An internal Reserve Bank of India (RBI) panel has recommended that money advanced by commercial banks to micro-finance institutions, or MFIs, should no longer be treated as priority sector loans. Under banking norms, 40% of a bank’s loans need to be given to agriculture and small industries, dubbed the priority sector. Many banks fail to meet this target and lend to MFIs, which are in the business of giving tiny loans to poor borrowers; indirect financing to agriculture and small industries through such intermediaries is classified as priority sector lending.

The panel’s report has not been made public yet, but I am told that it has recommended a two-year sunset clause for such loans. In other words, banks will have to wind down their exposure to MFIs through the priority sector channel in the next two years and cannot give any fresh loans, if the recommendations are accepted.

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What is the provocation for such a recommendation? MFIs borrow money from banks relatively cheaply, charge high interest rates when they lend, and make huge profits.

The success of the initial public offer of SKS Microfinance Ltd, India’s largest MFI, has also probably queered the pitch for such institutions. The float was subscribed 13.64 times and since its listing on 16 August, SKS Mircrofinance stock has risen close to 42%. Enthused by this, two more prominent microfinance firms—Share Microfin Ltd and Spandana Sphoorty Financial Ltd—want to list on the bourses. Hyderabad-based Share Microfin is merging with another MFI, Asmitha Microfin Ltd, to build size and scale ahead of its public issue. Share Microfin has at least 30.6 million borrowers and total assets of 2,595 crore; Asmitha has 1.8 million borrowers and a loan book of 1,700 crore. India’s second largest MFI, Spandana, which recently crossed the cumulative loan disbursement mark of 15,000 crore, is also planning a public listing.

I don’t have access to the latest data of all MFIs. In fiscal 2009, they added 8.5 million consumers, taking their consumer base to 22.6 million—an increase of 60%. The growth in their loan book was around 97%, from 5,950 crore to 11,734 crore. In terms of consumer acquisition, Spandana Sphoorty recorded the highest growth rate, 104%. Bandhan Financial Services Pvt. Ltd and SKS Microfinance expanded their consumer base by 91% and 87%, respectively. SKS and Spandana expanded their loan books by 214% each and Asmitha by 111%.

MFIs charge an interest rate of 24-36% while banks give them money at 10-13%, depending on their ratings. If bank loans to MFIs no longer carry the priority sector tag, the cost of such loans will go up by about 2 percentage points and make money more expensive for small borrowers. There have been rumours about capping MFI loan rates. It is not practical to have a uniform ceiling for such loan rates across India as the cost of delivery of loans is different in different parts of the country.

Some bankers see a bubble in the Indian microfinance industry. They say MFIs have bothered more about expanding their loan books than asset quality and knowing their customers. Theoretically, the tiny loans cannot go bad as in most cases such loans are repaid in weekly instalments and given to a group in which each member makes sure that others do not default. But too many MFIs are chasing the same set of borrowers and, in the process, many borrowers have higher exposure. They are finding it difficult to repay, but MFIs are not bothering too much at this point as they want to build scale, which is key to their valuations, bankers say.

As the loan books grow, their valuations go up. Some private equity funds have made investments in MFIs, valuing them at six to seven times their book value, against the global norm of 1.5-2 times.

Most bankers envy big MFIs for the profits they make by virtue of charging very high interest rates. But only 15% of around 250 MFIs in India are profitable and if indeed the interest rate at which they lend money is capped, small MFIs—some 200 of them—will be forced to shut.

“When I give money to an industrialist and he makes huge profits, I feel happy. Why should I grudge an MFI making money?" asks a senior banker, who has a contrarian view. He has a point but there is a difference between a manufacturing company borrowing money from a bank and an MFI borrowing money and on-lending it at a much higher margin and making profits. In a sense, MFIs are like diamond merchants who import rough diamonds and cut, polish and add value to them before exporting at a higher margin. They reach out to the poor in remote rural pockets where banks fear to tread.

If banks start raising the cost of loans, MFIs will have to tap other sources of money, but that will push up the cost of funds. The best way of solving the problem could be for banks to directly reach out to MFI customers. Banks don’t do that now because they cannot charge the high interest rates that MFIs do. Nothing prevents them from charging high interest rates for such loans as all loan rates are free, but banks are wary of politicians and parliamentarians who will start making a noise if they start charging say 20% on tiny loans even though that’s much lower than what MFIs are charging.

RBI doesn’t need to clamp down on banks’ exposure to MFIs. All it needs to do is to encourage banks to charge higher rates on loans – to take care of the transaction cost—and compete with MFIs in rural India.

Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Please email your comments to