Regulatory and Supervisory Issues Arising from the Andhra Pradesh Micro Finance Crisis

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

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

3. Types of MFIs in India A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956 and is engaged in the business of loans and advances, acquisition of shares/ stock / bonds / debentures / securities issued by Government or local authority or other securities of like marketable nature, leasing, hire-purchase, insurance business, chit business but does not include any institution whose principal business is that of agriculture activity, industrial activity, sale /purchase / construction of immovable property. A non-banking institution which is a company and which has its principal business of receiving deposits under any scheme or arrangement or any other manner, or lending in any manner is also a non-banking financial company (Residuary non-banking company).

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

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

6. Funding for MFIs • NBFCs can receive both equity and debt investments. • The main sources for domestic capital are currently SIDBI and NABARD in addition to the commercial, rural and cooperative banks. Recently local microfinance focused funds have also entered the market. • NBFCs can raise foreign equity investment, though a minimum investment USD 500,000 restriction applies. • Stringent foreign investment rules, make it hard for international investors (specially social investors) to invest in India. RBI’s Foreign Investment Promotion Board (FIPB) has mandated the following minimum capitalization norms for fund based NBFCs: • i) For FDI up to 51% - US$ 0.5 million to be brought upfront • ii) For FDI above 51% and up to 75per cent - US $ 5 million to be brought upfront • iii) For FDI above 75% and up to 100% - US $ 50 million out of which US $ 7.5 million to be brought upfront and the balance in 24 months • NGOs are prohibited from becoming shareholders in NBFCs

7. The SHG-Bank Linkage Model • Self Help Group Bank Linkage (SHG-BL) model pioneered by NABARD in 1992 • 15-20 women form a Self Help Group (SHG) and regularly contribute small savings, typically on a weekly basis • Savings are lent by the group to members, and are later supplemented by loans provided by banks for income-generating activities and other purposes for sustainable livelihood promotion • Weekly / monthly meetings at which new savings come in, and recoveries are made from members towards their loans from the SHGs, their federations and banks • NABARD provides grants, training and capacity building assistance to Self Help Promoting Institutions (SHPI), which in turn act as facilitators/ intermediaries for the formation and credit linkage of the SHGs • 4.5 million SHGs receiving credit nationwide, with 97 million rural households, through 7.46 million SHGs, representing 58% (Rs.312 billion) of the total loan outstanding portfolio of MFI sector in India

8. Progress of SHG-Bank Linkage Model

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

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

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

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

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

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

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

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

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

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

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

20. Entry Point Norm

21. Capital Requirement

22. Provisioning Norms

23. Pricing of Credit

24. Transparency in Interest Rates

25. Transparency in Interest Rates

26. Multiple-lending, Over-borrowing and Ghost-borrowers

27. Multiple-lending, Over-borrowing and Ghost-borrowers

28. Non-Coercive Methods of Recovery

29. Non-Coercive Methods of Recovery

30. Corporate Governance

31. Improvement of Efficiency

32. Priority Sector Status

33. Money Lending Acts

34. Credit Information Bureau

35. Customer Protection Code

36. Monitoring of Compliance

37. Key Points

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

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

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

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

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