4 min read.Updated: 26 Jul 2021, 10:07 PM ISTV. Anantha Nageswaran,Deepti George
An RBI paper with bold proposals for this sector should stir a discussion on broader policy reforms
Almost to mark 10 years of the Malegam Committee Report of 2011 that helped establish micro- finance as a legitimate asset class, the Reserve Bank of India (RBI) released its Consultative Document on Regulation of Microfinance in June 2021. This has several bold and fresh elements. Its big strengths are the light-touch approach and the level regulatory playing field it seeks to establish for the sector. It is also a welcome recognition by the regulator of the changing underlying composition of microfinance lenders. Public policy would take a huge leap forward if other policy institutions adopt a similar approach on archaic laws and rules. As one would expect in such a consultative document, it has left the field open for improvement and suggestions.
First, RBI is considering removing limits on loan amounts, tenures and the number of non-bank finance company-microfinance institutions (NBFC-MFIs) lending to a borrower, its minimum 50% income-generation requirement, and its pricing cap for NBFC-MFI loans. These are welcome, given the maturing nature of the sector. This awareness on RBI’s part also comes through in the document’s discussion on pricing, wherein the current ceiling on interest rates charged by NBFC-MFIs has become the benchmark for microfinance lending by banks, whose cost of funds is much lower. Understanding unintended consequences is a hallmark of sound public policy.
Second, RBI is considering a common definition for ‘microfinance’ to mean ‘collateral-free’ loans to households with annual household incomes of ₹125,000 and ₹200,000 for rural and other areas, respectively. The feature of equal monthly repayments seems to have been left out. This leaves open the question of whether all other loans to these households, such as agriculture, agri-equipment and gold loans, housing and two-wheeler loans, and also EMI purchases of electronic goods, might fall outside this definition.
The assumption seems to be that the poor may be served predominantly with microcredit. Any other lending to them would be beyond the ambit of the protections proposed. RBI’s approach on this reflects a product-level strategy, focused on microfinance, rather than a comprehensive one based on lender conduct covering all forms of lending to low-income households. Whether that was the intention is worth reflection. A better alternative, perhaps, is to protect borrowers against being mis-sold loans regardless of the lender.
Third, is it prudent to require lenders to assess household income and formal debt and not lend beyond a debt-to-income cut-off? A Dvara Research study of Indian household income quintiles from Centre for Monitoring Indian Economy’s Consumer Pyramids data indicates that income cut-offs for rural and the rest of India pertain roughly to the bottom two and three quintiles for rural and urban households respectively. Expenditure (excluding repayments) as a proportion of income is quite high for the bottom three quintiles (with quintile-1 operating at a deficit).
There are common situations where consumption credit may be unsuitable for a household with, say, 30% debt as a proportion of income. If the ‘dependent-to-earning member’ ratio is very high, expenditure would exceed income. Factors such as high informal debt, or a high likelihood of health or weather shocks, can render debt unsustainable for households that lack insurance, liquidity buffers, etc. Here, a 50% cut-off might be too high. But when a micro-loan is to be repaid by new projected cash flows from some productive activity, current inflows may be too meagre to get loan okays. The 50% cut-off might be too low and push such borrowers towards expensive informal debt.
A rationale for the cut-off needs discussion for the emergence of alternatives. One idea is to define a ‘debt-to-disposable income’ cut-off, lending beyond which will need to be substantiated by lenders; disposable income here could be net of routine expenses including repayments, and a liquidity buffer. Technology is helping the industry evolve methods to assess the cash flows and repayment capacity of micro-enterprises. Tailoring these to micro-lending, determining income ranges for various customer segments with the support of industry bodies and using combined bureau reports for loan pricing can lend momentum to sector-wide solutions by the private sector.
Finally, an overarching set of principles to prevent mis-selling by retail lenders is missing in our regulatory lexicon. The European Banking Authority’s Guidelines on Loan Origination and Monitoring, 2020, and Australia’s National Consumer Credit Protection Act, 2009, have clear lender obligations for consumer credit and prohibitions on unsuitable outcomes. These are worth considering for India.
In sum, the proposed framework is a great leap forward and reflects bold thinking. Yet, expanding it to cover the above elements can usher in responsible retail lending that includes but transcends microfinance. Eventually, it is up to the private sector to demonstrate that it is ready to pursue profits responsibly. Failing that, the next consultative document may look very different.
These are the authors’ personal views.
V. Anantha Nageswaran & Deepti George are, respectively, a member of the Economic Advisory Council to the Prime Minister, and deputy executive director and head of strategy, Dvara Research.
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