WHEN MORE MONEY IS NOT THE ANSWER.

An Analysis of Indias Microfinance Crisis and the Need for Comprehensive Regulation. Meena Aharam International Banking Regulation, Spring 2011

Table of Contents
I. Introduction to Microfinance .......................................................................................... 3
A. Differentiating the Innovative Features of Microcredit ....................................................... 4 B. Inherent Challenges of Microcredit .......................................................................................... 7

II. INDIAS MICROFINANCE CRISIS ..................................................................................... 8

A. Background to the Crisis ............................................................................................................ 9 B. Existing Regulatory Framework ............................................................................................. 11 C. Commercialization of MFIs The Case of SKS Microfinance ......................................... 13 D. Implementation of Andhra Pradesh Ordinance and the Collapse of the Microfinance Bubble .................................................................................................................................................... 15

III. Indias Proposed Micro Financing Development Bill ......................................... 17

A. Deficiencies of the Proposed 2007 Bill .................................................................................... 18 1. Scope should include all operating MFIs ......................................................................................... 18 2. MFIs should be exempt from interest rate caps in order to operate effectively .................. 20 3. NABARD would face conflicting interests as both a service provider and industry regulator ............................................................................................................................................................... 21 4. Uniform prudential requirements should be applied across all microfinance organizations ....................................................................................................................................................... 22 B. Looking forward to the 2010 Revision of the MFI Bill ....................................................... 24

IV. CONCLUSION ..................................................................................................................... 24

The practice of lending and making loans dates back thousands of years, from rudimentary bartering systems and more modernly to capital markets to be accessed from commercial banks1. At its earliest conception, lending was perceived to be a charitable act of helping a neighbor by temporarily providing something that they were not otherwise able to procure. To profit off of this act was deemed as usury and immoral as the lender was considered parasitic on the borrower2. Lending combined with capitalism resulted in the dramatic growth of the banking industry. The practice has created a wealth of

opportunities, such as creating money by lending out deposits to companies and individuals that would invest into their futures. In addition to the creation of opportunities, lending is a highly lucrative practice for the banking industry which at times has provided poor incentives of deregulation in a highly volatile industry. Perhaps as a return back to the original concept of charitable lending, microfinancing has been devised as a tool to reach out to the poor who would be otherwise excluded from mainstream loans. However, in order for microfinancing to be sustainable the desire to assist the poorest communities must be balanced with profitability, responsible lending, and the development of systems to encourage repayment. Another danger that plagues the microfinance industry is the greed that often accompanies targeting a vulnerable population such as the poor. This note will examine the microcredit crisis that occurred in Andhra Pradesh, India; specifically how the lack of regulatory framework and

Yaron Brook, The Morality of Moneylending: A Short History, The Objective Standard, Vol. 2, No. 3 (Fall 2007). Available at: http://www.theobjectivestandard.com/issues/2007-fall/morality-ofmoneylending.asp Id. (Describing Aristotles views in his first book on Politics and his argument for why charging interest on money is considered immoral.)
2

predatory lending led to financial crisis. In examining the India microcredit crisis, this note will examine the proposed Micro Finance Development and Regulation Bill that was presented in 2007 to Indias legislative body, and compare international regulatory schemes, and finally make recommendations on how India can adopt international microfinance regulatory principles into the bill so that a future crisis may be averted.

I.

Introduction to Microfinance Microfinancing is an umbrella that covers a multitude of financial services that are

provided on a small or micro scale to poor and underprivileged communities.

In

particular, microfinancing provides benefits to poor women allowing them to be more independent and productive members of their communities 3 . The basic concept of

microfinancing is to provide basic financial services to the poor who have little or no collateral in an effort to allow them to break the cycle of poverty. Included under

microfinancing are: microcredit, microsaving, and microinsurance4. Examples of financial services are micro-lending for those with no collateral, and micro-insurance policies that would allow the poor access to health insurance and life insurance policies. The microfinance revolution has been credited to Mohammed Yonus (Yonus) who recently won the Nobel Peace Prize in 2006 for his efforts with the Grameen Foundation5.

Grameen Bank states that of the 8.35 million borrowers, 97% are women. http://www.grameeninfo.org/index.php?option=com_content&task=view&id=26&Itemid=175 Defining the scope of microfinance. http://www.microfinancegateway.org/p/site/m/template.rc/1.26.9183/ [hereinafter microfinance gateway FAQ] See http://www.grameeninfo.org/index.php?option=com_content&task=view&id=329&Itemid=363 [hereinafter Yonus Biography] (Yonus is a Bengali economics professor who in 1983 founded Grameen Bank. His
5 4

Yonus has declared that microcredit should be considered a human right from which the poor should be given priority6. The U.N. officially vocalized support for the use of microcredit in order combat poverty and encourages other NGOs to provide microcredit services7. As a result, numerous microfinancing institutions (MFIs) have been established all over the world reaching over 152 million clients8. In conjunction with loaning money to poor individuals, CGAP and Grameen have emphasized the importance of teaching clients how to save while using money in a productive manner9. A. Differentiating the Innovative Features of Microcredit

Microcredit is a subcategory of microfinance that provides small-scale loans to persons who would otherwise not qualify for a commercial loan due to lack of collateral10. Collateral in normal commercial loans is essential because it: 1) indicates to the bank the customers ability to re-pay, 2) it creates an incentive for borrowers to re-pay11, and 3) it protects the bank from loss in the event of customer default. Microcredit has addressed the

work with Grameen and in growing microcredit to numerous countries has won him countless awards.) See http://www.grameeninfo.org/index.php?option=com_content&task=view&id=28&Itemid=108 [hereinafter Grameen credit features] U.N. General Assembly Res. 52/194 (Dec. 1997), see http://www.grameeninfo.org/index.php?option=com_content&task=view&id=41&Itemid=90 Estimation from Consultative Group to Assist the Poor (CGAP). CGAP was authorized by and is an offshoot of the World Bank. See http://www.cgap.org/p/site/c/template.rc/1.11.1792/ CGAP Key Principles of Microfinance available at http://www.cgap.org/p/site/c/template.rc/1.9.2747/
10 11 9 8 7 6

Collateral in a most basic sense gives a lender a right to an asset until repayment is complete.

Borrower incentive to repay is to prevent the loss of collateral which may be forfeited to the bank upon default.

first two necessities for collateral with innovative solutions. First, rather than valuing a loan based on an asset such as a house, microcredit views the asset to be a persons inherent potential to productively use the money to grow crops or make other goods that may be sold12. This concept is comparable to a student loan which is not secured to customer assets and instead repayment is based on potential future earning power. Second, microcredit has created a powerful incentive system for borrowers by relying on social lending in combination with access to future loans. Social lending is accomplished by considering an entire village as a re-payment group. If loans are made to community members who miss loan repayments, then future loans will not be made to the entire community. This creates a powerful social responsibility among village members who know that they may jeopardize not only their own possibilities for future loans, but also the future of the entire community13. These approaches have resulted in widely successful loan repayment percentages near 97%14. Additional factors that contribute to high levels of repayment include: small loan amounts, disciplined and short repayment requirements, and the participatory nature of many micro-lending schemes15. Loan amounts rarely exceed the equivalent of USD

Is Grameen Different, January 2011 see http://www.grameeninfo.org/index.php?option=com_content&task=view&id=27&Itemid=176 Grameen Bank: Credit Delivery System, available at http://www.grameeninfo.org/index.php?option=com_content&task=view&id=42&Itemid=92 [hereinafter Grameen Credit Delivery] (Describing the methodology of Grameen managers developing a system of trust amongst villagers. Managers are assigned to only one village and work closely with eligible clients.) Reported by Grameen Bank. Grameen Bank at a Glance, January 2011 available at http://www.grameen-info.org/index.php?option=com_content&task=view&id=26&Itemid=175 The Secretary-General, Role of Microcredit in the Eradication of Poverty, 11-12, delivered to the General Assembly, U.N. Doc. A/53/223 (Aug. 10 1998), available at
15 14 13

12

$1000, and often are made for less than $100 depending on the needs ability of the customer16. These small loans require weekly payments and usually require full repayment within a year17. Discipline is a key component to the system and is instilled by community managers who develop relationships with villagers while encouraging repayment, saving, and continued development. The close participatory and community nature of microlending has been credited with providing support for borrowers as well as the aforementioned community pressure to re-pay. Community pressure has been created in various ways; Grameen, for instance, has pioneered a system where a given communitys ability to receive more loans is affected by current citizens outstanding loan obligations. Another popular method was established by the National Bank for Agriculture and Rural Development (NABARD) based in India, which links self-help groups18 to commercial banks based on capital that has been collectively saved by the group19. Another notable microcredit approach has been person-person lending. This

concept was introduced by Kiva as crowd source capital and harnesses the Internet to bring together people from all over the world. Crowd source capital allow private

http://www.un.org/documents/ga/docs/53/plenary/a53-223.htm [hereinafter U.N. Report on Microcredit]

16 17 18

Is Grameen Different, supra note 7. Id.

Self-Help Groups (SHGs) are community pooling of capital in order to secure a loan that will be invested into community microenterprises. This system has been widely successful since its introduction in India, and is the most common way for MFIs to reach clients in India. This system has been widely used in India and has expanded the microcredit operations particularly in the state of Andhra Pradesh. K.C. Badatya, BB Wadavi, Ananthi S, Evaluation Study Series, NBARD, Microfinance for Microenterprises, An Impact Evaluation Study of Self Help Groups (2006), http://www.microfinancegateway.org/gm/document-1.9.30422/48.pdf [hereinafter Evaluation Study of SHGs]
19

individuals to make small loans (usually between $25-$300) to entrepreneurs of their choice20. The idea is to pay it forward and loans are not made with the intention of making a profit. Rather, people from around the world charitably contribute in a way that empowers the poor to develop financial responsibility while creating a better future. This approach boasts a repayment percentage of 98%21 with repaid loans often resulting in reinvestment in a new entrepreneur. Institutions such as Kiva are able to partner with existing MFIs, which allows their lenders to disburse funds to loan requests22. B. Inherent Challenges of Microcredit

Despite successes and affirmations that microcredit is a powerful tool to combat poverty, it is important to consider the sustainability of lenders in evaluating microcredit effectiveness. Challenges that threaten the sustainability of an MFI include high risk of loan default and dis-economies of scale. To combat these challenges, MFIs must create systems that issue loans efficiently, encourage re-payment, and charge interest to cover administrative costs. In an effort to create a sustainable organization MFIs have taken various approaches such as loan usage limitations and risk-adjusted interest rates. The most common loan usage limitation requires borrowers to use loans for income-generating activities in order to encourage repayment, however critics of this approach argue that the poor should be given access to funds for all purposes23.
20 21 22 23

Investors may browse websites such as Kiva.org to select potential borrowers. Kiva: Facts, http://www.kiva.org/about/facts How Kiva Works, http://www.kiva.org/about/how

U.N. Report on Microcredit, supra note 10, at 18. (Comparing income-generating approach to minimalist approach. The counter-argument to the minimalist approach is that there are other government programs that are available for the poor to access funds to pay for necessary costs such as medical bills, funerals, household expenses etc)

The risk-adjusted interest approach is also a widely used tool that is reinforced by CGAP as essential to continue the long-term sustainability of MFIs to support the needs of borrowers 24 . Recently, Yonus addressed the issue of interest rate premiums 25 by

categorizing premiums into green, yellow, and red zones26. Yonus describes the Green Zone to be poverty focused microcredit programs while the Red Zone27 signifies profitmaximizing MFIs. Using this evaluation method it can be concluded that although rate ceilings should not be imposed, MFIs should evaluate the purpose of their operation while engaging in efficient lending to cut down on operating costs28.

II.

INDIAS MICROFINANCE CRISIS In October of 2010, the Indian state of Andhra Pradesh issued an ordinance aimed

at protecting women from exploitative microfinance practices29. These practices, which

CGAP Key Principles of Microfinance, supra note 8, at 7. (Discussing how interest rate ceilings are harmful to poor peoples ability to borrow due to unsustainable costs incurred by MFIs.) Interest rate premium is defined as the difference between the rates charged by the MFI to the borrower and the cost of funds at the market rate paid by the MFI. Adrian Gonzalez, Analyzing Microcredit Interest Rates, Microfinance Information Exchange (March 2010). Available at http://www.themix.org/publications/mix-microfinance-world/2010/03/analyzing-microcreditinterest-rates-review-methodology- [hereinafter Analyzing Microcredit Interest Rates] Analyzing Microcredit Interest Rates, supra note 16, at 1. (The Green Zone consists of interest rate premiums (IRP) below 10 percentage points, Yellow Zone consists of IRPs below 15 percentage points, and the Red Zone consists of IRPs above 15 percentage points.) Id. Red Zone MFIs are also characterized by Yonus to be commercial enterprises whose main objective appears to be earning large profits for shareholders or other investors. Loan sharks would fall into this category of lending. Grameen Credit Delivery System, supra note 12. Operating costs of MFIs are often quite high due to the administrative burdens of providing small loans as opposed to large loans. Yonus contends that it is important for clients to meet explicit criteria in order to preserve MFI resources. Rama Lakshmi, India takes aim at abuse of innovative microcredit model, Washington Post, Nov. 26, 2010. (Describing the cause of dozens of rural farmer suicides that are attributed to the shame and harassment of non-payment.)
29 28 27 26 25 24

include predatory lending practices and harassment for non-payment, are being blamed for more than 50 suicides30. The ordinance requires all MFIs to cease lending and collecting on debts until they register with local officials31. Despite the best intentions of protecting impoverished consumers, this ordinance is being blamed for the microfinance crisis that is currently gripping India. The arguable cause rests is that the order to stop disbursing new loans has killed the important incentive for consumers to continue with required weekly repayments32. As a result default on loans, which was less than 2% prior to the ordinance, is now over 50%. India is currently considering regulatory legislation to re-instill confidence in MFIs companies and to ensure that future lending abuses do not occur33. A. Background to the Crisis

India historically carries an impoverished class of citizens that currently accounts for 41% of its one billion citizens34. These citizens survive on USD $1.25 a day and often live in areas where there is little to no infrastructure35. Given the staggering number of

30 31

Id.

David Roodman, Backgrounder on Indias Microfinance Crisis, Center for Global Development (November 2010), available at http://blogs.cgdev.org/open_book/2010/11/qa-on-indiasmicrofinance-crisis.php. Grameen Credit Delivery System, supra note 12. Weekly payments of loans are required under the Grameen scheme for customers to receive future funds. This aspect of the Grameen plan was considered crucial part of the high repayment rates. NABARD seeks feedback on Microfinance Regulation draft, Microfinance Focus, (Feb. 22, 2010), http://www.microfinancefocus.com/news/2010/02/22/nabard-seeks-feedback-onmicrofinance-regulation-draft/ Revised Poverty Estimates, What does it Mean for India?, http://go.worldbank.org/CG39MFTA90
35 34 33 32

Id.

persons that would be ideal candidates for microcredit loans, there can be little surprise at the growth rate of MFIs in India36. Following the success experienced by Grameen Bank in Bangladesh, India began following a similar formula of providing microcredit through group lending. The concept of microcredit and empowering the poor in India originally began in 1992 with the NABARD approach called the Self Help Group-Bank Linkage (SHG) program which encouraged communities to begin saving what they could so that they could collectively apply for loans through commercial banks37. The goal of these loans was to allow the community to create microenterprises that would further develop and benefit the village. This initiative proved successful especially at organizing women who were otherwise unable to contribute. Consequently, small NGO MFIs began flourishing in India due to lesser restrictions and oversight of smaller entities38. Companies such as Swayam Krushi Sangam (SKS) Microfinance were founded as NGOs in the late nineties initially reaching out to a modest 11,000 borrowers by 200339. However, after changing to a Non-Bank Finance Company (NBFC) within 7 years this

As of 2008, the World Bank estimates that 87% of Indias poor does not have access to formal credit sources. Informal credit sources often charge interest rates of 48%-120% while MFIs charge interest rates between 15%-30%. William Langer, The Role of Private Sector Investment in International Microfinance and Implications of Domestic Regulatory Environments, 5 B.Y.U. Intl L. & Mgmt. Rev. 1, 53 (2008).
37 38

36

Evaluation Study of Self Help Groups, supra note 13, at 15.

However, NGO MFIs found difficulties in raising capital due to restrictions on deposit taking. Greg Chen, Stephen Rasmussen, Xavier Reille, & Daniel Rozas, India Microfinance Goes Public: The SKS Initial Public Offering, CGAP Focus Note No. 65 (Sept. 2010), available at, http://www.cgap.org/gm/document-1.9.47613/FN65_Rev.pdf. [hereinafter SKS IPO] David Roodman, Backgrounder on Indias Microfinance Crisis, Center for Global Development (November 2010), available at http://blogs.cgdev.org/open_book/2010/11/qa-on-indiasmicrofinance-crisis.php.
39

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number swelled to over 5.8 million borrowers at the end of 2010. This fast growth is blamed for creating a microfinance bubble in India that inevitably crashed in late 201040. Indias growth and the resulting crisis can be contrasted from the success in Bangladesh for several factors such as a lack of regulation and the commercialization of the microcredit sector41. B. Existing Regulatory Framework

Indias lack of specific microfinance regulations was a major contributing factor to the 2010 crisis. The minimum regulations in place oversaw the various forms of entities that may operate as an MFI in India. MFIs have taken both not for profit and for-profit forms with the biggest different between them being that for-profit models are regulated by the Reserve Bank of India (RBI) and are allowed to take deposits. Thus far, non-profit MFIs are not subject to regulations so long as they do not engage in depositing taking. The most common forms of MFIs in India are: NGOs 42 , Societies and Trusts 43 , and

A bubble is defined as divergence of asset valuation with its true value. In India, success was measured on by the number of people serviced by microcredit rather than focusing on credit exposure and the repayment capability of loan recipients. Vijay Mahajan & P N Vasudevan, Microfinance in India: Twin Steps Towards Regulation, Microfinance Focus (Jan. 10 2010), http://www.microfinancefocus.com/news/2010/01/10/microfinance-in-india-twin-steps-towardsself-regulation-3/ David Rooman, Understanding Indias Microcredit Crisis, AID Watch (November 2010), available at http://aidwatchers.com/2010/11/understanding-india%E2%80%99s-microcredit-crisis/
42 43 41

40

Governed by the Societies Registration Act (1860) Governed by the Indian Trusts Act (1882)

11

Cooperative Banks.

The most successful forms of MFIs in India are: Section 25

Companies44, and Non-Banking Finance Companies (NBFCs)45. The National Bank for Agriculture and Rural Development (NABARD) was created in 1982 as an apex development bank46 and set to take on a coordinative role between the Indian Government, State Governments, and the RBI. NABARD additionally has been tasked with improving absorptive capacity of the credit delivery system, including monitoring, formulation of rehabilitation schemes, restructuring of credit institutions, training of personnel, etc.
47

NABARD is credited with creating the

innovative SHG linkage-system providing loans through MFIs48. Beyond regulations governing the structure of entities that may operate as MFIs, no uniform oversight exists to provide prudential guidance (capital adequacy, loan limitations, etc), nor interest rate controls to ensure that usury interest rates are not charged49. The only areas that the RBI does provide specific oversight are deposit-taking institutes. The

These special companies are able to operate as LLCs but are treated as non-profits therefore foregoing onerous regulations. Section 25 of the Companies Act governs them. Langer, supra note 36, at 58. Until recently, NBFCs had limited oversight and were not required to register with the RBI. However, they are now required to register with the RBI and non-deposit taking NBFCs maintain a capital adequacy ratio of 12%. Langer, supra note 36, at 57. Apex development bank signifies the bank taking on a coordination role between the federal government, state governments, and rural lending banks. Available at, http://www.nabard.org/introduction.asp
47 48 49 46 45

44

See generally, http://www.nabard.org/nabardrolefunct/nabardrole&functions.asp Evaluation Study of SHGs, supra note 14. Langer, supra note 36, at 64-5.

12

inability of MFIs to gain equity through deposits has inspired several MFIs to transfer from an NGO into a non-deposit taking NBFC in order to gain foreign investment50. C. Commercialization of MFIs The Case of SKS Microfinance

SKS Microfinance was originally founded as a non-profit in 1998 and was praised as a model MFI until its IPO in July of 201051. In 2005 SKS Founder, Vikram Akula, began implementing a for-profit MFI model in order to secure overseas investments52. Akula changed SKS Societies to SKS Microfinance and took it from operating as an NGO to a non-deposit taking NBFC. At this time SKSs portfolio consisted of standard group based loans (85%), micro-insurance policies, and small supplemental loans53.

50 51

SKS IPO, supra note 32, at 2.

Shloka Nath, The Indian Microfinance Lending Machine, Forbes India (Oct. 28, 2010), available at http://business.in.com/article/boardroom/the-indian-microfinance-lending-machine/18502/1
52 53

SKS followed in the footsteps of Banco Compartamos which went public in 2007. SKS IPO, supra note 32, at 3.

13

By changing into a NBFC, SKS was able to draw commercial venture capital from outside India to fuel growth with matching profitability. The switch from non-profit to a for-profit model required the creation of Mutual Benefit Trusts (MBTs), which acquired SKS assets prior to the shift to a NBFC. These MBTs named SKS clients as the After four rounds of

beneficiaries and were able to inject additional equity into SKS54.

equity financing spanning 2006-2009, SKS was able to raise over USD$125 million in private equity55. Since the initial investments, SKS has moved from being a 90% locally owned enterprise to having a 72% commercial ownership prior to the 2010 IPO56. This influx of capital allowed SKS to aggressively expand to the rest of India reaching more than 7.3 million women57. By the end of 2009, prior to the IPO, SKS had a net worth of over Rs. 1,016 crore (need to find dollar conversion)58. In July of 2010, SKS Microfinance went public with a 10.3% interest being issued on the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). The IPO was hugely successful with new capital of USD $155 million being raised and a valuation 40 times greater than its fiscal year 2010 earnings. This high valuation exceeds the valuation of Indias best performing banks and quickly raised concerns that the company was being overvalued. However, these fears were allayed because SKS was relatively less leveraged compared to other MFI-NBFCs in India59.
54 55 56 57 58 59

Id. at 5. Id. at 7. SKS IPO, supra note 32, at 6. Nath, supra note 42, at 1. Id. SKS IPO, supra note 32, at 9.

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Akula claimed that the switch from non-profit to profit-making would be beneficial to the poor as it allowed for greater penetration of services to the impoverished 60 . However, the change created a stark change in culture resulting in the 2,200 branches throughout India competing for loans. This aggressive competition led to irresponsible lending practices with loans being disbursed without checking the ability of or other financial responsibilities of clients. These predatory lending practices were followed by default of many borrowers and the subsequent harassment by SKS employees to villagers. Allegations of physical threats and verbal abuse to villagers were very prominent during this time, and is deemed to be the cause of the rash of suicides experienced prior to the introduction of the ordinance61.

Implementation of Andhra Pradesh Ordinance and the Collapse of the Microfinance Bubble
D. On October 15, 2010, shortly after reports of dozens of suicides resulting from harassment for non-payment, the southern state of Andhra Pradesh (AP) issued an

60 61

SKS IPO, supra note 32, at 3. Nath, supra note 42, at 2.

15

ordinance directed at curbing the abuses against clients62. The ordinance called for: the immediate cessation of disbursing and collecting of loans until MFI firms register with local officials, more disclosures, a ban on coercive loan recovery methods, and better controls on the issuance of multiple loans to one individual63. Although regulation and consumer protection was necessary, the AP ordinance had a disastrous impact on the microcredit industry for all of India. The microcredit model is only successful with several key factors that encourage steady repayment from borrowers. These factors include: habitual weekly payments, peer pressure from jointly liable borrowers, and access to new loans upon repayment of existing loans64. As this ordinance required the cessation of payments and disbursement of new loans, the first and third incentives for repayment became derailed. The result that

followed was massive default on existing loans as confidence in the microcredit system faltered among borrowers. Loan defaults that were below 2% quickly acted as a contagion among borrowers with default rates sharply rising and an estimated default rate of 58% in February 201165. The collapse of the microcredit system occurred despite the Microfinance Institutions Network (MFIN) obtainment of a temporary stay on the AP ordinance66.

62 63

Roodman, supra note 25, at 1.

Rama Lakshmi, India Takes Aim at Abuse of Innovative Microcredit Model, Washington Post, Nov. 26, 2010.
64 65

Roodman, supra note 25, at 1.

Nupur Acharya & John Satish Kumar, Repayment Slump Hits Indian Lender, Wall Street Journal Online (Feb. 3, 2011), available at http://online.wsj.com/article/SB10001424052748703652104576121741923730956.html
66

Roodman, supra note 25.

16

MFIN is an organization that was created in 2009 with the intention of creating a selfregulatory organization (SRO) aimed at developing guidelines for responsible lending and increasing financial lending to more low-income households 67 . The self-regulatory

approach has been backed by MFIs across India as the national government has been slow to pass a proposed Microfinance Development Bill that was introduced in 2007. Critics of the self-regulatory approach argue that this agency will lack enforcement power if MFIs do not abide by responsible lending guidelines68.

III.

Indias Proposed Micro Financing Development Bill As easy as it is to cite the greed and aggressive growth of SKS for the collapse of

the microfinance bubble, analysts agree that SKS was not the underlying cause. The most agreed upon factor of Indias microfinance collapse was the lack of regulatory framework that would have encouraged the growth of MFIs while ensuring protection of customers. As the popularity of MFIs increased in the 1990s and 2000s, India created opportunities for new MFIs to emerge69 however did little to create prudential measures because most MFIs operated as non-deposit taking financial institutions.

67 68

See generally, http://www.mfinindia.org/mfin-glance

Sonali Mehta-Rao, South Asia Perspective: Fast-tracking Microfinance Regulation, Microfinance Insights (Aug. 10, 2010), available at http://www.microfinanceinsights.com/blogdetails.php?bid=178 Throughout this time period, MFIs were allowed to operate as Section 25 companies and NBFCs. Both had lower entry requirements and few prudential regulations, as neither were deposit-taking operations.
69

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A.

Deficiencies of the Proposed 2007 Bill

India attempted to rectify the gap between MFI growth and the lack of regulatory restrictions with the introduction of a 2007 Micro Financial Sector (Development and Regulation) Bill (MFI Bill). The purpose of this bill was to foster growth and increased outreach of MFIs to the poor while protecting small depositors and vulnerable clientele from exploitation70. However the Lok Sabha71 never passed the proposed bill due to several serious shortcomings. These shortcomings, which will be examined in greater depth below, included a lack of defined scope that excluded Section 25 companies and NBFCs from the purview of the bill, not expanding the bill to include micro insurance and other financial instruments, overstretching the NABARD as both a service provider, and a lack of prudential norms in allowing MFIs to accept deposits72. 1. Scope should include all operating MFIs

As mentioned above, Indias microfinance sector allows organizations to operate in many forms and is subject to varying levels of regulation. The 2007 Draft MFI Bill defined applicability as, including societies, trusts, and cooperative banks which can be interpreted as excluding Section 25 companies and NBFCs73. In numbers this may make sense as these institutions make up a very small percentage of the 30,000 microfinance-

Biswa Bandhu Mohanty, Microfinance Sector in India Developing a Supportive Policy, Regulatory Framework, and Environment Positions and Perspectives, available at http://www.mra.gov.bd/conference/images/speakers/bb%20mohanthy-nabard.pdf
71 72

70

Lok Sabha is the lower house of the Indian Parliament.

Mukul Asher & Savita Shankar, Microfinance Bill: Need for Major Re-Think, School of Public Policy National University of Singapore, available at http://www.karmayog.org/billsinparliament/upload/8457/CFO_Article-final.doc
73

Id.

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dedicated institutions74. However, this is a serious error as the top 20 firms, all of whom fall into one of these two institution types, are responsible for 80% of Indias microcredit outreach75. The proposed MFI Bill would therefore regulate only charitable trusts, NGOs, and cooperative banks while the RBI would regulate NBFCs and Section 25 organizations76. The majority of Indias MFIs are set up as non-profits that are minimally regulated, so the proposed Bill would have been beneficial in bridging this regulatory gap. However, they have not been very effective at reaching Indias needy population because in order to stay un-regulated these institutions could not take deposits or receive external private funding77. Through Section 25 of the Companies Act trusts were could transform78 into formal ownership as a limited liability company but were exempted from many of the regulations applicable to for-profit companies79. These special MFIs are able to operate more actively and on a larger scale than traditional trusts because they are permitted to secure traditional bank loans for lending purposes and have done so through the help of ICICI BANKs MFI partnership program80.

74 75 76 77

Langer, supra note 36, at 56-7. Id. at 57. Id. at 58-9.

B R Bhattacharjee & Stefan Staschen, Emerging Scenarios for Microfinance Regulation in India, Deutsche Gesellschaft fr, Division 41 - Financial Systems Development, available at http://india.microsave.org/system/files/Microfinance_Regulation_in_India_2006.pdf This transformation, as regulated by RBI, requires high entry barriers and thus is difficult to achieve. Langer, supra note 36, at 59.
79 80 78

Langer, supra note 36, at 56. Id.

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NBFCs have been even more successful than Section 25 organizations because of their ability to attract and use foreign investment with limited prudential oversight so long as they do not accept deposits. To operate as an NBFC an organization must be licensed by the RBI and have minimum capital of Rs. 20 million ($450,000), which in India is an extremely high barrier. NBFCs are the most rare form of MFI in India although they are the most successful. 2. MFIs should be exempt from interest rate caps in order to operate effectively The international community is in agreement that interest rate caps are detrimental to the microfinance industry and works to hurt the poor81. The proposed MFI Bill does not create an exemption for MFIs in complying with Indias Usurious Loans Act82. This would mean that MFIs would be at the whim of the courts at determining interest rates and would ultimately hurt the MFI sustainability and growth to reach Indias poor population83. The reason why MFIs have to charge a higher interest rate compared to conventional loans is because the administrative costs remain constant regardless of the

The UN Report on microcredit expressed this assessment in addition to the Consultative Group to Assist the Poor (CGAP). CGAP Key Principles of Microfinance, supra note 8; UN Report on Microcredit, supra note 13. The Usurious Loans Act was passed in 1918 and allows the courts to provide relief from exorbitant interest rates. In taking account of whether interest is excessive, courts consider any amount charged (money or in kind) for expenses, inquiries, fines, bonuses, and factors in compound interest. The Usurious Loans Act of 1918, Act No. X, Mar. 22, 1918. Available at http://resources.lawyersnjurists.com/legal-documentations-litigations/laws-of-bangladesh/19131929/the-usurious-loans-act-1918/ The World Bank estimates that over 25% of the population lives below the poverty line. Of the 290 million poor, approximately 87% do not have access to formal sources of credit or traditional financial services.
83 82

81

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loan amount84. Therefore the costs of are inevitably much higher for MFIs, requiring a higher interest rate. It is often hard for the general public to understand why MFIs must charge a higher rate and often blame inefficiency or excessive profits to be the reason85. Although this is a legitimate concern, it would be a better solution for India to require full interest rate disclosure to customers rather than an outright limitation. 3. NABARD would face conflicting interests as both a service provider and industry regulator NABARD has been tasked by the Reserve Bank of India to provide credit, development, and supervisory functions86. Although these functions have been critical to the growth of Indias microfinance sector the multiple roles already pose somewhat of a conflict of interest. Critics of the combined service provider and regulator argue that this approach is poor governance87. The proposed MFI Bill creates a new arm of NABARD called the Micro Finance Development Council (MFDC)88. This new arm requires that all MFIs submit annual financial statements and if MFIs want to engage in deposit taking they must register with NABARD in addition to securing capital of Rs. 5 lakh (about USD $10,000), and has been in existence for at least 3 years89. In addition to thrift activities,

Robert Peck Christen et al., Microfinance Consensus Guidelines: Guiding Principles on Regulation and Supervision of Microfinance, CGAP / THE WORLD BANK GROUP, July 2003, at 19.
85 86 87 88

84

Id. See generally, http://www.nabard.org/introduction.asp; Langer, supra note 36, at 60. Asher, supra note 69, at 5.

See generally, Micro Financial Sector Development and Regulation Bill 2007, Bill No. 41 of 2007 as introduced in Lok Sabha on Mar. 20, 2007 (with commentary from Cooperative Development Foundation). Available at, http://www.cdf-sahavikasa.net/MF%20Bill%202007%20%20Clause-by-clause%20comments.pdf

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NABARD will be responsible for overseeing the proposed Microfinance Development and Equity Fund, which among other things will provide loans and grants to MFIs or may be applied to the discharge of any of its other responsibilities90. 4. Uniform prudential requirements should be applied across all microfinance organizations The proposed MFI Bill does little to bring uniform regulation to Indias microfinance industry. About 80% of current industry is regulated by minimal prudential requirements set forth by the RBI while the new bill seeks to create prudential requirements for the remaining 20%91. A more holistic approach would be beneficial to the microfinance industry because by nature it is sensitive to systemic and default risks92. Prudential regulations are important in ensuring the confidence of clients who are only likely to re-pay outstanding loans if they believe that future loans are at risk. Regulation is prudential in nature when it is aimed specifically at protecting the financial system as a whole as well as protecting safety of small deposits of customers and individual institutions93. This important kind of regulation needs to be balanced with considerations of expenses, government oversight, and difficulties with enforcement94.
89 90 91

Id. at 10. Id. at 23.

The majority of Indias microfinance clients are reached through Section 25 and NBFC organizations, which are outside of the scope of the proposed MFI Bill, are regulated by the RBI by requiring them to register and maintain capital adequacy requirements. Mohanty, supra note 67, at 6. Bhattacharjee, supra note 73, at 23. (Explaining why a special microfinance regulation would be beneficial to India because existing regulation is very piece-meal).
93 94 92

Peck, supra note 81, at 11. Id.

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Therefore, the CGAP consensus has advocated for non-prudential regulation 95 to be balanced with prudential regulation whenever possible96. The MFI Draft Bill does little to address either prudential or non-prudential regulations for MFIs in India. The bill does requires capital adequacy requirements of 5 Lakh rupees and a minimum operation period of 3 years for MFIs that choose to operate in thrift97 activities. However, as demonstrated by the Andhra crisis and in conjunction with the CGAP consensus recommendations, lending limitations are a crucial missing component. The CGAP consensus recommends rather than setting lending limitations to be a fixed percentage of an MFIs equity base98, rather lending limitations should be set based on the soundness of an MFIs lending, tracking, and collection procedures99. As the recent Andhra crisis occurred in large part due to the lack of enabling regulatory framework, these important requirements should be addressed to avoid another crisis.

Often non-prudential regulations can be accomplished through Commercial Laws or other administrative agencies. Two particularly relevant non-prudential issues relate to protecting borrowers against abusive lending and collection practices, and providing borrowers with truth in lending information about the cost of loans. Both of these consumer protection issues were not discussed in the 2007 Draft Bill. Id. at 12; Id. at 15.
96 97

95

Id. at 11.

Thrift activities are deposit taking activities. Any monies which are collected (other than in the form of current account or demand deposit) by a micro finance organization Development and Regulation Bill, supra note 85, at 2(l). In order to minimize risk, regulations often limit unsecured lending to some percentage often 100% - of the banks equity base. Such a rule should not be applied to microcredit because it would make it impossible for an MFI to leverage its equity with deposits or borrowed money. Peck, supra note 81, at 20. The most powerful source of security is derived from the soundness of an MFIs practices and the confidence that it would instill in its customers. It is recommended that rather than automatically provisioning percentages of microcredit loans at the time loans are made, it would be more prudent to instill higher lending limitations once loans are delinquent. Id. at 29.
99 98

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B.

Looking forward to the 2010 Revision of the MFI Bill

In light of the crisis, India is once again attempting to pass a more comprehensive microfinance statute in order to create an enabling regulatory environment. As evidenced from the discussion in the previous section there is much to be desired from the last proposed bill. The 2010 crisis illuminated the obvious fact that the microfinance industry is by its nature an unstable industry that must rely on prudent practice and regulations in order to future success and protect the vulnerable customers it services. As part of the enabling regulatory environment, India should remove interest rate caps on MFIs, increase prudential requirements for MFIs, address consumer protection concerns, and enlarge the scope of the Bill to uniformly govern all MFIs.

IV.

CONCLUSION The crisis in Andhra Pradesh highlights the potential for disaster in this financial

sector. The targeted clients of microfinance are often the poorest and most uneducated people in the world. As Yonus stated, access to financial services is a human right that should be enabled. In order for this to occur, the key concept of balance must be Balance between prudential and non-prudential

considered at every juncture.

requirements. Balance between sustainability and helping those in need. With the introduction of the last bill to Indias parliament, key factors were neglected which are essential to a successful microfinance industry. Among these factors are more robust prudential regulations, consumer protections against predatory lending, an education program that empowers consumers to do more than just borrow money, and ensure growth by not limiting interest rates. India has a huge untapped microfinance potential with 70% of poor still without financial services. Given a proper and

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comprehensive regulatory framework, client confidence in MFIs will rebound and future crises can be averted. IV. International Microfinance Regulatory Guidance (not sure where/if to include this) With the success and popularity of the microcredit approach at combating poverty, various international organizations have expressed support and guidance to encourage responsible lending. Most notably are the U.N., The Basal Committee, and The World Bank through CGAP. CGAP is arguably the most well recognized guidance with eleven outlined key-principles that have been endorsed by the G8-Summit. A. CGAP Key Principles of Microfinance The Consultative Group to Assist the Poor (CGAP) was created in 1995 as a consortium of over 30 development agencies100. It is housed at the World Bank although it remains an independent entity whose purpose is to provide market intelligence, promote standards, and develop innovative advisory services to governments, MFIs, donors, and investors. CGAP takes the position that governments should create a healthy environment for a microfinance sector to develop but maintain a limited role. CGAP further defines the limited role to extend to: 1) creating a supportive enabling environment with macroeconomic stability, and 2) creating a strong regulatory framework for microfinance and boosting supervisory capacity101. In 2004, CGAP published the key principles of microfinance with the goal of expanding access to microfinancing opportunities to the poor. The aim of the eleven
100 101

see generally, CGAP About Us, http://www.cgap.org/p/site/c/aboutus/ see generally, CGAP FAQ, http://www.cgap.org/p/site/c/template.rc/1.26.1312/

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principles is to allow MFIs to strive for sustainability while balancing the needs of their vulnerable clients. In brief, the eleven principles are as follows102: 1) The poor need a variety of financial services, not just loans. 2) Microfinance is a powerful instrument against poverty. 3) Microfinance means building financial systems that serve the poor. 4) Financial sustainability is necessary to reach significant numbers of poor people. 5) Microfinance is about building permanent local financial institutions. 6) Microcredit is not always the answer. 7) Interest rate ceilings can damage poor peoples access to financial services. 8) The governments role is as an enabler, not as a direct provider of financial services. 9) Donor subsidies should complement, not compete with private sector capital. 10) The lack of institutional and human capacity is the key constraint. 11) The importance of financial and outreach transparency. In evaluating the Indian microfinance crisis Principles 4, 6, 7 and 11 are the most relevant and will be the focus of the rest of this note.

102

CGAP Key Principles of Microfinance, supra note 8.

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