI has regulatory authority over all banks – state-owned, private and foreign – and cooperative banks.[40] In theory, this renders the RBI's regulatory authority over the use of the SHG-bank linkage model simple and absolute. In practice, however, the picture is at least potentially somewhat more complicated, owing to the involvement of various actors involved in the model, some of which (such as the SHGs themselves) are unregulated and others (such as the federations of SHGs) are regulated at the state level.
SHGs and SHG-Bank Linkages. Although SHGs engage in financial service intermediation with their members, the formal legality of their deposit-taking under Section 45S of the RBI Act, which prohibits unincorporated bodies from accepting deposits from the public, is questionable. However, the GoI and the RBI have openly tolerated deposit-taking by SHGs, and have actively encouraged SHGs to deposit member’s savings with banks including through announcements made as part of the Credit Policy statement. Moreover, the Government has recognized that under the SHG-bank linkage program, banks have the incentive to monitor and supervise the performance and activities of their partner SHGs carefully, and this has in practical effect conferred supervisory responsibilities for SHGs to the banks.
Promoters. The activities of promoters, which are typically NGOs, generally do not raise legal or regulatory questions because they typically fall clearly within the activities that NGOs are permitted to do under the relevant societies and trust acts.
SHG Federations. These are often registered under state-level societies or MACS legislation. The potential use of MACS legislation by federations of SHGs to enable the pooling of members' deposits may in the future create significant new legal and regulatory issues, as these structures evade meaningful supervision by the RBI and may also not be monitored meaningfully at the state level.[41]
3.3 Legal and Regulatory Bases of the Free-Standing MFI Model
3.3.1 MFIs Unregulated by the RBI
NGO MFIs. NGO MFIs providing microfinance do not have a specific legal and regulatory framework governing their formation or activities. They are civil society organizations that generally are established under state-level societies and trust acts.[42] Applicable state societies and trust laws vary somewhat between states. As AP has among the most active and well-established microfinance sector, the relevant AP laws are discussed in Box 1 as representative examples.
Box 1: Laws in AP applicable to NGO MFIs
The AP Societies Registration Act, 2001 (AP Societies Act) governs the formation of societies in AP. The act allows for the registration under the act of any society formed by seven or more individuals that has as its object the promotion of charity or any public purpose. It prohibits the registration of any society of which a firm or an unincorporated association of individuals is a member. Upon registration under the act, the society is recognized as an incorporated legal entity.
AP has no general legislation governing trusts.[43] Instead, the AP Charitable and Hindu Religious Institutions and Endowments Act, 1987 (AP Charitable Institutions Act) governs the activities of charitable institutions in the state. This act provides that any establishment, undertaking, organization or association formed with the purpose of relief of poverty, education or any other object of utility or welfare to the general public must register within 90 days of its founding with the state's Charities Commissioner.
State-level societies and trust laws do not contemplate the use of societies and trusts as vehicles for sustainable and profitable financial service delivery[44] nor do the laws address specifically microfinance or its charitable status. As a result, some NGO MFI activities are legally ambiguous. For example, some practitioners have indicated that NGO MFIs have been subjected to demands for taxes because they are construed to be undertaking for-profit activities and also to accusations that their interest rates violate state-level money-lending laws.
Another key limitation for NGO MFIs is the significant risk that non-profit entities will lose their tax-exempt status if they own shares in or transfer assets to for-profit entities in exchange for shares.[45] The Income Tax Act therefore limits the ability of NGO MFIs to engage in the most common method of "transforming" into a commercial entity: the exchange of the loan portfolio for shares in the for-profit company. Instead, for example, NGO MFIs in AP start anew by forming an independent commercial legal entity, investing (or finding investors with) "fresh money," and transferring only staff and know-how from the existing MFI.[46]
MACS. MACS operate in India pursuant to central law and applicable state law in the states in which enabling legislation has been enacted. As in the case of trusts and societies, state-level legislation governing MACS varies among states. Accordingly, the AP Mutually Aided Cooperative Societies Act, 1995 (AP MACS Act) is discussed as a representative example.
|Box 2: Key features of the AP MACS Act |
| |
|Pursuant to the AP MACS Act, a MACS may be formed by (i) ten or more unrelated individuals, (ii) two or more MACS (in order to |
|form a federation) or (iii) a society registered under the AP Cooperative Societies Act, 1964 (AP Cooperatives Act) that desires |
|to convert into a MACS. The AP MACS Act does not require a minimum share contribution and registration requires only minimal |
|funds. A MACS is permitted to transfer its assets and liabilities to another MACS or cooperative society (provided that the state|
|government is not a member of such MACS or cooperative society); create subsidiaries; mobilize funds in the form of share capital|
|from its members and in the form of deposits, debentures, loans and contributions from members and non-members (although from |
|non-members, a MACS may only collect term deposits);[47] and invest or deposit its funds outside its business in any |
|“non-speculative” manner. MACS are essentially unregulated and are nominally monitored by the Registrar of Mutually Aided |
|Cooperative Societies.[48] |
MACS provide a way to avoid the regulatory restrictions imposed on NGO MFIs, particularly restrictions on deposit-taking, because of the ease of formation and the ease of naming clients as new members. Although the relevant enabling legislation limits membership to individuals and cooperatives, in practice it has been possible to form MACS that are, for all practical purposes, controlled by management and staff of a legally unrelated NGO MFI. NGO MFIs, therefore, are increasingly using MACS as proxy vehicles to deliver financial services. At the same time, MACS are weakly supervised, which potentially increases the risk to members’ savings.
Recently, MACS are being formed in AP and other states to register multi-tiered federations of SHGs.[49] As MACS, these federations have the power to pool deposits taken by the member SHGs and thereby escape the inherent limitations on deposit-taking to which SHGs are subject. To date, it appears that few SHG federations formed as MACS, if any, are in fact pooling SHG deposits. Instead, they are mobilizing funds through institutional borrowing, as discussed above, although it is conceivable that pooling of deposits may happen at a large scale in the future.
The risks of deposit mobilization by federations of SHGs, however, have not gone unnoticed by the RBI. If these MACS do begin to pool SHG deposits, they could raise serious depositor protection risks. The RBI has indicated that it is not currently concerned about the growing utilization of MACS, partly because they are member-controlled. However, the RBI’s regional office in AP indicated that it is monitoring the deposit-taking activities of MACS and their federations, and may choose to act in the future if MACS begin to pool deposits in such a way that SHG members no longer have effective control over the governance of the organizations actually holding their deposits.
3.3.2 MFIs Regulated by the RBI
NBFCs. An NBFC is a company formed under the Companies Act that (i) has as its principal business lending or deposit-taking or (ii) is a "financial institution,"[50] which term is defined to include any company, corporation or cooperative that is engaged, principally or in part, in financial activities including, among others, the financing (by loans or otherwise) of activities other than its own, engaging in the insurance business, and acquiring marketable securities.[51] NBFCs must be registered with the RBI. In addition, NBFCs must meet a minimum capital (or "net-owned funds") requirement of Rs.20 million or about US$450,000. An NBFC with this minimum capital may accept term deposits[52] if it has received an investment grade rating from an accredited rating agency and if meets the minimum capital adequacy threshold of 15% defined by the RBI.
Various stakeholders argue that the regulatory requirements applicable to NBFCs are unreasonably stringent[53] and the qualification requirements in particular do not offer a practical entry into regulated deposit-taking. Some of these stakeholders believe that the minimum capital requirement is too high. Many others feel that the ratings requirement is not appropriate, particularly because the approved rating agencies have not developed their ratings models to account for the unique characteristics of microfinance, including especially uncollateralized lending. Perhaps for these reasons, few MFIs have chosen to form as NBFCs. Currently, only around 10 NBFCs are engaged in microfinance.
Section 25 Companies. Pursuant to a January 2000 RBI circular, an NBFC formed under Section 25 of the Companies Act and engaged in microfinance activities that (i) provides credit below certain specified limits and (ii) does not accept public deposits is exempt from certain RBI requirements (specifically, those relating to registration with the RBI, minimum net-owned funds, maintenance of liquid assets and transfers of profits to reserve funds). In addition, as a Section 25 company, it must promote a specified social goal ("commerce, art, science, religion, charity or any other useful object") and profits must be re-invested in the company to further promote these goals. Upon dissolution and after settlement of all debts and liabilities, the property of the company must be transferred to another Section 25 company, preferably one having similar objects as the dissolved entity. Only around ten Section 25 companies currently are providing microfinance services.
LABs. LABs are private banks licensed and regulated by the RBI that are permitted to operate only in three contiguous districts. Under the 1996 guidelines providing for the establishment of LABs, they are required to have an initial minimum capitalization of Rs.50 million, or about US$1,115,000. They are empowered to deliver credit and provide savings and channel insurance. The policy thinking behind the creation of the LAB regulatory category was at least in part to extend financial services to underserved areas and populations. However, LABs have not been utilized for microfinance to the extent that the Government hoped. To date, only four LABs have been established, and only one of these, affiliated with BASIX, provides microfinance on a significant scale. And in August 2003, the RBI issued a Notification that no additional licenses would be issued for LABs. The notification also required that existing LABs (i) be required to reach net worth of at least Rs.250 million (around US$5.5 million) over a period of five to seven years, (ii) maintain a minimum capital adequacy ratio of 15% over the same period and (iii) be treated like any other commercial bank, with their regulation being entrusted to the same wing of the RBI.
There are several possible reasons that LABs have not generated interest among financial institutions and microfinance advocates. First, geographic restrictions on LABs limit expansion and outreach. Second, given these limitations, the recently imposed additional requirements may be too onerous. Third, even for those institutions willing and able to meet the new requirements, there is no realistic “next step” in the evolution of a successful LAB. They are not permitted to expand beyond their initial three districts. Moreover, a LAB cannot realistically hope to transform into a conventional private commercial bank due to the extremely high jump in minimum capital requirements: Rs.2,000 million (around US$45 million). There is even question whether the RBI would look favorably upon an application for a license were an LAB able to attract the necessary capital, given the recent initiatives at stimulating consolidation within the banking sector.
3.4 Legal and Regulatory Bases of the Bank Agency Model
The bank agency model allows banks to use agents to reach populations and areas that the banks are not well-positioned to serve through their own branch networks and employees. The legal basis for the model is the same as for commercial banking generally: the RBI Act and the Banking Regulation Act. Until recently, the Banking Regulation Act and relevant regulatory pronouncements of the RBI have placed potentially significant limitations on the use of the model, depending on how their provisions are construed.[54] However, in April 2005, the RBI issued a circular entitled "Door-step banking" announcing the RBI's decision that banks may propose schemes, to be approved by the RBI, for providing banking services at customers' premises. And, as discussed in Section 2.2.3, in January 2006, the RBI issued a circular entitled "Financial Inclusion by Extension of Banking Services - Use of Business Facilitators and Correspondents" permitting banks to use agents to conduct various financial activities.
The RBI's January 2006 circular outlines two different types of agency relationships ─ the "Business Facilitator Model" and the "Business Correspondent Model" ─ and permits agents to undertake specified activities on behalf of banks. Under the Business Facilitator Model, the agent[55] is permitted to (i) identify suitable microborrowers, (ii) conduct a preliminary processing of loan applications, including verification of primary data, (iii) market savings and other products, (iv) process loan applications, (v) promote and nurture SHGs, (vi) monitor loans and SHGs and (vii) assist in loan recovery. Under the Business Correspondent Model, the agent[56] may engage in the activities permitted under the Business Facilitator Model, and may also: (i) disburse "small value credit," (ii) collect payments of principal and interest, (iii) collect "small value deposits," (iv) sell microinsurance, mutual fund products, pension products and other third party products and (v) receive and deliver small value remittances and other payment instruments. Under both models, the bank pays the agent a service fee, but the agent cannot collect a fee from customers.
The circular warns banks that in both models the use of agents "involves significant reputational, legal and operational risks" and instructs banks to give due consideration to those risks and "to adopt technology-based solutions for managing the risk." The circular further stipulates that the agreements between a bank and an agent in the Business Correspondent Model shall: (i) specify suitable limits on cash holding by intermediaries and limits on individual customer payments and receipts, (ii) require that the transactions be accounted for and reflected in the bank's books by end of day or next working day and (iii) require that all agreements with customers clearly provide that the bank is responsible to the customer for acts of omission and commission of the business correspondent (this third requirement also applies to arrangements under the Business Facilitator Model.)
The circular also provides that compliance with "know-your-customer" (KYC) requirements will be each bank's responsibility, although the RBI further states that "[s]ince the objective is to extend savings and loan facilities to the underprivileged and unbanked population, banks may adopt a flexible approach within the parameters of guidelines issued on KYC from time to time." The circular specifically permits banks to rely on certificates of identification issued by the agent or by others, including any "public functionary" known to the bank.
* * * *
Having discussed the various microfinance models and the legal and regulatory bases for each model, the following section discusses the various proposals – formal and informal – for legal and regulatory reform, all of which pertain to the free standing MFI model.
IV. Proposals for and Positions on Regulatory Reform
4.1 Introduction
As the dialogue over the possibility of microfinance-related regulatory reform has intensified since the Finance Minister’s 2005 budget address, much attention has been given to the question of how reform could help to extend access to financial services for the poor without jeopardizing savers' funds or the safety of the Indian financial system. This has resulted in the RBI's issuance in January 2006 of a circular permitting banks to work with agents to carry out various financial activities as well as other proposals of varying degrees of specificity, some of which are new and others which resurface ideas that have been discussed in India before. No other significant reform proposals have been made with respect to the bank agency model nor have any significant reform proposals been made with respect to the SHG-bank linkage model,[57] reflecting the absence of serious regulatory constraints to the functioning of this approach to microfinance.[58]
The current discussion concerning specialized regulatory treatment of microfinance is, therefore, focused on the free-standing MFI model. The recent proposals made by different stakeholder groups with respect to the free-standing MFI model are summarized below.
4.2 Reform Proposals and Positions Related to the Free-Standing MFI Model
4.2.1 Overview
The recent dialogue regarding the merits of a specialized regulatory framework for free-standing MFIs in India[59] has been motivated by concerns both within and outside the microfinance sector regarding what are perceived as key regulatory barriers that prevent MFIs from expanding outreach and providing clients a full range of financial services. The two issues that arise most frequently and are considered – at least by the microfinance sector – the most crucial are the high minimum capital requirements applicable to regulated entities that mobilize deposits under the existing regulatory framework and the lack of an alternate framework for deposit-taking by MFIs.
The RBI internal working group that produced the July 2005 report entitled “Report of the Internal Group to Examine Issues Relating to Rural Credit and Microfinance” (RBI Report) did not endorse the adoption of specialized regulation of free-standing MFIs at this time.[60] In December 2005, two proposals -- overlapping in some respects -- emerged from the microfinance sector. One was in the form of a technical paper (drafted by an apex institution) proposing the establishment of a specialized form of "microfinance NBFC" (the ‘apex proposal’). The other, more detailed proposal (the ‘sector proposal’) emanated from microfinance practitioners.[61] This second proposal includes a draft “law on microfinance” addressing the governance of qualifying MFIs.
Both the apex proposal and the sector proposal address many issues relating to free-standing MFIs that have been under discussion among policy makers, regulators and practitioners for some time. It remains to be seen whether the ultimate decision on these issues will fall closer to the “no substantial change at this time” position put forward by the RBI’s internal working group or to the specific proposals contained in the sector proposal. The text below summarizes the most significant issues addressed in the various proposals concerning the regulation of free-standing MFIs, concluding with an overview of the proposals under the sector proposal (which unites most of these themes in a single piece of proposed legislation).
4.2.2 Proposals Aimed at Formal Government Recognition of Credit-Only MFIs not Regulated by the RBI
Many in the microfinance sector in India have been concerned about the absence of any specific legal recognition of the hundreds of heterogeneous legal entities already operating as free-standing MFIs. This has led to various proposals for new categories of MFIs recognized by the central Government. These proposals are aimed partly at eliminating problems encountered by NGO MFIs specifically because the laws governing trusts and societies were not designed for institutions engaged in the provision of financial services. For these NGOs, formal recognition would also provide a greater degree of legitimacy and a means of establishing standardized practices and improving transparency, as discussed further below.
Some disagreement surrounds the question whether to consider the Indian NGO MFIs that take compulsory savings (but not voluntary savings) as “credit-only” or as “depository” MFIs. Various senior level officials in the RBI have unofficially articulated the view that taking compulsory savings does not constitute deposit taking, at least if the funds are segregated and not used to fund loans or other investments. This does not settle the issue, however. There is no reliable data concerning the proportion of NGO MFIs that do set compulsory savings aside in an escrow account or otherwise separate them to prevent their use for anything other than repayment of the particular saver's loan.
Good arguments exist for distinguishing even those NGO MFIs that do not segregate compulsory savings from those institutions accepting voluntary deposits, as in most cases the clients of the former are net borrowers and can protect themselves by simply failing to repay if the MFI becomes insolvent. These arguments, however, offer little comfort to those clients who happen to be net depositors at the time of an institution’s collapse. Interestingly, no major reform proposal addresses the problem directly, such as by establishing procedures for the segregation of compulsory deposits to prevent their intermediation.
The provisions of the sector proposal's draft law, discussed in detail below, represents the most concrete proposal for formalizing central government recognition of MFIs not currently regulated by the RBI.
4.2.3 Proposals Aimed Primarily at Enhancement of Transparency in the Microfinance Sector[62]
Many different stakeholders interested in the development of microfinance in India point out the problems that result from the lack of transparency and the absence of clearly agreed standards among the many different legal forms currently operating as free-standing MFIs. Independent of whether reforms are adopted to reduce minimum capital requirements or to enable deposit-taking by MFIs, it is widely recognized that increased transparency would stimulate competition, promote healthier organizations and facilitate access to capital markets.
Specific proposals, including under the apex proposal, have been made to create a microfinance commission that would (i) establish minimum performance standards and the standardization of reporting formats for MFIs, (ii) maintain a database of the scope, activities and performance of the microfinance sector in India and (iii) facilitate the rating of MFIs.[63] It has also been proposed that the Securities and Exchange Board of India (SEBI) and the Institute of Chartered Accountants of India (ICAI) formulate appropriate reporting and disclosure norms for MFIs.
The provisions of the sector proposal's draft law also include the concept of a transparency enhancing and standard setting body, at least for those organizations that might seek to fit within the non-bank regulatory categories proposed in the draft, as discussed below.
4.2.4 Proposals Aimed at Permitting Voluntary Savings Mobilization by MFIs not Regulated by the RBI
Much discussion has focused on the issue of permitting MFIs not regulated by the RBI to mobilize voluntary savings, at least on a limited basis, without subjecting such MFIs to prudential regulation and supervision by the RBI or another regulator. Proponents argue that such a reform would allow MFIs to begin to satisfy the vast demand for savings services from India's poor, and that it would provide MFIs access to an assertedly less expensive source of funds than commercially-available funds,[64] which would in turn, enable MFIs to scale up their lending activities more quickly and efficiently.
Any such reform, however, would of course present the issue of how to limit the activity of such MFIs so that they are clearly distinct from prudentially-regulated institutions. Commonly discussed possible limitations include: a ceiling on the aggregate deposit amount of any single depositor, capping the aggregate deposits that may be held by an unlicensed or ineligible institution, and limiting deposit-taking only to the MFI’s “members”[65]. Some commentators have also proposed protection of the deposits held by MFIs through some form of deposit insurance or at least mandated liquidity reserves.
The broad provisions of the draft law (sector proposal), discussed in detail below, represent the most concrete proposal for permitting limited deposit taking by unlicensed MFIs.[66]
4.2.5 Proposals Aimed at Easing Eligibility Requirements for Operating as a Deposit-Taking Microfinance NBFC or Microfinance Bank
Many within the microfinance sector believe the current requirements for qualifying as a deposit-taking NBFC are unreasonably stringent and, therefore, the legal form does not present a realistic option for MFIs seeking to provide savings products and to access retail deposits as a source of funds. In response, some proponents have proposed easing the requirements for "transformation" to a deposit-taking NBFC through changes to the current minimum capital requirement and the ratings requirement.[67] The apex proposal, for example, proposes allowing a microfinance NBFC to engage in all activities, including deposit taking, in which deposit-taking NBFCs are currently permitted to engage. The sector proposal, discussed further below, would bypass the need for a form of NBFC with lower minimum capital by simply creating new categories of MFI that would exist in parallel with those MFIs meeting the RBI requirements applicable to deposit-taking NBFCs.
4.2.6 Proposals Aimed at Accomplishing Substantially all the Foregoing Objectives Through New Microfinance-Specific Legislation
Some within the microfinance sector have proposed overarching microfinance-specific legislation covering all the issues discussed above: conferring central government recognition on credit-only MFIs, enhancing transparency of MFIs, and permitting limited voluntary deposit-taking by MFIs (without applying the qualification requirements applicable to NBFCs today). Such legislation might take the form of an "umbrella" law over existing actors in the microfinance sector, subjecting heterogeneous organizations to unified regulatory treatment, or perhaps an entirely new regulatory framework set up parallel to, but outside the purview of, the existing financial system legislation and regulations. Alternatively, such legislation might be a hybrid, combining elements of these approaches.
The sector proposal's draft law adopts the hybrid approach: it brings under one law all types of microfinance service providers other than banks (and those that fail to meet the "principal business" test described below)[68] and establishes a new regulatory framework for those organizations.
The proposed law would recognize two new categories of free-standing microfinance entity, each of which is defined as having microfinance as its principal business.[69] The "business of microfinance" is defined to include the following services: (i) providing thrift services to members of a "microfinance unit;" (ii) making loans and guarantees up to Rs.50,000 (or such other amount as is specified by a “Microfinance Development Council” called for under the draft, as described below); (iii) making loans, grants and equity investments in microfinance organizations or MFIs (both defined below); (iv) money transfer services; and (v) acting as agent to provide insurance and pension services.
It is notable that both types of microfinance service providers would be entitled to take savings, although they would face limitations on their deposit taking, as described further below.
The two categories of free-standing microfinance entity proposed in the draft law would have the following attributes:
• Microfinance organizations. Microfinance organizations could be formed as any one of the following: societies governed by the central societies legislation, state mutual benefit societies registered under a state law relating to such central-level societies, multistate cooperative societies, trusts and Section 25 companies. Each of these legal forms would generally be permitted to engage in all types of microfinance business, as well as various other activities relevant to microfinance and the support of microbusinesses, including leasing, business development services and acting as a correspondent of any scheduled commercial bank.[70] Deposit taking, however, would be subject to the following limitations: (i) savings could only be collected from members of a “microfinance unit,” defined in the draft law as a group – whether an informal group or association of "homogenous individuals," an SHG or a joint liability group – formed for the purpose of carrying on any economic activity jointly or severally for the benefit of the individual members; (ii) the amount of savings collected from any member of a microfinance unit would not be permitted to exceed Rs.5,000; and (iii) savings instruments could not be in the form of a current account or demand deposit or have a term of less than three months.
• Microfinance institutions.[71] Microfinance institutions could be formed as any one of the following: companies registered under the Companies Act (including Section 25 companies), cooperatives, mutually aided or mutual benefit societies,[72] whether operating on a for-profit or non-profit basis for tax purposes. Any of the foregoing legal forms would generally be permitted to engage in all of the activities permitted of microfinance organizations, provided that the maximum amount of savings collected from any member of a microfinance unit would be subject to a higher limit of Rs.10,000. As with microfinance organizations, savings could not be collected from legal entities or from individuals not members of a microfinance unit.
Pursuant to the draft law, a newly established Microfinance Development Council (MFDC) would be responsible for registering microfinance organizations, microfinance institutions and microfinance banks.[73] In addition, it would be responsible for regulating and supervising microfinance organizations and microfinance institutions, although the extent of the MFDC’s regulatory and supervisory authority over microfinance institutions is conditioned on delegation by and approval of the RBI.
In addition to its registration, regulation and supervisory responsibilities, the MFDC would collect data from microfinance organizations and microfinance institutions, specify the standards of accounting for microfinance organizations and microfinance institutions, develop performance standards and disclosure norms as well as governance standards and codes of conduct for microfinance organizations and microfinance institutions, approve chartered accountants and empanel rating agencies and adjudicate disputes between microfinance organizations or microfinance institutions and their clients.[74]
As for specific prudential regulations applicable to the two different categories of microfinance entity, the proposal provides the following:
• Microfinance organizations would be subject to a 10% capital adequacy requirement[75] as well as a "net owned fund" requirement of Rs.100,000 (around US$2,200). In addition, microfinance organizations that receive thrift would be required to establish a reserve fund, contributing 10% of net profits annually.[76] Any microfinance organization that, at the end of any financial year, has aggregate loans and other financial assistance of Rs.10 million (around US$220,000) or more or aggregate deposits of Rs.2.5 million (around US$56,000) or more would be required to register as a microfinance institution.[77]
• Microfinance institutions would be required to meet a minimum capital requirement of Rs.2.5 million (around US$56,000), although Section 25 companies would be permitted to apply to the MFDC for an exemption from such requirement. At least 10% of the capital would be required to be contributed by the promoter/founders.[78] Microfinance institutions would also be subject to certain other prudential requirements, including a capital adequacy ratio of 15% and a deposit-capital ratio, and those receiving thrift would be required to establish a reserve fund, contributing 15% of net profits annually.[79]
* * * *
The decision-making process with respect to the various proposals that have been described in this section can benefit from consideration of foreign countries' experiences where legal and regulatory reform has been proposed to address similar issues. The following section describes such foreign country experiences.
V. Foreign Experience with Specialized Regulatory Treatment of Microfinance Applied in the Indian Context
5.1 Introduction
For several reasons, applying in India the lessons learned from foreign countries' experiences is complicated. As discussed above, India is unusual among developing countries by virtue of the sophistication and complexity of its financial system and its microfinance sector.[80] In addition, the period during which developing and transitional countries have experimented with specialized regulation of microfinance is short and sound studies of the results are few and, of course, are also difficult to compare with other countries’ situations. Finally, there is increasing recognition that ‘template’ solutions to regulatory constraints in microfinance never work, because of the uniqueness of each country’s financial system, legal and regulatory framework and regulatory culture and the unique history of the interplay among the three.
Therefore, attempting to draw lessons from foreign experiences warrants caution. Can the differing understandings of what specialized microfinance regulation in India could mean be synthesized to a point where meaningful comparisons can be made? Can the topic, once synthesized into a relatively simple set of common parameters, be compared meaningfully with other countries, given not only the disparity among available country examples but also the paucity of sound studies of foreign experiences? These challenges, among others, must be acknowledged.
The following discussion of foreign experience with specialized regulatory treatment of microfinance attempts to factor in these challenges by drawing comparisons on an issue-by-issue basis, rather than seeking broader parallels. Also, rather than limiting the foreign experiences discussed to those on which published analysis is available, the discussion draws on insights derived through interviews with persons who participated in or observed closely the situations discussed.[81]
5.2 Regulation of Non-Depository Institutions
Specialized microfinance institutions targeting exclusively poor clients with loan products – particularly those identifying themselves as ‘microcredit’ institutions – are a phenomenon of relatively recent origin. In many countries, a variety of different types of such specialized financial institutions have entered the field and operate side-by-side, conducting operations outside of the mainstream financial sector. The credit-only institutions are often not regulated nor are they specifically recognized (in legislation) as institutions offering specific financial services. In contrast, depository institutions are generally recognized and subject to some level of prudential regulation and supervision.[82]
Although many experts may find it unnecessary (and even undesirable), in many countries these unrecognized credit-only institutions are now seeking or have already obtained formal legal recognition. Most often, the motivation for seeking this recognition stems from a belief, in many cases true, that the sector and the institutions lack legitimacy in the eyes of policy makers and the financial sector. Unfortunately, however, it is often the case that insufficient attention is paid to other changes that can result – changes that might be undesirable for both the institutions and their clients, such as diminished operational flexibility, increased attention from tax authorities or unwelcome attention from policy makers on a variety of issues, including the highly sensitive issue of interest rate caps.
The growth worldwide of the microfinance sector, including the number and the reach of credit-only MFIs, and the push in many countries for this explicit legal recognition has been accompanied by a growing realization that non-depository microfinance does not present risks to retail depositors or the broader financial system. This has led to an increasingly solid global consensus that less expensive and intrusive regulatory treatment is necessary for non-depository institutions than the kind of prudential regulation and supervision called for when the objective is to protect institutional solvency and prevent losses to suppliers of capital.[83] This trend invites attention to the question of what the compelling regulatory objective is in the case of non-depository institutions.
The issue of regulatory treatment of non-depository institutions might seem like one of questionable relevance in the current Indian context, given the prevalence of deposit taking by many Indian MFIs and strong interest in the Indian microfinance sector in expanding deposit taking through regulatory reform. However, a strong argument can be made that since an estimated 80% of the deposit taking NGO MFIs in India accept only compulsory savings, the situation is best analogized to foreign country experience with the regulation of non-depository institutions.[84]
Three countries with strong credit-only MFIs – Armenia, Bosnia and Morocco – are each presently in the process of working out answers to the questions of why and how to regulate non-depository MFIs. In all three, however, the motivation goes well beyond conferring official government recognition and enhancing the legitimacy of the institutions in question. Of perhaps equal importance is the aim of establishing greater transparency for non-depository microlending organizations, which, it is hoped, will lead to a more efficient allocation of investment in the sector, increased competition and ultimately more efficient microlending institutions that can serve more clients cost-effectively. The relevance of these three foreign country experiences to Indian reform proposals is therefore potentially twofold: they provide examples of possible approaches to (and outcomes from) the establishment of formal regulatory categories of microlending institutions; and they may also shed light on relevant issues that may arise when the government steps in to mandate transparency for the microfinance sector.[85]
In Armenia, microlending is currently carried out by licensed commercial banks, licensed commercial “credit organizations” and unlicensed NGOs formed as foundations. Both banks and credit organizations are regulated by the Central Bank of Armenia (CBA). The Armenian credit organizations law, passed in 2002, neither explicitly addresses microlending foundations nor explicitly exempts them from its sweeping coverage, leaving ambiguity surrounding the legality of their operations and leaving them unregulated (except for minimal regulatory requirements applicable to Armenian foundations generally). However, recently, the CBA has informed the MFIs operating as foundations that they must (i) by the end of 2005, give written indication to the CBA of their intent to “transform” into a licensed commercial credit organization[86] and (ii) present the documents for the registration by March 1, 2006. After registering, MFIs will be granted a grace period to comply with the CBA regulations applicable to non-depository credit organizations.
Regulations initially drafted for credit organizations did not distinguish much between the vast majority of Armenian credit organizations that are non-depository and the very small number that engaged in limited financial intermediation using borrowings from members.[87] Instead, all credit organizations were subjected to a prudential regulatory regime patterned closely on the prudential regime aimed at protecting the solvency of Armenian banks. However, the CBA proved receptive to arguments from microfinance advocates that organizations not mobilizing funds from the general public should be subject only to transparency-driven reporting requirements (as well as other non-prudential regulation applicable to the full range of institutions active in the financial system, such as anti-money laundering/combating financing of terrorism rules and limitations on storage of and transactions in cash).[88] New regulations for non-depository credit organizations with this basic content have been drafted and are expected to be put in force within the calendar year.
A further point is important to mention in connection with Armenia’s regulatory reform applicable to credit-only MFIs. Careful attention was paid to the specific transparency requirements imposed. Although all the transforming NGO MFIs will be required to upgrade their systems to enable them to report to the CBA in a standardized format, the data reported generally will not go beyond those that would need to be collected for the preparation of audited financial statements as well as some additional data generally reported by credit organizations for statistical analysis. Armenian policy makers paid particular attention to the fact that the MFIs’ costs of compliance would have to be passed on to their clients in the form of higher interest charges if the institutions are to operate sustainably as credit organizations.
Relevant legislative bodies in Bosnia and Herzegovina adopted specialized legislation for non-depository NGO microcredit organizations in 2000 and 2001. Now, after five years of experience with this legislation – and its limitations – the relevant ministerial bodies are proposing to their parliamentarians a new draft microcredit organizations law that is aimed at fixing shortcomings identified in the original laws.
In contrast to the arguably over-intrusive regulation initially put in place for Armenian credit organizations, the original 2000/2001 legislation left Bosnian microcredit organizations almost entirely unregulated. It also left them without any legally feasible means of “transforming” into any other legal form. The proposed draft law addresses both of these issues by providing for transparency reporting to the banking agencies and providing authority for NGO microcredit organizations to remain as NGOs or "transform" into a for-profit microcredit company – with the choice left to the microcredit organization. If, in the future, a microcredit company wishes to "transform" into a licensed commercial bank, it may do so pursuant to the banking law. Both microcredit foundations and microcredit companies will be regulated and monitored by the Banking Agency. However, the regulatory regime envisioned is aimed only at ensuring transparency and compliance with the provisions of the new law, and prudential regulation and supervision aimed at protecting the solvency of the microcredit organizations is not anticipated (beyond relatively low minimum capital requirements established in the new law). The details of the transparency reporting that microcredit foundations and companies will be required to undertake have yet to be decided. However, extensive discussions with the banking agencies have already focused attention on the fact that costs of compliance will be passed on to clients, so care should be taken to make the requirements proportionate with the benefits to be expected from increased transparency.
Microcredit associations in Morocco, like their Bosnian counterparts, are governed by special legislation passed in 1999 that creates for them legal authority to carry out lending activities within parameters set in the law and regulations adopted by the Ministry of Finance. Microcredit associations are de facto the only legal form that can engage in sustainable microlending as their exclusive business, as both banks and financial companies in Morocco (the only other available legal forms) face interest rate caps that do not permit them to operate typical microlending portfolios profitably, although they can – and do – refinance microcredit associations profitably within the allowable cap.[89]
The Moroccan law on microcredit organizations currently gives regulatory responsibility for the non-depository microcredit associations to the Ministry of Finance. Although the Ministry has issued a license to each of the existing active microcredit associations, it lacks the human resources to engage in any ongoing monitoring of them. For this reason, parliament has announced an intention to pass supervisory jurisdiction from the Ministry of Finance to Morocco’s central bank, the Banque Al-Maghrib (BAM). Under this plan, the Ministry of Finance will remain responsible for designing the regulatory regime to which the microcredit associations will be subject, but responsibility for implementing the regulations will rest with the BAM.
Initial discussions with the Ministry of Finance and BAM about the content of future regulation of Moroccan microcredit associations have highlighted the need for transparency of operations, so that the regulator is in a position to know about the performance of licensed microcredit associations and to confirm they are working within the constraints imposed by the microcredit associations law. It remains to be seen, however, whether regulation may reach beyond transparency and impose prudential requirements similar to those initially imposed on Armenian credit organizations. Unfortunately, there is precedent for this in Morocco, where non-depository finance companies are regulated much like commercial banks.
In overall terms, as evident from the illustrations and discussion above, international experience demonstrates that efforts to regulate non-depository institutions require an analysis of the underlying rationale for such regulation, as well as an understanding of the possible consequences.
5.3 Encouraging Formation of and Transformation into Regulated Depository MFIs through Less Stringent Licensing Requirements
5.3.1 Lowering Minimum Paid-In Capital Requirements to Encourage Formation of Depository Microfinance
The initial paid-in capital requirement, which specifies the minimum amount of capital an institution must have when applying to be a licensed financial institution, is often asserted to protect the safety of the financial system by excluding financial institutions that do not have sufficient scale to engage safely in financial intermediation.[90] However, many commentators view the minimum capital requirement not primarily as a safety mechanism, but as a means of controlling the number of financial institutions subject to prudential regulation and supervision. A primary purpose of raising the barrier to entry is to ensure that the supervisory capacity matches the number of institutions that make use of a particular regulatory category.[91]
In India, an increase in the minimum capital required to form NBFCs was used effectively to reduce radically the number of such institutions to a level where effective supervision was feasible.[92] Now, both the apex proposal and the sector proposal provide for lowering the level of capital required to form proposed specialized institutions serving the poor below currently applicable levels (a 50% reduction, in the case of the apex proposal, for the proposed microfinance NBFC and a reduction to one-eighth the current level, in the case of the sector proposal).[93] The goal of the proposed reduction is in each case to stimulate an increase in the number of the institutions in question. Other countries’ experiences with using the level of required minimum capital – either to ration licenses to a number low enough to supervise effectively or to increase the number of particular types of institutions – is therefore potentially highly relevant.
Concern with limiting deposit-taking MFIs to a number that can be effectively prudentially regulated and supervised through variable levels of required minimum capital is reflected in a number of regulatory regimes permitting depository microfinance, including the regime put in place in Pakistan. In 2001, Pakistan adopted an ordinance creating a new category of deposit-taking banks -- "microfinance banks" -- licensed, regulated and supervised by Pakistan's central bank, the State Bank of Pakistan (SBP). This legislation was adopted in part to address demand for financial services by the rural poor. The SBP, which was opposed to having unregulated deposit-taking institutions in Pakistan (because of the risk that they would present to depositors and the financial system), required that microfinance banks fall under its regulatory authority. However, the SBP recognized that it had limited capacity to supervise and regulate additional institutions[94] and it set the minimum capital for microfinance banks accordingly.[95]
Only five banks have been licensed under this ordinance, four of which have begun operations.[96] Three of these are barely operational. The fourth is First MicroFinanceBank (FMFB), a national bank that is the result of the "transformation" in 2002 of the microfinance program of the Aga Khan Rural Support Program, which had operated for more than twenty years. This is a modest number of institutions for a country as populous as Pakistan.[97] Of course, it is impossible to draw a clear and strong causal connection between the relatively small number of new institutions and the practice of setting minimum capital to a level commensurate with available supervisory capacity. However, since a significant goal in setting required minimum capital was precisely to limit the volume of new market entrants, it is not unreasonable to hypothesize a significant connection.
The practice of using high required minimum capital as a rationing mechanism for limited supervisory capacity is not without its critics. For some, the goal of extending the reach of depository institutions – particularly to remote rural areas – inevitably leads to advocacy for low minimum capital requirements so that financial institutions will serve these markets. International experience demonstrates that reducing minimum capital requirements for deposit-taking institutions serving the rural poor can be effective in increasing the supply of such institutions. Indonesia and Ghana, for example, have each expanded the number of rural deposit-taking institutions by establishing low minimum capital requirements for certain types of rural depository institutions. However, in each case, low minimum capital requirements also resulted in less desirable consequences and each country has had occasion subsequently to revisit or consider revisiting its minimum capital policy for such institutions.
In Indonesia, financial deregulation measures implemented in 1988 liberalized requirements for community banks known as Bank Perkreditan Rakyat (BPR), a term that "emerged in the mid 1980s as part of the effort to formalize the secondary banking sector and enable new secondary banks to expand the outreach of the financial system to rural areas and low-income households."[98] BPRs are permitted to offer savings and time deposit accounts and rupiah loans, but are not permitted to offer demand deposits or other common banking services, including foreign exchange facilities, trade finance and trust services. In addition, they do not have access to central clearing and payments systems. Pursuant to the 1988 deregulation measures, BPRs became subject to an initial paid-in capital requirement of only 50 million Indonesian rupiah, the equivalent at the time of about US$28,000.[99] The result was a significant increase in the number of BPRs from 423 in 1988[100] to almost 1,800 in 2000 (representing approximately 1,425 newly established BPRs and 370 converted BPRs[101]; if former rural fund and credit institutions known as LDKPs were included, the number would increase to over 2,400).[102]
Unfortunately, this flood of new depository institutions, often in hard to reach areas but also and perhaps more importantly in the Jakarta metropolitan area (where the BPRs had significant numbers of clients), proved more than what the bank supervisors could handle. A crisis ensued, caused by "low capitalization, weak management and unsound banking practices" (GTZ-ProFI Microfinance Institutions Study, p. 64). Between 1988 and 1996, almost 100 BPRs closed down and another 58 had their licenses withdrawn; others were converted into commercial banks or merged. During the following three years, Bank Indonesia froze the operations of 72 BPRs and withdrew another five licenses. (Id.) In 1999, the year in which, pursuant to newly adopted legislation, the central bank became independent and free from government interference, Bank Indonesia increased the minimum paid-up capital requirements to Rp.2 billion (US$192,000) for BPRs operating in the Jakarta region, Rp.1 billion (US$96,000) for those operating in the provincial capitals and Rp.500 million (US$48,000) for those operating in more remote areas.[103] In addition, the regulations prohibited foreign shareholders of BPRs and included many other prudential requirements intended to comply with international best practices. According to a study by GTZ-ProFI,[104] the new minimum capital requirements made the establishment of new BPRs, “especially in rural areas and economically less favorable areas, almost impossible.” The BPRs operating today are generally in good financial health, due in part to the 1999 regulations, including the higher minimum capital requirements, but also because of improved supervision.
In Ghana, the central bank introduced low minimum capital requirements for its "rural and community banks" (RCBs), community-owned banks first established in 1976 that are licensed to provide financial intermediation in rural areas.[105] In the 1990s, the central bank became increasingly concerned with the poor quality of RCB portfolios and their failure to comply with capital adequacy ratios. In 1992, the first year of classification by the Banking Supervision Department of the Bank of Ghana (BoG), only 23 of the 123 RCBs were classified as "satisfactory"; 82 were classified as "mediocre" and 18 as "distressed" (meaning insolvent).[106] The BoG implemented a series of increases in the minimum capital requirement, from the equivalent of US$22,000 (in 1994) to US$67,000 in 2002.[107] During this period, 23 distressed RCBs were delicensed by the BoG.[108]
Beyond the possibility of precipitating the formation of a larger number of institutions to be supervised than the supervisory entity has the capacity to manage effectively, reduced minimum capital requirements have on occasion had another unintended consequence: regulatory arbitrage leading to unintended market entrants. For example, in Bolivia, in the 1990s, the Bolivian government was interested in creating a regulatory category to allow MFIs to become licensed intermediaries without having to comply with the capital requirements applicable to commercial banks. In 1995, it created a form of low minimum capital deposit-taking institution[109] known as a Private Financial Fund (FFP).[110] The new category attracted the attention of wealthy Chilean investors who operated consumer lending institutions in Chile. These investors took advantage of the low capital investment needed to launch FFPs and began providing consumer loans to salaried employees in Bolivia. Later, because the Bolivian consumer lending market was limited, they extended their outreach to the traditional clients of Bolivia’s MFIs. The FFPs had no experience with MFI lending technology and engaged in irresponsible lending practices, disbursing huge amounts of credit and flooding the low-end market.[111] These factors resulted in levels of household indebtedness that were often as much as twice what MFIs generally considered to be safe. When a recession hit Bolivia's economy, many clients of FFPs who had taken on excessive debt, and often had borrowed from multiple lenders, defaulted. The Bolivian government did not raise minimum capital requirements for FFPs in response to widespread defaults by FFP clients (although it has significantly increased the minimum capital requirement since), partly because the government recognized that FFPs weathered Bolivia's economic recession better than banks and were vital to the Bolivian financial system. Instead, the government strengthened supervision of FFPs and rules governing lending practices.
The experiences of Pakistan, Indonesia and Ghana demonstrate that the use of minimum capital requirements to limit or increase the supply of financial institutions requires a careful weighing of the capacity of the applicable regulatory body to effectively supervise the financial system against the need for increased access to financial services, as well as a recognition of the very real possibility of regulatory arbitrage.
5.3.2 Adding Tiers to Banking Regulation to Permit/Facilitate NGO Transformations
In order to expand access to financial services for the poor by facilitating the “transformation” of existing MFIs into deposit-taking institutions, some countries have provided for "lower" regulatory tiers within their basic banking/non-bank financial institution regulatory framework, meaning less stringent minimum capital and other prudential requirements than those applicable to existing forms of regulated institution. Both Mexico and Uganda have adopted such an approach.[112] Although relevant Indian law severely limits the options for NGOs to “transform” into commercial legal entities, these experiences may nonetheless have relevance to proposals currently under discussion in India, including the proposed new form of microfinance NBFC in the apex proposal.
The longstanding failure of the banking sector in Mexico to reach huge portions of the population – particularly the rural poor – resulted in the development over many decades of a wide variety of different types of semi-formal “stop-gap” financial institutions, including groups formally organized on cooperative principles, informal rotating savings and credit funds and more traditional NGO MFIs, serving the otherwise unmet demand. By the late 1990s, the number of these heterogeneous and entirely unregulated institutions had grown to over 600, the largest of which boasted over a million clients and many branches, and the smallest of which remained informal groups of a few dozen participants. A majority were accepting voluntary savings. Moreover, some of these institutions had themselves become concerned about frauds reportedly being perpetrated by promoters who pretended to mobilize deposits from the rural poor to form a new institution but then simply absconded with the funds collected.
In 2001, Mexico adopted legislation governing deposit-taking institutions that brought the largest 500 of these semi-formal institutions under one legal and regulatory scheme. The new law provided for two types of retail deposit-taking institutions – a cooperative model and a model formed as a joint stock company – to be authorized by the Mexican bank regulatory commission.[113] Today, the vast majority of institutions operating, or planning to operate, under this law are cooperatives.[114] However, both types of institutions are required to be associated with a federation[115] authorized by the bank regulatory commission. Although the bank commission adopts the regulations applicable to these institutions, the authorized federations are tasked, as auxiliary regulators, with supervision of the retail institutions.[116]
There are currently approximately a dozen authorized federations, most of which existed prior to the adoption of the 2001 law and provided technical assistance, training and advocacy for their members. Under the law, each authorized federation must have a supervisory committee that is sanctioned by the banking commission. These committees have developed into a key component of the supervisory scheme and are reported to be staffed with highly competent professionals, many of whom are chartered accountants.
The minimum capital requirements, ranging from the equivalent of US$34,000 to US$8.5 million depending on the particular category (of which there are four) are far lower than those applicable to commercial banks (US$19 million). Other prudential requirements (such as liquidity and reserve requirements) are also generally less stringent than those applicable to banks. Although there are reports that the institutions operating under the law (including the supervisory federations) are operating well, it is too early to gauge the success of the new regime.
In Uganda, beginning in 1996, the Bank of Uganda (BOU), the country’s central bank, began working with donors and the microfinance sector to develop a legal form that could address the severe shortage of financial services in Uganda's rural areas. The outcome was the Microfinance Deposit-Taking Institutions Act of 2003, which provided for Microfinance Deposit-Taking Institutions (MDIs) subject to minimum capital requirements of the equivalent of US$250,000 (in contrast to the requirement applicable to banks, the equivalent of US$2 million). The BOU follows a tiered approach to regulation of financial institutions that weighs its own supervisory capacity against the needs for development of the financial sector. The BOU recognized that microfinance would require flexibility in order to provide innovative financial service delivery and developed regulations that differed from those of banks and other regulated financial institutions. At the same time, BOU subjected MDIs to capital adequacy requirements that are in fact more stringent than those applicable to banks.[117]
Some experience to date suggests that these lower institutional tiers may not be utilized to the extent hoped because of the high cost of “transformation”, primarily due to the requirements – such as more stringent Management Information Systems (MIS) standards – that must be met by the regulated entity and small numbers of NGO microlenders who are profitable enough to sustain these costs as well as the additional ongoing operational costs of deposit mobilization and compliance with the associated prudential regulation and supervision. In the case of Uganda, the maximum ownership limitations also pose a difficulty for NGOs wishing to “transform,” as they must find several additional owners to participate in the “transformation”. Thus far, for example, only four MDIs are operating in Uganda, although donors have provided financial support for the transformations that have been undertaken.[118]
International experience, therefore, is inconclusive as to the ability of lower regulatory tiers to stimulate the creation of deposit-taking institutions, but does suggest that the benefits to MFIs of "lower" regulatory tiers are countered by the costs associated with the more stringent regulatory requirements that may be required to protect the safety of depositors.
5.4 ‘Umbrella’ Legislation Imposed Over Existing Heterogeneous Financial System
Globally, stakeholders within the microfinance sector have often advocated for “umbrella” legislation that would be imposed over a heterogeneous array of existing institutions that provide financial services to poor people. The aim of such “umbrella” law proposals is generally to clarify and legitimize the activities of existing players and to impose rational and effective regulation and supervision on those that take deposits. In India, the provisions of the proposed draft law has elements of such an “umbrella” approach, given the wide array of different existing legal forms, each with its own separate enabling legislation at either the central or state level, that would be covered.
The appeal of such an approach lies in its apparent simplicity, as well as in its seeming capacity to remedy the gaps, overlaps, ambiguities and irrationally disparate regulatory treatment that almost inevitably exist in a legal and regulatory system with numerous institutional types, each added piecemeal over time. In practice, however, “umbrella” legislation, if it is to remedy these problems, is never simple. And, there is the risk that if the true complexity of the existing picture is not recognized and adequately handled through labor-intensive harmonizing amendments to numerous other laws and regulations, “umbrella” legislation can even make matters worse by introducing new ambiguities between the new legislation and relevant existing provisions. Effective implementation typically requires conforming amendments to various existing laws regulating or otherwise affecting the financial system to clarify the interplay between existing legislation and the new umbrella legislation.
Furthermore, these problems are far more likely to arise in a federal system like India’s, because the existing picture includes provisions of law and regulation both at the central level and at the level of the various states. The Parliament, at the central level, does not always have the power to amend the relevant provisions adopted by the legislative bodies of the states. Although the central Government may well be able to preempt application of state-level provisions of law and regulation, this, too, is often a contentious exercise that has the capacity to introduce new uncertainty rather than adding clarity and simplicity.
In Indonesia, after many months of discussion, Bank Indonesia and the Ministry of Finance together with GTZ-ProFI concluded in 2000 that a microfinance law was needed to address two specific issues: (i) the considerable gap in Indonesia between the demand and supply for microfinance services and (ii) the fact that many MFIs that are neither banks nor cooperatives (and therefore not subject to prudential regulation and supervision) take deposits from the public, in some cases in substantial amounts.[119] Regarding the latter issue, one particular problem faced by many MFIs was their inability, due to their small size, to meet the entry requirements applicable to BPRs (which had been raised the previous year, as discussed above in connection with the setting of minimum capital of depository institutions serving the poor).
A draft “umbrella” law, prepared by the central bank together with advice from GTZ-ProFI in 2001 and submitted for review and comment to a committee composed of various government ministries and representatives of the microfinance sector, was produced and submitted to the Ministry of Finance.[120] As stated in a background paper on the draft law, "the major impact of the law will be to enable the establishment of new MFIs licensed to take deposits and operating only in rural areas." The draft provided a list of the types of MFIs that could be licensed as a "Non-Bank MFI" (NB-MFI) and permitted to make loans and take savings and time deposits (up to a maximum of Rp.1 billion). (MFIs with total deposits of less than Rp.50 million would not be required to be licensed and regulated pursuant to the law). The law would not cover microbanks or cooperatives, which would continue to be governed by, and regulated and supervised pursuant to, the laws applicable to banks and cooperatives. The NB-MFIs governed by the draft would be regulated and supervised by a national supervisory body (whether the body would be an existing one or newly-established was not decided). The Ministry of Finance rejected the draft in 2003 and advised that the solution to the problem of unlicensed financial institutions collecting savings from the public was to have Bank Indonesia ease the entry requirements for BPRs.[121]
There are conflicting opinions regarding the reason for the Ministry's rejection of the draft law. One opinion is that Indonesia's formal financial system reaches large numbers of both the urban and rural poor primarily through the mainstream commercial banks and so-called secondary banks (including the rural banks further discussed below).[122] Given that the banks are the primary providers of microfinance services and are already clearly legislated and regulated, the draft legislation was not viewed as necessary. Others are of the opinion that although the banks do play a significant role in the provision of microfinance services in Indonesia, there is still a substantial gap between demand and supply. In fact, Indonesia’s National Microfinance Strategy paper, which was submitted to the President in December 2005 by the Ministries for State Planning and for Cooperatives and Small and Medium Enterprises (SMEs), takes this view. Some in the latter group believe that the Ministry of Finance rejected the draft because it was not properly positioned and presented. In addition, some who had worked on the initial draft law disagreed with various changes made to the draft during the consultation process among Ministries and various MFIs and did not ultimately support the version presented to the Ministry of Finance. The Microfinance National Strategy paper outlines steps that would be taken to promote the healthy development of the sector, including an appropriate legislative and regulatory framework for MFIs that would establish a "third window" for non-bank depository MFIs that are not cooperatives.[123]
In contrast to the decisions thus far reached in Indonesia against adoption of an “umbrella” law, Mexico, as discussed above, recently adopted legislation that governs all deposit-taking institutions not already covered by existing law, bringing 500 semi-formal institutions with varying characteristics under one legal and regulatory scheme. The new law has characteristics of an “umbrella” law in that it sought specifically to impose a rationalized and standardized regulatory order over heterogeneous existing actors. As mentioned, the law provides for two types of retail deposit-taking institutions – a cooperative model and a model formed as a joint stock company – each to be licensed by the Mexican bank regulatory commission. Any institution taking voluntary savings over a low minimum threshold (other than existing formal financial institutions governed by another law) is required to receive a license. Those institutions that were neither formed as a cooperative nor a joint stock company (for example NGOs using group lending methodologies where voluntary savings from the groups exceeds the minimum threshold) are required to “transform” by forming a new institution in one of the permitted legal forms and transferring the assets of the existing institution to it.[124] Thus, the challenges of harmonizing the new law with enabling legislation for multiple types of existing institutions were avoided, but at the cost of requiring all institutions of any significant size that were not already either a cooperative or a joint stock company to change their legal form into one of these two permitted options.
From the illustrations discussed above it is evident that international experience demonstrates that umbrella legislation can, in fact, help to standardize regulatory treatment of financial institutions, but also that such legislation may be difficult to achieve and may impose significant costs on institutions to which it applies.
5.5 Parallel Frameworks for Microfinance
Various types of stakeholders within the microfinance sector at times advocate for a parallel legal and regulatory framework for microfinance, separate and distinct from that of the rest of the financial system. The salient substantive distinctions between this approach and the “umbrella” approach described above are debatable in some situations, particularly where existing institutions are obliged to come within the ambit of the new parallel framework. A typical distinguishing feature of the “parallel framework” approach, however, is the imposition of a more or less rigid definition of “microfinance” – commonly through restrictions on loan size and possibly other product attributes, limitations on the characteristics of clients, or a combination of the two. The parallel framework approach has often been proposed in India, including, most recently, in the sector proposal's concept of the "business of microfinance," delineated by reference to the characteristics of the principally served clients.
Two countries in which a parallel framework for microfinance has been established alongside the existing financial sector framework are Kyrgyzstan and Tajikistan. In both countries, the parallel systems have been designed to include tiered institutional types and to provide for transformation options from one tier to the next.
In 2003, Kyrgyzstan adopted legislation requiring all MFIs to register either as microlending NGOs, microlending companies or deposit-taking microfinance companies. For all three institutional types, the legislation limits the maximum size of loans. Prior to adoption of the law, relevant legislation accommodated, as least arguably, various types of MFIs, although there was not total consensus as to the sufficiency of the legal basis for some types of institutions. The initial interest in a new microfinance law stemmed from the desire of one prominent MFI to establish itself as a deposit-taking institution, but other MFIs advocated for the inclusion of non-depository institutional forms as well.
The law prohibits any MFI from operating outside of the framework of the law. Microlending NGOs and microlending companies register with the nonbank financial institutions department of the National Bank of Kyrgyzstan (the country’s central bank and its bank regulatory agency). Regulations for such non-depository entities are non-prudential in nature and focus primarily on reporting requirements. In contrast, the deposit-taking microfinance companies are subject to both prudential and non-prudential regulation and supervision by the central bank. “Transformation” is permitted for microlending NGOs and microlending companies that wish to become deposit-taking microfinance companies, but only after two years of successful operation as non-depository institutions.
Tajikistan adopted a microfinance law in 2004 that differs little from the Kyrgyz law in terms of the tiered framework for which it provides. In Tajikistan, the motivation for the legislation arose initially primarily out of NGO MFIs' concern regarding whether they were legally permitted to engage in microlending.[125] In addition, policy makers and others viewed the Kyrgyz legislation as a positive step forward in terms of financial sector development and advocated for the inclusion of a depository form of MFI, although there were no NGOs at that time operating profitably enough to be financially sustainable as microlenders, let alone to cover the additional costs of mobilizing deposits and complying with prudential regulation and supervision. Unlike the Kyrgyz law, the Tajik law allows an MFI to operate under the Civil Code and outside of the framework created by the law, provided the MFI does not accept retail deposits (most MFIs have decided to register under the new law nonetheless). In its fundamental regulatory aspects, the Tajik legislation is similar to the Kyrgyz microfinance law: microlending NGOs and companies register with the National Bank of Tajikistan, the country’s central bank and its bank regulatory agency, and are subject to non-prudential regulation; the deposit-taking MFIs are regulated and supervised by the central bank and are subject to both prudential and non-prudential regulation. For each of the three types of institutions, a maximum loan size is established by regulation.
A parallel framework like those adopted in Kyrgyzstan and Tajikistan is sometimes advocated as a means around amending a country’s banking law or central bank law – something that frequently cannot realistically be undertaken for important political reasons. However, in many countries, without amendments to these basic legislative pillars of the banking system, it will not be possible to adopt a parallel framework without introducing potentially serious ambiguities between the mainstream financial system and legal and regulatory infrastructure and the parallel system established for microfinance.[126]
In some contexts, there may also be an adverse psychological impact of a separate parallel framework not integrated into the mainstream framework in terms of marginalizing microfinance and MFIs. This marginalization may turn into more than just a perception problem. In both Kyrgyzstan and Tajikistan, for example, there is no mechanism for top-performing depository microfinance companies to “transform” into a conventional commercial bank, meaning that institutions are forever constrained to operate within the three tiers of microfinance institution described in the microfinance law.
A final potential problem that a parallel system presents is the risk of regulatory arbitrage. The entrance into the market in Bolivia of newly formed and badly behaving players from the Chilean market, cited in the discussion above as an example of a possible unintended consequence of lowering minimum capital to stimulate the creation of new depository MFIs, is also an example of a broader problem where market participants might seek to take advantage of virtually any respect in which the regulatory treatment of a newly created regulatory option for microfinance is perceived as lighter, less restrictive or less burdensome than the treatment afforded by other available regulatory options.
The experiences of Kyrgyzstan, Tajikistan and Bolivia show that, although parallel frameworks may help to clarify and legitimize the activities of MFIs in the overall financial system, their implementation may result in significant restrictions on those activities, and may introduce legal ambiguities and opportunities for regulatory arbitrage.
5.6 Bank Agency Relationships
Bank agency models utilize existing channels of financial service delivery and therefore present potentially vast increases in access to financial services with relatively little additional investment.[127] Among several countries (including Brazil, Mexico, South Africa and the Philippines) where regulatory authorities have allowed for the use of bank agency relationships to expand access to financial services for poor people, Brazil stands out as a leader. India has looked to development of the bank agency model in Brazil with respect to credit products and, following the RBI's January 2006 circular, will examine the Brazilian example with respect to a wider range of financial services.
In the 1990s, Brazil suffered macroeconomic problems that resulted in a string of bank failures and a deterioration in financial access. The government responded with several proactive initiatives seeking to stabilize the economy and strengthen the financial system. In order to improve financial access, especially to the rural poor, the government implemented a series of regulations that encourage banks to use agents to provide financial services. Banks have responded to these regulations by developing a huge and expanding network of "banking correspondents" through contractual arrangements with grocery stores, drugstores, gas stations, the postal system and even the ubiquitous lottery outlet chain. The banks use technology, including point of sale devices and communications networks, to provide deposit, withdrawal, bill payment, account opening, money transfer and other services through these banking correspondents.
The results have been dramatic. Since the banking correspondent model first appeared in 2000, banks have utilized banking correspondents to open approximately 8 million new accounts, primarily in underserved areas. Banking correspondents now serve every municipality in Brazil.
VI. Summary Analysis of Legal and Regulatory Reform Proposals
6.1 Introduction
Given the complexity of the existing legal and regulatory picture for institutions serving poor clients in India, it is hardly surprising that consensus among different stakeholders on a way forward has thus far proved elusive. Against this backdrop, it is also not surprising that in the past few years, ideas for reform have emerged, been tabled, and emerged again, sometimes with a renewed vigor and sense of urgency.
The key legal and regulatory reform proposals presently under discussion in India – all of which relate to the free-standing MFI model[128] – must be viewed in this context. In brief, the proposals are aimed at: (i) formal central government recognition of MFIs that are engaged exclusively or predominantly in credit delivery and are not regulated by the RBI; (ii) enhancement of transparency in the microfinance sector; (iii) permitting limited deposit-taking by MFIs not regulated by the RBI; (iv) establishing a form of specialized deposit-taking NBFC with less stringent licensing requirements; and (v) accomplishing substantially all the foregoing objectives through new microfinance-specific legislation.
In all likelihood, it will not be a question of adopting any proposal wholesale, as it is probable that none will gain acceptance in all aspects from all critical decision makers. For this reason, an analysis of the content of the various proposals – on an issue-by-issue basis – offers greater potential utility as a tool for decision makers than a critique or a defense of any proposal in its entirety.
The discussion below provides, in a summary form, such an issue-by-issue analysis. It includes, where relevant, observations concerning the lessons that the foreign experiences discussed in the previous section may offer, and also recognizes that on many issues Indian experience may be sufficiently distinctive as to render foreign experience of little or no value.
It is important to point out that the discussion below does not address the critically important question of timing of reform.[129] The discussion offers factors to consider in assessing the timeliness of reform proposals, but cannot substitute for policy makers’ judgment as to which issues should be addressed at any particular time.
6.2 Proposals Aimed at Formal Government Recognition of Credit-Only MFIs Not Regulated by the RBI
Reforms designed to confer formal regulatory status to free-standing MFIs engaged exclusively or predominantly in credit delivery[130] could potentially clarify their legal situation, and could do so without triggering issues of depositor protection discussed below with respect to reform proposals aimed at increasing the number of MFIs engaged in mobilization of voluntary savings. In particular, this could serve to legitimize these organizations[131] and eliminate doubt as to the appropriateness of their profit-generating lending activities, notwithstanding their status as organizations generally formed under state-level legislation intended for conventional charitable organizations. For those institutions that accept compulsory deposits, legislation providing for central-level government recognition could also include standards for segregation of these funds, to avoid putting them at risk of loss through poor investment decisions (although no current proposals include such provisions). Finally, this type of formalization could also help to establish minimum obligations for MFIs, such as entry into a consolidated central-level registry and centralized reporting requirements, which could in turn also serve to increase transparency, as discussed further below.
However, imposing a formal central-level definition of what is and is not to be considered “microfinance”, risks constraining MFIs' flexibility with respect to both products and clients. This risk must be weighed against the merits of explicit central government recognition. The flexibility to design credit products to suit client demand and the MFIs’ chosen market niche is widely recognized as a factor contributing to the healthy development of the sector and expanded access to credit products for the poor. Indeed, this fact was noted by the RBI’s internal working group as a significant factor militating against an attempt to adopt comprehensive regulation of free-standing MFIs at the present time.
The recent experiences of the microfinance sector in Bosnia and Herzegovina, Morocco and Armenia are informative on this issue. In both the Bosnian and Moroccan cases, the legislation and regulation in question not only impose constraining maximum size limitations on MFIs’ credit products, they also largely restrict their lending activities to business purposes (with some limited categories of exception in the Moroccan case). However, in both these cases, the constraints on flexibility could be justified when considered in light of the fact that before the adoption of the specialized legislation and regulation in question, microlending was not legally or practically feasible at all – a state of affairs far different from the present situation in India. In the Armenian case, the cost of formalization of government recognition was the removal of any legal option to operate as an NGO (in addition to the costs of “transforming” into a suitable commercial legal form and meeting the ongoing transparency reporting standards that are in the process of being imposed by the Central Bank of Armenia).
An additional potential disadvantage of central-level recognition of free-standing MFIs formed under state-level law is the risk of legally unclear interplay between the relevant central-level and state-level legislation and regulation. Although care can be taken to limit this possibility through thorough preparatory research and careful drafting, the possible disharmonies may not be completely foreseeable.
In weighing the value of formal central government recognition of free-standing MFIs, a critical consideration should be the inherent unpredictability of the political process that would be needed to implement the proposed reforms. It cannot be assumed that even an extremely well-conceived reform proposal hatched in a ministry or a central bank will meet with favor in parliament.[132] Moreover, the high rate of interest necessary for sustainable microfinance virtually inevitably surfaces as an issue in the political process, with inherently unpredictable consequences.[133]
Overall, there are advantages to central government recognition, although it is important to ensure that any legislation granting formal regulatory status to MFIs does not unduly impede MFIs’ operational flexibility. Also, it will be important to minimize possible disharmonies with state-level law and to maximize buy-in by state governments.
6.3 Proposals Aimed at Enhanced Transparency in the Microfinance Sector
Broad consensus exists internationally concerning the merits of enhanced transparency in the microfinance sector. Requiring MFIs to maintain and report operational data according to standardized criteria potentially offers the world at large a clearer picture of MFI performance, exposing inefficiencies, enhancing competition, creating a better informed basis for investment in the sector and ultimately expanding outreach.
For these reasons, but also partly because of the broad support among virtually all stakeholders in India for improved transparency in the microfinance sector, adoption of transparency-related reform is clearly politically feasible and should be pursued. However, reform measures cannot be implemented without first considering what form they will take. A key consideration is whether such transparency will be (i) mandated by law or regulation, (ii) self-regulated by the microfinance industry or (iii) voluntary on the part of individual MFIs. Transparency mandated by law or regulation is the trend in those countries in which credit-only MFIs have been explicitly provided for in laws or regulations, including Bosnia and Herzegovina, Morocco and Armenia, each discussed in Section 5.2. The central risks, however, are that the regulator may tend towards over-regulation and may be both less sensitive to the costs associated with compliance (which sustainably operated MFIs must pass on to their poor clients) and less well-equipped to do a careful analysis of the necessity of imposing particular requirements.
In addition to the concern regarding whether transparency standards will be legally mandated, there is also the basic consideration of whether MFIs are able institutionally to gather and report the relevant data accurately. This would apply whether the standards are legally mandated or set by a self-regulating body.[134] Although the current lack of capacity among many Indian MFIs is not a reason to reject transparency measures, it is important that those who develop the standards be aware that compliance with reporting and other requirements may be extremely costly for the vast majority of free-standing MFIs in India, whose available human resources and MIS are most likely not currently up to the task. There will also, of course, be additional costs imposed on the body responsible for receiving, analyzing and making public the data received as well as the costs of enforcement action against those institutions that fail to comply with the requirements.
Foreign country experience on these issues is not helpful in terms of identifying what the specific requirements should be: too much varies according to the type of institution involved, level and type of data gathering that may already be required, the human and MIS capacity of MFIs and their sheer number, among many other factors. In Armenia and Morocco, for example, the very small number of institutions that are soon to become subject to transparency-driven regulatory regimes currently under development renders the capacity-building exercise necessary to enable their compliance an entirely different question than would be the case with India’s estimated 800 free-standing MFIs. Indian policy makers, therefore, will have to make their own difficult calculus on this issue.
It is clear, however, that well-designed transparency measures (whether legally mandated or not) should, in the long run, contribute to a more efficient and healthy sector and better-served clientele. In India, the level of consensus on the general idea of promoting improved transparency in the microfinance sector is high and the idea needs to be supported, perhaps initially focused on building MFIs' capacity to collect and report data.
6.4 Proposals Aimed at Permitting Limited Voluntary Savings Mobilization by MFIs Not Regulated by the RBI
Proposals to permit free-standing MFIs that are not regulated or supervised by the RBI to engage in limited voluntary savings mobilization have been the topic of considerable debate. As discussed below, the intent behind such proposals is laudable; however, the downsides appear to outweigh the potential benefits (particularly when factoring in the potential increase in deposit mobilization by MFIs working as agents for banks, made possible by the recently adopted RBI circular).
Proponents of the proposals commonly mention two basic justifications: first, to extend needed small-balance savings services to presently unserved clients; and second, to provide MFIs with an additional source of funding for their credit activities. Most proponents appear to recognize that neither goal could be achieved cost effectively if the MFIs in question were subject to substantial prudential oversight (whether by the RBI or another body), given their generally small size and often remote spheres of operation.
Although there is clearly high unmet demand for savings services among India’s poor, particularly in certain states and remote rural areas, several issues need to be considered regarding the proposal to permit the vast majority of free-standing Indian MFIs to accept retail deposits.
Costs of deposit-taking. Only a small handful of free-standing Indian MFIs are estimated currently to be operating profitably enough to cover all their costs as lending institutions on a subsidy-adjusted basis, let alone the significant additional costs of mobilizing voluntary deposits. Although it is true that the marketing costs of deposit taking in addition to credit activities might be minimal for many Indian MFIs (given their close relationship with their credit clients and the prevalence of group methodologies that provide ready access to clients for a potential variety of services), the same cannot be said of the costs of profitably administering retail deposit taking, such as those related to the establishment of a treasury function and sophisticated liquidity and asset and liability management procedures.[135]
Proposed justifications for having no prudential oversight. The proposals for permitting essentially unregulated and unsupervised deposit-taking by free-standing MFIs commonly assume two restrictions on the MFIs' activities: (i) deposit-taking will be limited to an MFI’s members and (ii) the MFIs will be subject to a cap on the deposits of any one depositor (as well as typically a limitation on retail deposits in the aggregate). Regarding the first assumed restriction – that deposit-taking will be limited to an MFI's members – the theory is that members’ vigilance substitutes for external oversight. In practice, however, the capacity for such vigilance proves radically uneven among different institutions and tends to break down entirely when institutions grow over a certain size or federate into larger units that are entrusted with management functions.[136] As for the second restriction (setting a cap on maximum deposit size), although it would limit the amount that any individual depositor stands to lose upon the collapse of an MFI, it also further reduces the chances that the MFI will be able to operate profitably enough to protect poor people’s savings in the first place, as small-balance deposit taking is inherently challenging to manage profitably.
This last point also casts doubt on the asserted justification for permitting MFIs to accept retail deposits as a source of funding for their lending activity. Will retail deposits truly be competitive with rates charged on bank loans to MFIs for onlending (to say nothing of the cost of capital from a public source such as NABARD’s Microfinance Development and Equity Fund), once the administrative costs of managing small-balance deposits are factored in? The question needs careful analysis, which may lead to the conclusion that the financial benefits of deposit mobilization are limited given the easily available and increasingly competitive loans offered by wholesale lenders.
Fraud. Another question that arises in connection with proposals to permit limited deposit taking by free-standing MFIs is whether the practice would increase risk of fraud on depositors. The answer here appears unclear. Given that MACS can already mobilize deposits legally from their members (and even from non-members, if the deposits are term deposits), it seems unlikely that legally sanctioned limited deposit taking by other types of MFIs would have a substantial impact on the overall risk of fraud.
Foreign country experience, unfortunately, offers little to allay the concerns outlined above.[137] Indeed, the difficult choice always remains whether to permit unregulated community based depository institutions where no safer option for poor savers is available. This observation, however, leads to an additional argument against permitting largely unregulated Indian MFIs to mobilize voluntary savings: In India there do appear to be safer options to pursue. One of these options is the use of the bank agency model in deposit mobilization, which has been made possible under the January 2006 RBI circular. It seems clear that this linkage of credit-only MFIs with the branch network of India’s banks may prove a safer approach to meeting the unmet demand for small balance savings.
Overall, the weaknesses of the proposals to permit limited voluntary savings mobilization by largely unregulated MFIs appear to outweigh the benefits, especially given the increase in the availability of savings services that can be expected through the newly authorized use of bank agents for this purpose.
6.5 Proposals Aimed at Establishing a Form of Specialized Deposit-Taking Microfinance NBFC with Less Stringent Licensing Requirements
Proposals for a specialized depository form of microfinance NBFC with less stringent licensing requirements than those currently applicable to deposit-taking NBFCs stem from the same desire to satisfy unmet demand for small-balance savings services.[138] The legal and regulatory issues – and the supervisory issues – however, are quite different. Here, all credible proposals acknowledge the importance of prudential regulation and supervision. These proposals focus on two specific entry criteria ideas: lowering the level of paid-up capital required for licensing a prudentially regulated and supervised deposit-taking MFIs and, in the case of the proposed specialized depository microfinance NBFC, providing a more workable means of satisfying the requirement for an investment grade external rating.
On the issue of lowering required minimum capital to encourage the formation of new depository financial institutions, foreign experience seems relatively clear. The experience of both Ghana and Indonesia, for example, support the conclusion that lowering required minimum capital can indeed help to stimulate formation of new depository institutions.[139] Of course, this also means an increase in the number of institutions that the relevant regulatory and supervisory authority will be required to regulate, and by definition, they will tend to be institutions with a smaller capital base. Moreover, if the push is to serve currently underserved markets (as it was in Ghana and Indonesia and would be in India), it must be assumed that a large number of the newly licensed institutions would be located in remote rural areas.
To be sure, relaxation of required minimum capital can be approached with due attention to supervisory capacity, as the experience of Pakistan demonstrates. Whether the RBI would be willing to assume the regulatory and supervisory duties is not clear given its stated policy objective of encouraging consolidation in the banking sector generally.
The Indonesian example shows a significant potential risk if the number of new institutions to be regulated and supervised increases beyond the supervisory authority’s capacity:[140] there is an increased possibility of a supervisory crisis, resulting in the failure of institutions and loss of vulnerable depositors’ savings (or a decision on the part of the public authorities to bail the failing institutions out). This is not the only risk, however. As the Bolivian example establishes, there is no assurance that the newly licensed institutions will be the type of institution envisioned by proponents. Regulatory arbitrage presents a potential risk whenever licensing requirements are eased.
By contrast, proposals to render more workable the current requirement for deposit-taking NBFCs to obtain and maintain an investment grade rating from an accredited rating agency present few foreseeable downsides. The proposals, which call for the microfinance sector to educate rating agencies about microfinance methodologies and demonstrate that MFIs do not need to collateralize their loans in order to operate at a profit,[141] seems sensible and merit serious consideration.
Overall, the analysis of proposals to lower entry barriers for deposit-taking NBFCs points to a balance between (i) arguments suggesting that such reforms may stimulate formation of new depository institutions and (ii) arguments highlighting the possibility of regulatory arbitrage and the risk of a supervisory crisis. A final view on the question would likely hinge on the willingness and capacity of the regulator to assume an increased regulatory and supervisory burden (including the possible increase that might result from regulatory arbitrage).
6.6 Proposals Aimed at Accomplishing Substantially All the Foregoing Objectives Through New Microfinance-Specific Legislation
While the adoption of central-level microfinance-specific legislation aimed at addressing all of the foregoing topics could theoretically carry all the benefits described above, it would also be subject to all of the potential risks. Moreover, omnibus legislation addressing a wide range of topics would increase the general challenge of harmonizing such legislation with existing laws and regulations on both the central and state levels. The topics are therefore perhaps better addressed through more selective and targeted legislation focused on those issues on which the benefits of proposed reforms most clearly outweigh the potential risks.
An omnibus central-level microfinance law – whether adopted in the form of (i) an "umbrella" law over all existing actors in the microfinance sector, (ii) a law establishing a new regulatory framework separate from the existing financial system legislation and regulations or (iii) a law with elements of both (such as the sector proposal) – offers the potential of preempting problematic or burdensome central-level and state-level legislation, clarifying the position of microfinance in the overall financial system and even enhancing the legitimacy and acceptance of the very concept of microfinance. However, the concept has a potentially misleading appearance of simplicity. Especially in a country such as India with a federal system and a complicated mix of regulatory bodies and financial institutions, there is a significant risk of introducing new ambiguities into the relationship between the new law and existing central-level and state legislation.
The sector proposal's draft law demonstrates careful and methodical consideration of many of the risks associated with the reform proposals discussed topic-by-topic above. Nonetheless, it also shows the intractable nature of many of them. Some examples from the draft law illustrate the potential problems. The draft law’s “principal business” test would place severe limitations on the ability of any microfinance service provider to lend to men (and could embroil both the institutions and their regulators in a potentially expensive exercise of demonstrating and monitoring compliance). The lack of any explicit language on the treatment of institutions engaged in microfinance outside of the draft law would likely increase, rather than reduce, questions as to their legal legitimacy – although presumably there will be many such institutions that cannot meet the draft law’s “principal business” test or other requirements.[142] The uncertain efficacy of the draft law's “non obstante” clause,[143] which attempts to provide for preemption of existing central- and state-level legislation (including in particular the RBI Act), could give rise to serious disputes as to the legal effect of certain provisions of the draft law. Finally, while the draft law would enhance the legal legitimacy of those institutions that can bring themselves within its purview, it would also legitimize deposit-taking (albeit subject to significant limitations) by minimally regulated institutions[144] whose capacity to handle the associated challenges is in grave doubt based on the profitability performance of the large majority of existing Indian MFIs.
Overall, the concerns of the microfinance sector, regulators and other stakeholders can be addressed more safely and effectively through narrower and more targeted reforms tackling a limited range of issues. Such an approach is less likely to present the serious risks that an overarching microfinance law would likely present, including those related to possible disharmony with existing central- and state-level legislation, ambiguous lines regarding different regulators' responsibilities and the uncertain situation of MFIs not covered by the law.
If the Government elects to take such a more targeted approach, then the salient considerations will obviously vary according to the issues chosen for inclusion and the specific approaches proposed for addressing them. If the legislation is intended to bestow increased legal legitimacy upon MFIs, then this must be handled with due concern not to limit unnecessarily their operational flexibility. The significant arguments against permitting even limited deposit taking by small, unregulated or lightly regulated MFIs counsel against including this objective among the issues addressed by the proposed legislation (particularly in light of the new opportunities for MFIs to mobilize deposits as agents for banks under the January 2006 RBI circular). Finally, if the legislation proposes creation of a new apex body for the microfinance sector (as is proposed in the sector proposal), then before vesting such body with regulatory and supervisory responsibilities, the Government should carefully consider the potential downsides[145] of adding another regulatory body to the variety of financial regulators currently operating in India. To avoid these risks, a primarily developmental and policy coordination role to promote the microfinance sector may be the most appropriate focus for the apex body.
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Annex 1: Persons Consulted during India Mission
Ahuja, Mr. Ashish, Chief Manager, Alternate Channels Group, ICICI Bank Limited, Oct. 20, 2005
Bhalla, Mr. Bhupinder S., Director, Ministry of Finance, Department of Economic Affairs (Banking Division), Oct. 19, 2005
Goel, Mr. Ashish, McKinsey & Company, Inc. (Advisor to State Bank of India), Oct. 20, 2005
Hegde, Mr. Brahmanand, Head, Products & Credit, Rural & Micro Banking Group, ICICI Bank, Limited, Oct. 20, 2005
Joshi, Dr. (Ms.) Deepali Pant, Chief General Manager, Hyderabad Secretariat, Reserve Bank of India, Oct. 22, 2005
Karmakar, Mr. K. G., Executive Director, Micro Credit Innovations Department, National Bank for Agriculture and Rural Development, Oct. 20, 2005
Khera, Mr. Manish, Joint General Manager, Alternate Channels Group, ICICI Bank Limited, Oct. 20, 2005
Krishnamurthy, Mr. P., Chief General Manager-in-charge, Department of Non-Bank Supervision, Reserve Bank of India, Oct. 21, 2005
Leonard, Ms. Jennifer, Assistant Vice President, Finance, SKS Microfinance, Oct. 22, 2005
Lewis, Mr. Mark, Department for International Development, Oct. 17, 2005
Marti, Mr. Adrian, Country Director, Swiss Development Cooperation Office, Oct. 19, 2005
Mishra, Mr. Mahesh, Economic Advisor, Department for International Development, Oct. 17, 2005
Misra, Ms. Rewa Shankar, Manager, Policy & Research, CARE India, Oct. 18, 2005
Murthy, Mr. C. S., Chief General Manager-in-Charge, Rural Planning & Credit Department, Reserve Bank of India, Oct. 21, 2005
Rai, Mr. Vinod, Additional Secretary, Ministry of Finance, Department of Economic Affairs (Financial Sector), Oct. 19, 2005
Rao, Mr. K. Muralidhara, General Manager, Micro Credit Innovations Department, National Bank for Agriculture and Rural Development, Oct. 20, 2005
Rao, Mr. Sitaram, Director, SKS Microfinance, Oct. 22, 2005
Reddy, Mr. C. S., Chief Executive Officer, Andhra Pradesh Mahila Abhivruddhi Society (APMAS), Oct. 22, 2005
Salim, Mr. K. A., Deputy General Manager, Microfinance Department, State Bank of India, Oct. 20, 2005
Saraf, Mr. Kanti, General Manager, Rural Planning & Credit Department, Reserve Bank of India, Oct. 21, 2005
Savyasaachi, Ms. Achla, Policy Team Leader, Sa-Dhan (Association of Community Development Financial Institutions), Oct. 17, 2005
Sharma, Mr. Vipin, Program Director, CARE India, Oct. 18, 2005
Singh, Mr. Sukhbir, Chief General Manager, Micro Credit Innovations Department, National Bank for Agriculture and Rural Development, Oct. 20, 2005
Sinha, Mr. Gaurav Ranjan, Program Executive, Sa-Dhan (Association of Community Development Financial Institutions), Oct. 17, 2005
Sinha, Mr. Sanjay, Managing Director, Micro-Credit Ratings International Ltd, Oct. 18, 2005
Sircar, Mr. Debashish, Economic Advisor, Department for International Development, Oct. 17, 2005
Titus, Mr. Mathew, Executive Director, Sa-Dhan (Association of Community Development Financial Institutions), Oct. 17, 2005
Annex 2: Persons Consulted regarding Foreign Experiences
|Anjali Kumar, World Bank |Brazil |
|Blaine Stephens, The MIX |India, Morocco |
|Braco Erceg, Mikrofin |Bosnia |
|Carlos Cuevas, World Bank |Mexico |
|David Porteous, Recap International LLC |South Africa* |
|Dirk Steinwand, GTZ Sri Lanka |Indonesia |
|Gabriel Davel, Microfinance Commission of South Africa |South Africa* |
|Joselito Gallardo, World Bank |Ghana, Indonesia, Philippines* |
|Koro Outtawara, World Bank |Ghana |
|Michael Hamp, GTZ-ProFI |Indonesia |
|Monica Harutyunyan, USAID/Armenia Micro Enterprise Development Initiative, Chemonics |Armenia |
|International Inc. | |
|Pierre Giguère, DesJardins |India, Mexico |
|Stefan Staschen, Consultant |Uganda |
|Stephen Rasmussen, World Bank |Pakistan |
|Richard Rosenberg, CGAP |Bolivia, Pakistan |
|Robert Christen, Boulder Institute of Microfinance |Bolivia |
|Sergio Navajas, Inter-American Development Bank |Bolivia |
* Various experiences in these countries (South Africa and the Philippines) were considered but not included in this note's discussions.
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[1] See for example, “Finance, Inequality and Poverty: Cross Country Evidence”, The World Bank, 2004.
[2] The total outstanding credit from microfinance amounts relative to outstanding credit of the entire banking system is a mere 0.5% in end-March 2005.
[3] As discussed in Section IV, the proposals on deposit-taking take two distinct approaches: permitting unregulated institutions to accept small deposits and permitting MFIs to form as Non Banking Finance Companies (NBFCs, or another type of deposit-taking institution, as presented by a proposed draft microfinance law prepared and submitted by the microfinance sector to the Ministry of Finance in December 2005) that would be subject to less stringent regulatory requirements, including in particular lower minimum capital requirements and no rating requirement for qualification to take deposits.
[4] For literature that demonstrates such a link between stronger, deeper, broader, more market-oriented financial sectors and impact on poverty alleviation, see for example, “Finance, Inequality and Poverty: Cross Country Evidence”, The World Bank, 2004, and “Doing Business in 2005”, The World Bank, 2005.
[5] It is possible that the demand for savings products will be satisfied, at least in part, by the increase in deposit-taking services offered by banks using the bank agency model authorized by the circular (described in detail in Section 2.2.3).
[6] Primary research for this note was conducted during a research mission conducted in Delhi, Mumbai and Hyderabad in October 2005, as well as during follow-up consultations. The authors express their appreciation to the persons consulted, who are listed alphabetically in Annex 1.
[7] The inherent challenges of drawing meaningful comparisons among countries in widely differing political and economic situations and with widely varying financial systems, legal and regulatory frameworks and regulatory traditions are discussed in the introduction to Section V.
[8] The authors express their appreciation for these resources, which are included among the resources consulted in the Bibliography list.
[9] The Mumbai office of Trilegal, an Indian law firm has assisted in the development of Section III of this note, as well as researching targeted questions posed by the authors. They have also reviewed the entire note for legal accuracy and completeness.
[10] The authors express their appreciation to these persons listed in Annex 2 for the time they spent discussing various countries' experiences.
[11] Indeed this factor, together with the need for improved prudential regulation and supervision of RRBs as well as credit cooperatives, is an important topic for policy makers to consider. This note, however, focuses on the microfinance sector and related proposed regulatory reforms and does not include a discussion of possible reform measures of RRBs or credit cooperative banks.
[12] India’s banking system compares well in international comparisons in terms of indicators such as area per branch and, to a lesser extent, population served per bank branch. See also “Scaling-up Access to Rural Finance in India” (2004).
[13] See for example, "A Financial System for India's Poor," p. 4009, citing a World Bank-NCAER survey that showed that 59% of rural households do not have a deposit account and 79% of rural households do not have access to credit from a formal source.
[14] These models are not always mutually exclusive and some significant actors in microfinance in India employ more than one of the models.
[15] In fact, the pioneering Indian MFI, SEWA Bank, is an urban cooperative bank.
[16] This is not to say that there are no other legal and regulatory issues pertaining to these excluded categories. Indeed, for example, legal, regulatory and governance reform with respect to cooperative banks (with their three tiered structure at the state, district and village levels) is a topic of considerable discussion although peripheral to the current discussion of specialized regulation for microfinance in India.
[17] As noted in Section IV of this note, although the SHG-bank linkage model presents potential regulatory issues, there are currently no reform proposals specifically addressing this model. The discussion of the SHG-bank linkage model is therefore limited to a description of its components and the model's legal and regulatory framework. Similarly, in light of the January 2006 RBI circular permitting banks to use agents to conduct financial activities, there are no other reform proposals with respect to this model discussed in this note.
[18] As discussed further in Section 3.2 and Section 3.3 below, recent efforts to federate SHGs under state-level cooperative legislation raise potentially significant legal and regulatory issues.
[19] Historically, bank lending to SHGs has been facilitated by NABARD refinancing, though the proportion of loans refinanced by NABARD has recently been declining. Between 2001 and 2005, the share of NABARD refinancing of total annual bank lending to SHGs declined from 83 percent to 43 percent.
[20] This is an aggregate number of all SHGs that received financing from banks between 1992-March 2005 and likely overestimates the number of active/functional SHGs in India. During the financial year ending March 2005, about 800,000 SHGs (of the cumulative 1.6 million figure) actually received financing from banks and only 25 percent of the SHGs existing at the beginning of the year received loans during the year.
[21] For example, data from NABARD on the SHG-bank linkage program and from ICICI Bank and other industry sources shows that the estimated share of MFIs’ annual loan disbursements to total microfinance loan disbursements has increased from around one fifth to one third between March 2001 and March 2005.
[22] This note does not discuss the three tiered cooperative bank structure nor cooperatives registered under the state cooperative acts.
[23] All trusts must, if carrying out public charitable activities, register with the Commissioner of Charities established in the state in which the trust operates.
[24] MFIs may be also formed as societies governed by central level legislation: the Societies Registration Act, 1860 (Societies Registration Act). However, several states have enacted state level legislation that overrides the Societies Registration Act, thus making central societies largely an academic issue.
[25] More information regarding the legal and regulatory requirements applicable to each type is provided under Section 3.3 which deals with the legal and regulatory bases of the free-standing MFI model.
[26] Senior level officials at the RBI, however, have unofficially indicated a tolerance for the acceptance by NGO MFIs of compulsory deposits that are used as collateral.
[27] States have adopted MACS legislation largely in response to concerns about state influence over the governance of state and district level credit cooperative banks and their grass root level constituents, the Primary Agricultural Cooperative Society (PACS), all of which are partly state-owned and operate under significant state control.
[28] Each of these may have a tiered structure, meaning that there is a much larger number of constituent, smaller size MACS.
[29] Only one NBFC engaged in microfinance activities had, in 2003, received the requisite investment grade rating for mobilizing term deposits from the public. However, even this MFI is currently not mobilizing deposits.
[30] These conditions are described further below in Section 3.3 which deals with the legal and regulatory bases of the free-standing MFI model.
[31] Currently, many commercial banks offer lines of credit to MFIs in addition to term loans.
[32] Some free-standing MFIs are also using the bank agency model (discussed below), whereby they facilitate retail transactions on behalf of banks without serving as a legal intermediary.
[33] Extrapolation of data from M-CRIL, a specialized rating agency for microfinance.
[34] Since the late 1990s, in response to the discovery of significant scams involving NBFCs, RBI regulations have tended to become increasingly more stringent and have led to a fall in the number of deposit taking NBFCs over time.
[35] These deposit schemes involved daily or weekly collections by banks, through local agents, at the homes of depositors. Cash leakage, fraud and accounting problems were prevalent.
[36] Specifically, a 1997 amendment to the RBI Act prohibited the taking of deposits by unincorporated bodies; 1998 RBI Directions set forth various prudential norms applicable to NBFCs.
[37] The internal working group’s report, entitled “Report of the Internal Group to Examine Issues Relating to Rural Credit and Microfinance,” is discussed below in Section 4.2 dealing with the reform proposals related to the free-standing MFI model.
[38] For example, both the RBI and state governments have regulatory authority over cooperative banks. The RBI, however, has expressed its concern regarding its inability to ensure that the cooperative banks comply with the "relatively diluted" (in the words of an RBI Task Force on Cooperative Credit Institutions) prudential regulations applicable to them and to enforce punitive measures against those that are in poor health. This lack of enforcement power is, according to the report of the Task Force, due to the "shared" control.
[39] For example, some MFIs recently have taken advantage of state-level MACS legislation, which allows them to avoid central-level restrictions on deposit-taking. These MACS are largely unregulated and weakly monitored and, without adequate oversight, could eventually result in depositor risk.
[40] The RBI has delegated supervision of RRBs and cooperative banks to NABARD.
[41] The issue of the regulatory treatment of federations of SHGs is discussed further below in Section 3.3. The establishment of SHG federations as MACS also raises concerns of a non-regulatory nature. For example, each tier adds administrative costs that must be passed on to the SHG-member retail borrower if the entire structure is to be sustainable.
[42] As noted above, there is central legislation that governs societies. However, most states (including Andhra Pradesh) have enacted corresponding state level legislation that applies instead of the central level Societies Registration Act, 1860.
[43] Although there is no specific state legislation on trusts in AP, several court judgments, including a Supreme Court decision, have held that principles of the Indian Trusts Act, 1882, may be applied to public charitable trusts.
[44] And although a society may borrow funds and receive grants and donations (as may a trust), a society is not permitted to raise equity from its members.
[45] The Income Tax Act, 1961 (Income Tax Act) provides for the exemption from income taxation of charitable and religious organizations. However, any part of the income of an organization that is applied to non-charitable purposes or ceases to remain invested in specifically identified investments is treated as taxable income. The effect of non-compliance with these provisions of the Income Tax Act is the loss of tax-exempt status. Further, the Income Tax Act provides that a charitable organization will lose its tax-exempt status if it owns shares in any company other that a government company or statutory corporation.
[46] In order to avoid this limitation, some NGO MFIs have engaged in complicated, labor- and time-intensive, multi-step transactions, typically involving the formation and registration of multiple entities to allow for the transfer of accumulated assets to a for-profit entity.
[47] If a MACS were to accept demand deposits from non-members, it would be deemed to be engaged in banking business (as defined under the banking law) and would be subject to regulation by the RBI as a cooperative bank.
[48] The AP MACS Act requires that MACS provide to the Registrar a report within 30 days of its annual general meeting. A MACS must include in this report a statement of its activities, audited statements of accounts and an auditor's report, a list of members, a statement of its disposal of surplus funds or allocation of deficit, the names, addresses and terms of its directors, and compliance reports relating to audits, special audits and inquiries. In addition, the Registrar may initiate special audits of MACS at the request of a creditor, where such creditor is the government or a non-member individual or institution and may conduct inquiries into the operations of MACS to confirm that they are conducting their affairs in accordance with cooperative principles and the provision of the AP MACS Act.
[49] SHGs are treated as natural persons and therefore are legally able to form MACs and participate as their members.
[50] Those financial institutions formed as corporations or cooperatives (and not as companies) that engage in one or more of the activities referred to in the definition of "financial institution" are considered non-bank financial institutions and are treated differently from NBFCs for regulatory and other purposes.
[51] The RBI may, with the previous approval of the Central Government and by notification in the Official Gazette, also classify other non-banking institutions or classes of such institutions as NBFCs.
[52] An NBFC may not collect demand deposits.
[53] While the requirements applicable to NBFCs are in fact more stringent than those applicable to RRBs and cooperative banks, the requirements applicable to these two types of banks are generally viewed as too lax and are not an appropriate benchmark for what is desirable for NBFCs.
[54] In particular, the Banking Act explicitly prohibits any bank from engaging in deposit taking activities off bank premises without prior RBI permission. And a 1983 RBI circular advised banks not to extend banking activities at the premises of their customers without RBI permission.
[55] Entities permitted to act as agent under the Business Facilitator Model include NGOs, cooperatives, community based organisations, information technology-enabled rural outlets of corporate entities, post offices, insurance agents and others.
[56] Entities permitted to act as agent under the Business Correspondent Model include NGOs MFIs, MACS and cooperatives formed at the state level, Section 25 companies, post offices and NBFCs that do not accept public deposits. The circular specifically requires banks to ensure that agents in the Business Correspondent Model are well-established, enjoy a good reputation and have the confidence of the local people.
[57] In fact, the RBI’s July 2005 Report of the Internal Group to Examine Issues Relating to Rural Credit and Microfinance” promoted expanded use of the SHG-bank linkage model without qualification. The report makes suggestions for improving the operations of SHGs, but it does not raise any legal or regulatory issues.
[58] As stated earlier, the only significant regulatory issue on the horizon concerns the possible use of SHG federations to pool deposits of the individual members of the federated SHGs without adequate supervision if it emerges that individual members of SHGs have no control over the governance of the federations involved and depositor risks arise.
[59] As noted, the broad topic of microfinance regulation was raised in the Finance Minister’s February 2005 budget speech, in which he announced the Government’s intention to explore the possibility of a draft bill on specialized regulation of free-standing MFIs.
[60] The RBI Report instead focused on the further development of regulatory preconditions for the bank agency model.
[61] This proposal may not reflect the views of all free standing MFIs, although it reflects the views of an important sub-set of all MFIs.
[62] These proposals for officially mandated transparency overlap significantly with the proposals to confer government recognition on unregulated MFIs discussed above.
[63] The apex proposal also identifies other activities of the commission that are not necessarily tied to transparency. These include (i) facilitating the provision of capital resource support, (ii) supporting capacity-building initiatives of microfinance service providers and (iii) promoting microfinance sector-related research.
[64] Retail deposits, however, are not the only new source of funding being proposed for free-standing MFIs. As a solution to MFIs' need for capital, the Minister of Finance proposed in his February 2005 budget speech to re-designate the existing Rs.1,000 million (around US$2.2 million) Micro Finance Development Fund as the 'Micro finance Development and Equity Fund,' and increase the corpus to Rs.2,000 million (around US$45 million). He also proposed that the RBI permit qualified NGOs engaged in microfinance activities to use the External Commercial Borrowing (ECB) window.
[65] These proposals raise issues concerning the definition of “members” from whom deposit taking would be permitted. Under Indian law, the terms "shareholders" and "members" are used almost synonymously. Thus, every company, including a Section 25 company, would have "members" as understood within the meaning of the Companies Act, 1956. It is not clear, however, that the legally recognized members of Section 25 companies or societies would necessarily be the same parties that a society or Section 25 Company would aim to target as depositors. Furthermore, trusts have no legally recognized members, raising a question regarding how deposit taking from “members” would be construed in the case of MFIs formed as trusts.
[66] However, under the sector proposal, any such institution is subject to a few prudential requirements, including a capital adequacy ratio, a minimum "net owned funds" requirement and the establishment of a reserve fund.
[67] NABARD has proposed in its technical paper that the minimum capital requirement for a microfinance NBFC be Rs.10 million (around US$220,000, i.e., lower than the requirement applicable to NBFCs in general).
[68]Although the proposal implies a new law, there is a possibility that the proposals could be put together as an amendment to an existing law; this would have a similar intended effect, since the objectives behind the proposals may be met equally well through an amendment to an existing law as through a new law. In either case, it would bring under one law all the specific proposals for MFIs that are currently regulated through multiple laws.
[69] The draft law includes a "principal business" test which applies to both categories: at the end of any financial year of an institution, the aggregate financial assistance (i.e., loans, guarantees or other credit facilities) granted to eligible clients (defined to include, among others, the following categories, which are not further defined: urban poor, persons of small means, low income households, microenterprises) must be at least 80% of the institution's total and the number of eligible clients must be at least 80% of total clients. In addition, 70% of the total number of clients must be women.
[70] This proposal recognizes the fact that the various models of microfinance delivery in India are not mutually exclusive, and some free-standing MFIs also promote SHG-bank linkages and serve as agents under the bank agency model.
[71] The term "microfinance institution" as used in the sector proposal has a narrower definition than the common usage for the term in this note as well as in general microfinance discussions in India and globally.
[72] The term "registration" has different meanings for the different categories of microfinance service providers. For microfinance organizations, it appears that the requirement is satisfied by the filing with the MFDC of an affidavit stating that the business of microfinance will be conducted in accordance with the microfinance law. In contrast, the proposal specifically provides that microfinance institutions must have a certificate of registration which is issued by the Council following the submission of an application, the components of which are described in the sector proposal. Any microfinance organization that, at the time of passage of the law, exceeds the thresholds regarding annual business volume and savings applicable to a microfinance organization must apply to be registered as a microfinance institution.
[73] The sector proposal also provides for a microfinance development fund capitalized with funds (i) received by the MFDC from the Government and other sources and (ii) received from any bank charged by the central Government due to a shortfall in meeting targets for priority sector lending. The fund would provide capital support to microfinance institutions and microfinance organizations (in accordance with a plan developed by the MFDC), support capacity-building initiatives among low-income people. There is no indication how this fund would relate to the existing Microfinance Development and Equity Fund in NABARD.
[74] The proposal does not include a definition of "risk weighted assets" nor of capital. However, it requires that the aggregate amount of financial assistance outstanding at the end of any financial year must not exceed the lesser of (i) ten times the net owned funds and (ii) Rs.10 million (around US$220,000).
[75] With respect to any microfinance organization, the MFDC would be permitted to suspend the requirement if the reserve fund is equal to or greater than the net-owned fund.
[76] The proposal does not explain how this is to occur in the case of a type of legal entity that is permitted as a microfinance organization but not as a microfinance institution.
[77] It is unclear how this provision is to be interpreted as there is no concept of founder under the Companies Act nor is there a concept of founder or promoter under the legislations governing other incorporated bodies such as MACS and societies.
[78] With respect to any microfinance institution, the MFDC would be permitted to suspend the requirement if the reserve fund is equal to or greater than the net-owned fund.
[79] Among the more challenging features of the legal and regulatory framework in India is its federal structure, split, as it is, between responsibilities vested with the central level of government and those exercised by Indian states. In addition, there is a plethora of institutional forms (including those utilized by MFIs), that are governed by separate legislations.
[80] These persons, as well as the countries on which insights were offered, are listed in Annex 2. For each issue, the discussion of foreign country examples is necessarily limited to a narrow snapshot with respect to each country discussed, and does not include any consideration of the historical, political, social and economic factors that might render the experience of the country in question more or less applicable to the Indian situation. This Section should be read with this in mind.
[81] Observers have long noted the significant respects in which the risks presented by non-depository institutions differ from those presented by retail deposit-mobilizing institutions. See "A Framework for Regulating Microfinance Institutions," H. Von Gruening, World Bank (December 1998). The failure of the latter type of institution risks losses to savers and possibly even systemic consequences whereas the failure of a credit-only financial institution risks losses only to suppliers of capital. This is true whether the institution is an ownerless form of NGO relying on donor grants and/or commercial loans for its lending capital or a commercial consumer finance company getting its lending capital from substantial shareholders and the occasional bond issue. See also CGAP Guiding Principles on Regulation and Supervision of Microfinance, pp. 7-8.
[82] See "A Framework for Regulating Microfinance Institutions," H. Von Gruening, World Bank (December 1998) pp. 11-12; CGAP Guiding Principles on Regulation and Supervision of Microfinance, p. 7. The consensus, however, is still far from complete, and certain regulatory traditions – notably those of France and many other francophone countries – continue to subject institutions that accept no retail deposits to prudential regulatory treatment.
[83] As observed in Section 4.4.2, some disagreement surrounds the question whether to consider the Indian NGO MFIs that take only compulsory savings as “credit-only” or as “depository” MFIs. One argument is that taking compulsory savings does not constitute deposit-taking, at least if the funds are segregated and not used to fund loans.
[84] Pakistan provides an important example of successful efforts at transparency without government regulation. In Pakistan, the sector, with the technical support of the MIX Market and the SEEP network, prepares annual reports with detailed financial and outreach information provided individually for the reporting MFIs.
[85] The requirement that NGO MFIs transform into commercial organizations was not uniformly supported by all stakeholders, including several of the MFIs themselves, as well as some donors and other stakeholders.
[86] The credit organizations law governs various types of institutions, including cooperatively-owned institutions, which are permitted to borrow from their members (although very few such member-owned institutions exist in Armenia today).
[87] Much attention was paid in the drafting of the regulations to assure that the likely benefit from each requirement was weighed against the additional incremental cost of compliance.
[88] The law on microcredit associations permits the Moroccan Ministry of Finance to set a separate interest cap for microcredit associations by regulation, a power that the Ministry has thus far elected not to exercise.
[89] Although the term "minimum capital requirement" is used also to refer to two requirements applicable to licensed financial institutions – minimum regulatory capital (which must be maintained at all times) and the capital adequacy ratio – this note uses the term to refer to the initial paid-in capital requirement.
[90] See for example, CGAP Regulation and Supervision, pp. 18-19.
[91] Indian NBFCs that wish to take deposits are also required to have an investment grade rating, which is not something that is common in other jurisdictions.
[92] In addition, neither proposal includes a rating requirement.
[93] SBP is responsible for the regulation and supervision of 40 commercial banks, including 16 foreign banks, 5 public sector banks, 16 private banks and 3 specialized banks. SBP is hoping to force bank mergers and have fewer, but stronger banks. To effect this, it will soon raise the minimum capital requirement for a commercial bank from Pakistani Rs. (PRs.).2 billion to PRs..3 billion.
[94] There are three different paid-in capital requirements, depending on whether the bank obtains a national license (PRs..500 million), a provincial license (PRs..250 million) or a district license (PRs.100 million). It should be noted that the four provinces have widely varying market sizes as do the 110 districts. NGO MFIs and projects engaged in microlending may apply for a license and may contribute up to 50% of the required capital in the form of their portfolio of microloans and other assets (subject to due diligence by a reputed Chartered Accountancy firm on SBP's panel of auditors). The remaining 50% must be contributed in cash or Pakistan government securities.
[95] There is a sixth microfinance bank, Kushhali Bank, that was formed in 2000 under its own specific statute. This bank has approximately 200,000 borrowers and has plans to increase this figure to 500,000 by year-end and to 1,000,000 by the end of 2007.
[96] In addition, these institutions have not achieved great success in terms of outreach. FMFB, which has by far the greatest outreach, has approximately 25,000 savings accounts and approximately 13,000 active borrowers, fewer than it had when the transformation was effected. This lack of outreach is due, at least in part, to the limited capacity of the institutions.
[97] GTZ-ProFI Microfinance Institutions Study, p. 62. The term Bank Perkreditan Rakyat means "people's credit bank" and is generally used today to refer to four different types of small financial institutions with different histories: village credit boards (BKDs), which do not accept public deposits; rural fund and credit institutions (LDKPs), most of which provide credit only; "old style" or converted BPRs (that is, secondary banks – market and trader banks – established before 1988) and "new style" BPRs established after 1988 (mostly by private investors) and regulated by Bank Indonesia, the central bank. In this note, the use of the term BPR does not include (i) BKDs, which were granted BPR status by the Ministry of Finance (but did not legally convert) and are "supervised" by Bank Rakyat Indonesia (BRI) through its branch managers, acting on behalf of the Bank Indonesia or (ii) LDKPs, which are non-bank financial institutions that do not have to comply with BPR regulations and are supervised by provincial governments.
[98] The Role of Central Banks in Asia and the Pacific, Indonesia chapter, p. 7. There was no differentiation (for purposes of regulation) based on the population served by a BPR; instead, the same capital requirement was applied to all BPRs, whether operating in rural or urban areas.
[99] GTZ-ProFI Microfinance Institutions Study, p. 64. These 423 institutions were secondary banks but, as noted above, were not referred to as BPRs and in fact primarily operated in large urban areas.
[100] Id., p. 62.
[101] Indonesia BTO Memorandum, p.7; GTZ-ProFI Microfinance Institutions Study, p. 65.
[102] The paid-up minimum capital requirement for a BPR organized as a cooperative is altogether different (equal to the initial savings, compulsory savings and grants received by the cooperative), as specified in the government regulations on cooperatives.
[103] GTZ-ProFI (Promotion of Small Financial Institutions) is a donor-financed program established in 1999 by Bank Indonesia, the Indonesian Ministry of Finance and the German Gesellschaft für Technische Zusammenarbeit (GTZ) to increase the supply of rural financial institutions in Indonesia.
[104] The initial minimum capital requirement in the late 1970s was the equivalent of US$20,000 at Ghana's overvalued exchange rate, but was significantly less when calculated according to market exchange rates. Furthermore, the initial capital was in fact provided by the government in the form of preference shares. In 1994, the minimum capital requirement was fixed at the equivalent at the time of US$22,000 and required to be funded by the institutions' owners (as opposed to the government). Rural and Microfinance Regulation in Ghana, pp. 21-22.
[105] Id., p. 8. The number of RCBs peaked at 133 in 1998 although the number of RCBs classified as "satisfactory" increased from 52, in 1998, to 87 in 2001 (the last year of available data, when there were a total of 115 RCBs with the remainder classified as "mediocre").
[106] This is still extremely low when compared to the US$2 million requirement for savings and loan companies.
[107] Regulation, Supervision and Access to Microfinance: The Case of Ghana, p. 8. At the end of December 2004, 13 RCBs (11%) were operating with capital below the minimum regulatory requirement. Id., p. 9.
[108] Although FFPs were generally subject to the same prudential and non-prudential norms as banks, they had a significantly lower minimum capital requirement of approximately US$1 million (as compared with the US$8.2 million requirement applicable to commercial banks). However, the majority of the FFPs that were formed under the new legislation probably could have met the minimum capital requirement for banks.
[109] The Bolivian government created the FFP as a regulatory category only after several financial NGOs demonstrated strong performance over several years, and after regulators had gained experience through the supervision of BancoSol, which as a commercial bank did not require a special license.
[110] Moreover, they had no access to credit information, because unlicensed MFIs were not required to report to the credit bureau.
[111] Tiers can either be added to existing legislation by amendment (as in Uganda) or be contained in a separate law (as in Bolivia and Mexico).
[112] All deposit-taking institutions must be authorized pursuant to the 2001 law unless they (i) already fall under the regulatory jurisdiction of the bank regulatory commission pursuant to existing legislation or (ii) fall below certain size limitations, both in terms of membership and total assets. This latter exception, which was added to the law in 2003, is intended to permit small operations, such as Rotating and Savings Credit Associations (ROSCAs), to continue.
[113] Unless an organization was organized prior to the adoption of the new law as one of the underlying legal entities permitted by the law (a cooperative or joint stock company), its “transformation” and licensing as a retail institution requires the formation of an entirely new legal entity. No conforming amendments to the legislation and regulations governing the existing legal forms were needed in order to permit these transformations.
[114] Although many of the MFIs are members of federations, the law requires only an "association." Mexican constitutional law prohibits legislation from requiring any individual or legal entity to pay membership dues in an organization.
[115] Although the federations are to carry out onsite and offsite supervision on behalf of the banking commission, ultimately regulatory authority remains with the commission. For example, in the event of a regulatory violation by one of the institutions, the supervising federation would recommend a warning, penalty or other actions to the banking commission. If there is no objection, then the federation in practice can pursue the recommended action.
[116] Finance experts globally have debated the need to impose more stringent capital adequacy requirements on deposit-taking MFIs. See for example, CGAP Regulation and Supervision, pp. 21-22. .
[117] One of the MDIs received its operating license but did not receive licenses for its branches so it is not yet operational, although it is currently negotiating with the BOU for its branches' licenses. This raises an important issue faced by most “transforming” MFIs that have branch offices: if individual branches must be licensed, this needs to be done upon “transformation” for existing branches.
[118] GTZ-ProFI estimated in 2003 that more than two million people had savings accounts in unlicensed MFIs.
[119] This submission was followed by further consultations and discussions among various stakeholders.
[120] GTZ-ProFI strongly believed that Bank Indonesia, with more than 2,000 BPRs to supervise, would be unlikely to agree to ease the entry requirements.
[121] Over two-thirds of the aggregate microfinance portfolio in Indonesia is served by the banking sector: BRI provides microfinance services through its 4,000 plus "units" and there are currently almost 2,200 "secondary banks" or rural banks (BPRs) engaged in microfinance.
[122] The "third window" would have two categories, one of which would include small and medium MFIs with total deposits below a specified threshold that would be licensed under regional or district-level regulations. In general, these institutions would not be subject to prudential regulation and supervision, although the regional/district governments might impose some regulatory and supervisory requirements. The other category would be subject to prudential regulation and supervision by the central regulator.
[123] As in Uganda, despite the availability of donor-funded technical assistance for transformation, at least some institutions have had significant difficulties implementing the costly and institutionally demanding steps necessary to accomplish such a “transformation” and receive the required license.
[124] Tajik law permitted central bank-licensed financial institutions to engage in "crediting"; the Civil Code permitted any individual or legal entity to engage in "lending." Although the central bank took the position that the Civil Code provided an adequate legal basis for the NGO MFIs' activities, many NGO MFIs remained concerned that the central bank would at some point in the future determine that NGO MFIs were engaged in crediting and therefore in violation of the banking law.
[125] For example, in Bosnia and Herzegovina, new banking legislation adopted in 2002, after adoption of the legislation on microcredit organizations, inconsistently permitted only banks licensed by the banking agencies to engage in lending as a business activity. As a result of significant lobbying efforts, the language of the banking legislation was amended also explicitly to permit unlicensed microcredit organizations to engage in lending business.
[126] As noted, the type of relationship in question may or may not constitute true “agency” in the legal sense of the term, depending on local law.
[127] As discussed in Section 4, neither the SHG-bank linkage model nor the bank agency model is the subject of any significant legal or regulatory reform proposals at present.
[128] The RBI internal working group's July 2005 report, after considering the SHG-bank linkage model, the free-standing MFI model and bank agency model, reaches the conclusion that reforms to facilitate the bank agency model are timely (a conclusion which is supported by the RBI's January 2006 circular relating to the bank agency model), but that a comprehensive scheme to regulate free-standing MFIs would not be.
[129] Arguments in favor and against viewing Indian MFIs that accept only compulsory savings as “non-depository” are discussed in Section 4.2.2. Although these MFIs are referred to in this Section VI as “largely credit-only,” this terminology should not be read to minimize the important concerns regarding protection of compulsory deposits discussed in Section 4.2.2.
[130] Although many in the Indian microfinance sector are eager to have clear and explicit central Government recognition of largely credit-only MFIs, it is noteworthy that all well-performing credit-only MFIs, and even many poorly performing ones, have ample access to commercial funds for onlending.
[131] This was the experience in Uganda, where a proposal emanating from a working group led by the Central Bank of Uganda was sent back to square one by parliamentarians when they received it.
[132] In the Indian context, it is not clear whether the interest rate issue might be favorably resolved at the central level, effectively silencing proponents of strict interest caps at the state level. This would depend on many factors, including the clarity with which central-level legislation explicitly preempted conflicting state-level interest rate-related provisions. Of course any central-level legislation attempting explicitly to legitimate the high rates of interest necessary for sustainable microlending would be subject to the usual political forces that make the issue so difficult to successfully tackle legislatively in country after country.
[133] As noted above, Pakistan serves as a useful example of successful transparency measures being set by the microfinance sector, together with the MIX.
[134] Although these challenges are lower in the case of institutions only accepting term deposits, they are nonetheless still potentially extremely significant.
[135] Moreover, as noted above, problems potentially surround the definition of members who can be depositors. Trusts, for example, have no legally recognized members. Even in the case of societies and Section 25 companies, which do have legally recognized members, these may not be the poor clients from whom the MFI wants to accept deposits.
[136] In Mexico, for example, the prevalence of fraud in deposit mobilization among unlicensed institutions was a factor leading the respectable community based financial institutions to support a new law putting larger institutions under a specially designed prudential regulatory regime. The regime leaves smaller institutions unregulated, however, and it remains to be seen whether the line determining which institutions must be regulated has been drawn in the optimal place. At least some organizations argue that it has been set too low.
[137] As noted above, it is possible that some of this demand will be satisfied by banks that will, pursuant to the January 2006 RBI Circular, begin using Business Correspondents to take small scale deposits on the banks' behalf.
[138] It is not necessarily the case that lower minimum capital requirements will stimulate the formation of new depository institutions. For example, few LABs have been formed in India despite the fact that they are subject to lower minimum capital requirements than commercial banks. However, this may be due, at least in part, to other limitations to which LABs are subject, most notably geographic limitations.
[139] It is, of course, possible to form a new supervisory authority, although are potential downsides of adding another regulatory body to the variety of financial regulators currently operating in India, including, among others, (i) the cost of establishing a new regulator and of its ongoing operations, (ii) likely reductions in efficiency and effectiveness and (iii) the risk of lack of coordination on policy and principles of regulation. Moreover, it is not clear what advantage outsourcing supervision to a newly formed body would confer.
[140] Such a campaign to educate rating agencies about microfinance could have additional benefits for outreach to the poor, including a possible increase in commercial funds available to MFIs and greater interest by banks in direct downscaling.
[141] The draft law also does not have any "carve-out" for tiny, informal or semi-formal savings schemes such as ROSCAs, although they will likely not be able to meet the conditions for recognition under the draft law.
[142] Generally, a “non obstante” clause seeks to give legal effect to the provisions of legislation in which it is contained whenever the relationship of such provisions with previously existing legislation presents a conflict or is unclear.
[143] The effectiveness of the reserve fund requirement, one of the minimal regulatory requirements proposed for microfinance organizations under the draft law, is questionable given that the regulator may (on a case by case basis) waive the requirement of any institution if the institution's reserves equal or surpass the low net owned funds requirement.
[144] These include, among others, (i) the cost of establishing a new regulator and of its ongoing operations, (ii) likely reductions in efficiency and effectiveness, (iii) the risk of lack of coordination among regulators on policy and principles of regulation and (iv), to the extent regulatory responsibility is delegated to it by an existing regulatory body (such as the RBI), the risk that the delegation proves unsuccessful, so that the delegating agency must reclaim jurisdiction.
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