Former Reserve Bank of India (RBI) governor Y.V. Reddy recently wrote a tough piece on microfinance in the Economic and Political Weekly (EPW). Given his stature, these views will be read carefully in policy circles, especially given the proposed Microfinance Institutions (Development and Regulation) Bill. His essay, therefore, deserves a detailed analysis.
Before this, a personal disclosure, by way of background. I run a microfinance institution (MFI). It was born of the strong conviction that market forces can help solve social issues. Having worked earlier in the formal financial sector, I am acutely aware that the market is a double-edged sword: the benefits of price discovery, innovation and customer centricity can sometimes be undone by an excessive focus on greed. Recognizing this, our approach was to design our MFI—Janalakshmi—in a two-tier structure: a non-profit Section 25 holding company where all the promoters’ shares are held; and a for-profit non banking financial company (NBFC) operating company that works as a commercially viable enterprise. This dual structure ensures fair returns to investors, but places a higher bar on me as a promoter.
I offer this context specifically to address a perception about microfinance entrepreneurs that has unfortunately become entrenched in the public imagination ever since the Andhra Pradesh (AP) crisis broke last year—that the raison d’être for MFIs is to make money. In my case, I get no economic benefit from the success of my company. I also know that most other microfinance promoters’ motivation to start for-profit MFIs was not to enrich themselves, but to build viable, scalable enterprises. We have chosen different institutional forms, but for the most part, our purpose is the same. The vilification of all MFIs because of the questionable behaviour of some has to stop. By this yardstick, we wouldn’t have a single honourable entrepreneur in any economic sector in India today.
To Reddy’s EPW essay on microfinance. His assessment can be summarized as follows:
• RBI has always been uncomfortable with for-profit institutional structures to serve a development agenda. This discomfort comes from a belief that the market’s profit motive will compromise the public intent.
• Microcredit is a small part of microfinance, and microfinance itself a small part of financial inclusion, whose canvas includes deposits, remittances and other financial services. Moreover, financial inclusion cannot be divorced from economic inclusion, or else we could end up artificially boosting the poor with credit steroids without the commensurate economic capacities to repay loans, resulting in exactly what happened in AP.
• When an earlier microfinance crisis occurred in AP some years ago, RBI stepped in and secured a voluntary code of conduct from MFIs—on over-lending, rates of lending and recovery practices. Unfortunately, these voluntary commitments were never honoured, resulting in a metastasized problem in 2010 that blew up the entire sector. The conclusion from this was that for-profit MFIs are not to be trusted.
• Reddy’s views on the sector are different now that he is out of RBI and closer to the ground reality.
• There is a distinction between for-profit MFIs and non-profit MFIs, not just in institutional form, but in their vision of the poor and the context in which financial services are provided. He sees for-profit MFIs as no different from moneylenders, just more institutionalized.
• Reddy holds strong views about the microfinance Bill, which is the proposed regulatory architecture for microfinance:
• These regulations are soft on for-profit MFIs, with small capital haircuts, etc.
• The regulations are likely to create “back-door” entry for MFIs into banking, given the somewhat vague provision for “thrift” services that MFIs could offer to their clients.
• Given the decentralized nature of microfinance, it is not only impossible for RBI to be able to regulate the sector by itself, but also incorrect to leave the state governments out of the regulatory oversight process.
I agree with many observations that Reddy makes, beginning with the nested typology where microcredit is a small part of microfinance, which in turn is a small part of financial inclusion that cannot be solved without addressing economic inclusion. I also agree with the assessment of microfinance excess in AP. Reddy also makes a good point that the private capital raised by for-profit institutions should bear the risk of non-performing assets. Finally, I find the distinction that he makes between “profit” and “profiteering” an important one and a possible cornerstone for how to regulate MFIs.
As to the proposed regulation, Reddy’s concerns about MFIs offering thrift services is a valid one, and needs to be protected against becoming a back door for MFIs trying to become bank-like without bank regulations. He also makes a sound case for a decentralized regulatory regime. However, the solution is not to split the oversight between RBI and states, since this will create regulatory confusion. Also, it may not be appropriate to vest regulatory power with a state government whose behaviour could be unpredictable and unilateral. For instance, nothing prevents other states from following the precedent of the AP government in establishing a state-run NBFC-MFI, thereby creating a clear conflict of interest—being both umpire and batsman. Hence, while states should have a voice in a decentralized regulatory system that is run by RBI, they should have no formal regulatory oversight of MFIs.
However, for all the areas of agreement with Reddy, there are many aspects of his assessment that I find troubling. To begin with, there is no mention of the fundamental link between weak regulations and moral hazard, i.e. unprincipled behaviour by MFIs. It would not be unreasonable to claim that if only a tighter regulatory regime were present, many, if not all, excesses of MFIs in AP would never have come to pass. The issue in AP was not for-profit MFIs per se, but weakly-regulated for-profit MFIs. Reddy makes a tacit acknowledgement of this when he writes, “In retrospect, RBI should have insisted on enforceable regulations and not be content with an advisory role.”
Perhaps the mistake was to presume “noble” behaviour on the part of market participants solely based on the client base being poor—RBI certainly doesn’t have the same expectation from the more mainstream parts of India’s financial system, insisting rather on clear checks and balances. Indeed, the AP experience shows the need for more, not less, regulatory clarity, given the sensitive nature of the client base. Unbridled laissez faire is perilous when it comes to the poor. Relying solely on market equilibrated prices and behaviour is misplaced for three reasons: structurally inappropriate due to massive information asymmetries in the marketplace; morally unacceptable, given the vulnerability of the poor; and politically unfeasible, given the entrenched patron-client relationship between politicians and the poor.
Any vague sense that Reddy’s diagnosis of the AP crisis might perhaps be ideological is confirmed by his suspicion of the for-profit MFI model itself. There is no question that the role of for-profit institutions in addressing social issues needs to be thoroughly debated. But we need rigorous arguments from our policymakers for precisely why “for-profit” institutional structures are fundamentally anti-poor. Unfortunately, Reddy does not provide any convincing arguments in his essay. In fact, evidence from a range of other industries suggests that for-profit models are in fact making a difference—from mobile telephony to consumer goods to healthcare innovation, India is a hotbed of frugal innovation aimed at bringing services to the poor. Admitted that financial services are different, but the argument cannot rest on simply stating this as a sermon.
Policymakers who hold this position must not only defend the theoretical soundness of the argument, but also answer a host of operational questions. At which economic strata of clients is the for-profit structure acceptable? Where do we cross the threshold for profit-based service? How will the baton of customer relations get handed off between the non-profit and for-profit entities to match clients’ rising prosperity, or do we expect the poor to remain poor? How will these benchmarks get recalibrated year-on-year with India’s changing development trajectory? Without such operational clarity, what we have are policies as statements of intent, not enablers of action.
The poor existed long before the idea of an MFI was even a gleam in someone’s eye. It is convenient to make MFIs the whipping boy of financial inclusion in our country, when the real failure to solve the challenges over six decades has been that of our public institutions and regulators. Sixty years of error and error on mandated targets, new public institutions and branch proximity-based formulae have barely made a dent on the desolate landscape of financial inclusion. Clearly, in the line-up of those who have failed the poor, our regulators and government must stand first, well before the handful of unscrupulous MFI promoters.
The most troubling aspect to Reddy’s approach is the continuing reliance on institutional form—and picking winners and losers in form rather than outcomes. Any strategy for increasing access to financial services will require the creation of a vibrant ecosystem that enables financial inclusion. This means moving away from a “bank-only” model to a “bank-centric” model of inclusion, with many participants in it. Certainly the mainstream commercial banks will be at the centre, connected to a range of other players, including specialized financial institutions—some of which are for-profit—that cater exclusively to the needs of the poor, rural or urban. This kind of ecosystem will not only drive innovation on the customer front, but also in other areas of financial inclusion infrastructure—human resources, business processes, information systems, technology and so on.
In such an ecosystem, for-profit MFIs can play a credible, responsible, sustainable role. These MFIs need to operate under and be held accountable to clear regulations that are overseen by a single regulator—RBI, with inputs from state governments.
In his EPW article, Reddy is gracious enough to admit that he didn’t get a few things right when he was governor of RBI—this is an admirable admission from someone who held the highest regulatory office in the financial sector. Such candour bodes well for the kind of debates we need to have about financial inclusion regulation in our country—based on principles rather than personalities.
Ramesh Ramanathan is chairman, Janalakshmi Financial Services (P) Ltd
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