Hyderabad/Chennai: We’re talkin’ about a revolution that isn't a whisper.

Over the past two months, operational and policy debates on India’s microfinance sector have grabbed acres of space in newspapers, television and blogs in both India and overseas. Even America-centric National Public Radio offered a microphone to Vijay Mahajan, founder of one of India’s largest microlenders, the Basix Group, to chart falling borrower repayments and liquidity in India’s largest small-loans market, Andhra Pradesh.

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After a failed struggle to get the Andhra Pradesh government to alter its October ordinance—since become law—that was triggered by allegations of suicides by harassed borrowers, the spotlight is on a Reserve Bank of India (RBI) panel that’s to submit a report in January on regulating the sector. The committee’s headed by chartered accountant Y.H. Malegam.

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“A clear RBI directive is key because without regulation you are an illegitimate child,” said Vineet Rai, founder of consultancy Intellecap that advises these companies doling out loans below Rs 50,000 largely to the poor.

Also Read Previous coverage of MFI industry

“Right now, the word going around is that MFIs (microfinance institutions) are goons and all investors are rapacious greedy bastards," added Rai, who is also the chief executive of Aavishkaar India Micro Venture Capital Fund, an investor in Bhartiya Samruddhi Finance Ltd, a part of Mahajan’s Basix group.

Financial sector experts say it is unlikely that India’s central bank will allow non-banking financial companies (NBFCs), including for-profit microcreditors, to collect deposits as memories persist of a spate of scams in the 1990s when depositors lost money.

In Bangladesh, the world’s first MFI, not-for-profit Grameen Bank, collects savings—a cheaper source of funds for MFIs than commercial bank borrowings, thus keeping a rein on interest rates.

What the microcredit sector wants is either a law or a special MFI category under RBI without wriggle room for states such as Andhra Pradesh to have their own rules, said a top Union finance ministry official who didn’t want to be named. Alternatively, it could even mimic current bank governance with a combination of an act, like the Banking Regulation Act, backed with circulars on say interest rate caps from RBI.

“The debate right now is whether regulation should be light touch or heavy handed,” said the Delhi-based bureaucrat in a telephone interview.

So far, regulation has been hands off and that in some ways largely spurred the expansion of the industry to more than Rs 25,000 crore in loans outstanding, with for-profit MFIs taking at least 80% of the pie, said the latest State of the Sector Report 2010.

When a similar delinquency crisis emerged in 2006 in Andhra Pradesh’s Krishna district, where MFIs were accused of spurring suicides due to high borrowing costs, and last year in Karnataka’s Kolar region that saw rising micro debts, RBI requested lenders to cut interest rates and curb multiple lending. In November, wounded by the Andhra Pradesh ordinance, the Microfinance Institutions Network (MFIN), a year-old lobby group of 34 for-profit MFIs, moved to shrink interest rates over 18 months to 24% from around 30%, limit individual borrowers to three companies, and reiterated caps on lending limits to Rs 50,000 per debtor.

But the industry itself is doubtful about voluntary rules, which were limply enforced after the 2006 crisis.

“Self-regulation can work but unfortunately, there are lot of internal dynamics that curb collective action,” said Padmaja Reddy, managing director of Spandana Sphoorty Financial Ltd—India’s second-largest MFI that was blamed for some of the deaths in Krishna district. “So codes are best enforced by a regulatory authority with a penalty for non-compliance.”

Many industry critics are hoping there will be a single overseer for the variously labelled MFIs—non-government organizations, for-profit non-banking financial company, non-profit companies, and cooperatives. What’s key is also for a sole regulator to impress on micro lenders a few non-negotiable tenets regarding corporate governance, client protection and portfolio management, said Ramesh Arunachalam, a rural finance practitioner.

“Only MFIs meeting those minimum standards should be allowed access to priority-sector lending from commercial banks,” adds Arunachalam who has been blogging extensively on this issue. “The current crisis has been caused by regulatory failure.”

Some microfinanciers opine it may be imperative to allow lenders of these tiny non-collateral loans to collect savings for true financial inclusion of the poor. RBI has repeatedly given a cold shoulder to this idea. Weeks before the Andhra Pradesh ordinance, RBI dashed the hopes of for-profit NBFC microlenders to become business correspondents for banks, citing potential conflicts of interest in loan disbursements. In a September announcement, the central bank waved a green flag at for-profit companies but stopped non-banking finance entities such as MFIs from turning bank retail agents to provide savings, credit and insurance services at locations other than a bank branch or an ATM.

“Prima facie, it is a right decision,” said Arunachalam of RBI’s move. “Deposit-taking by MFIs is a big ‘no’ right now as their internal controls are very weak and suspect.”

Despite reports of some MFIs being in the race for bank licences and implementing a core-banking technology system that allows deposits, a few microlenders visualize the need for a separate microbanking licence.

“If microlenders become mainstream bankers then we will be (a) complete disaster since there are enough banks out there who are far more superior to us,” said P.N. Vasudevan, chief executive of three-year-old for-profit MFI, Equitas Micro Finance India Pvt. Ltd. “We won’t touch the current banking licence.”

In a representation to RBI, Equitas recommended likely norms for a microbanking licence for interested firms to include start-up capital of at least Rs 300-500 crore. There could also be a savings limit of Rs 2 lakh, a fixed deposit cap of Rs 5 lakh and a lending limit of Rs 10 lakh, which means larger deposits and loans would have to flow to regular commercial banks.

While this may be a distant view, a starting point could be to control the rising competition in the MFI space and probably increase loan sizes to shrink multiple borrowing and ensure its use for business purposes, according to development economist Esther Duflo of the Massachusetts Institute of Technology (MIT). Small loan sizes incapable of supporting a start-up business idea have been blamed for the customer rush to borrow from several MFIs. “I think there is a real danger of a sudden stop of commercial microfinance in India, and perhaps all types of microfinance,” said Duflo via email.

Duflo is a director of MIT’s Abdul Latif Jameel Poverty Action Lab, which has studied the behaviour of Spandana borrowers. “It doesn’t mean a regulation change isn’t needed but discussions need to happen in a calm environment, not in the middle of a huge chaos.”

The series is concluded.

anupama.c@livemint.com