Report of the

Sub-Committee of the Central Board of

Directors
of Reserve Bank of India
to Study Issues and Concerns in the MFI Sector

RESERVE BANK OF INDIA

January 2011
1 Introduction
1.1 The Board of Directors of the Reserve Bank of India, at its meeting held on
October 15, 2010 formed a Sub-Committee of the Board to study issues
and concerns in the microfinance sector in so far as they related to the
entities regulated by the Bank.

1.2 The composition of the Sub-Committee was as under:-

Shri Y.H. Malegam – Chairman
Shri Kumar Mangalam Birla
Dr. K. C. Chakrabarty
Smt. Shashi Rajagopalan
Prof. U.R. Rao
Shri V. K. Sharma (Executive Director) – Member Secretary

1.3 The terms of reference of the Sub-Committee were as under:-

1. To review the definition of ‘microfinance’ and ‘Micro Finance
Institutions (MFIs)’ for the purpose of regulation of non-banking
finance companies (NBFCs) undertaking microfinance by the
Reserve Bank of India and make appropriate recommendations.
2. To examine the prevalent practices of MFIs in regard to interest
rates, lending and recovery practices to identify trends that
impinge on borrowers’ interests.
3. To delineate the objectives and scope of regulation of NBFCs
undertaking microfinance by the Reserve Bank and the regulatory
framework needed to achieve those objectives.
4. To examine and make appropriate recommendations in regard
to applicability of money lending legislation of the States and
other relevant laws to NBFCs/MFIs.
5. To examine the role that associations and bodies of MFIs could
play in enhancing transparency disclosure and best practices
6. To recommend a grievance redressal machinery that could be
put in place for ensuring adherence to the regulations
recommended at 3 above.
7. To examine the conditions under which loans to MFIs can be
classified as priority sector lending and make appropriate
recommendations.

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 8. To consider any other item that is relevant to the terms of
reference.

2 The Microfinance sector

2.1 Microfinance is an economic development tool whose objective is to
assist the poor to work their way out of poverty. It covers a range of
services which include, in addition to the provision of credit, many other
services such as savings, insurance, money transfers, counseling, etc.

2.2 For the purposes of this report, the Sub-Committee has confined itself to
only one aspect of Microfinance, namely, the provision of credit to low-
income groups.

2.3 The provision of credit to the Microfinance sector is based on the

following postulates:
a) It addresses the concerns of poverty alleviation by enabling the
poor to work their way out of poverty.
b) It provides credit to that section of society that is unable to obtain
credit at reasonable rates from traditional sources.
c) It enables women’s empowerment by routing credit directly to
women, thereby enhancing their status within their families, the
community and society at large.
d) Easy access to credit is more important for the poor than cheaper
credit which might involve lengthy bureaucratic procedures and
delays.
e) The poor are often not in a position to offer collateral to secure
the credit.
f) Given the imperfect market in which the sector operates and the
small size of individual loans, high transaction costs are
unavoidable. However, when communities set up their own
institutions, such as SHG federations and co-operatives the
transaction costs are lower.
g) Transaction costs, can be reduced through economies of scale.
However, increases in scale cannot be achieved, both for
individual operations and for the sector as a whole in the
absence of cost recovery and profit incentive.

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2.4 Given the above considerations, the essential features of credit for
Microfinance which have evolved are as under:-
a) The borrowers are low-income groups.
b) The loans are for small amounts.
c) The loans are without collateral.
d) The loans are generally taken for income-generating activities,
although loans are also provided for consumption, housing and
other purposes.
e) The tenure of the loans is short.
f) The frequency of repayments is greater than for traditional
commercial loans.

2.5 The players in the Microfinance sector can be classified as falling into
three main groups
a) The SHG-Bank linkage Model accounting for about 58% of the
outstanding loan portfolio
b) Non-Banking Finance Companies accounting for about 34% of
the outstanding loan portfolio
c) Others including trusts, societies, etc, accounting for the balance
8% of the outstanding loan portfolio. Primary Agricultural Co-
operative Societies numbering 95,663, covering every village in
the country, with a combined membership of over 13 crores and
loans outstanding of over Rs.64, 044 crores as on 31.03.09 have a
much longer history and are under a different regulatory
framework. Thrift and credit co-operatives are scattered across
the country and there is no centralized information available
about them.

2.6 The SHG-Bank Linkage Model was pioneered by NABARD in 1992. Under
this model, women in a village are encouraged to form a Self help Group
(SHG) and members of the Group regularly contribute small savings to
the Group. These savings which form an ever growing nucleus are lent by
the group to members, and are later supplemented by loans provided
by banks for income-generating activities and other purposes for
sustainable livelihood promotion. The Group has weekly/monthly
meetings at which new savings come in, and recoveries are made from
members towards their loans from the SHGs, their federations, and banks.
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 NABARD provides grants, training and capacity building assistance to Self
Help Promoting Institutions (SHPI), which in turn act as facilitators/
intermediaries for the formation and credit linkage of the SHGs.

2.7 Under the NBFC model, NBFCs encourage villagers to form Joint Liability
Groups (JLG) and give loans to the individual members of the JLG. The
individual loans are jointly and severally guaranteed by the other
members of the Group. Many of the NBFCs operating this model started
off as non-profit entities providing micro-credit and other services to the
poor. However, as they found themselves unable to raise adequate
resources for a rapid growth of the activity, they converted themselves
into for-profit NBFCs. Others entered the field directly as for-profit NBFCs
seeing this as a viable business proposition. Significant amounts of private
equity funds have consequently been attracted to this sector.

3 The need for regulation

3.1 All NBFCs are currently regulated by Reserve Bank under Chapters III-B, III-
C and V of the Reserve Bank of India Act. There is, however, no separate
category created for NBFCs operating in the Microfinance sector.

3.2 The need for a separate category of NBFCs operating in the

Microfinance sector arises for a number of reasons.

3.3 First, the borrowers in the Microfinance sector represent a particularly

vulnerable section of society. They lack individual bargaining power,
have inadequate financial literacy and live in an environment which is
fragile and exposed to external shocks which they are ill-equipped to
absorb. They can, therefore, be easily exploited.

3.4 Second, NBFCs operating in the Microfinance sector not only compete
amongst themselves but also directly compete with the SHG-Bank
Linkage Programme. The practices they adopt could have an adverse
impact on the programme. In a representation made to the Sub-
Committee by the Government of Andhra Pradesh, it has been argued,
that the MFIs are riding “piggy-back” on the SHG infrastructure created
by the programme and that JLGs are being formed by poaching
members from existing SHGs. About 30% of MFI loans are purportedly in
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 Andhra Pradesh. The Microfinance in India- A State of Sector Report 2010
also says that there are many reports of SHGs splitting and becoming
JLGs to avail of loans from MFIs. The A.P. Government has also stated that
as the loans given by MFIs are of shorter duration than the loans given
under the programme, recoveries by SHGs are adversely affected and
loans given by the SHGs are being used to repay loans given by MFIs.
While we did not, as committee, examine each of these issues in depth,
the fact that these complaints have been made reinforces the need for
a separate and focused regulation.

3.5 Thirdly, credit to the Microfinance sector is an important plank in the

scheme for financial inclusion. A fair and adequate regulation of NBFCs
will encourage the growth of this sector while adequately protecting the
interests of the borrowers.

3.6 Fourth, over 75% of the finance obtained by NBFCs operating in this
sector is provided by banks and financial institutions including SIDBI. As at
31st March 2010, the aggregate amount outstanding in respect of loans
granted by banks and SIDBI to NBFCs operating in the Microfinance
sector amounted to Rs.13,800 crores. In addition, banks were holding
securitized paper issued by NBFCs for an amount of Rs.4200 crores. Banks
and Financial Institutions including SBIDBI also had made investments in
the equity of such NBFCs. Though this exposure may not be significant in
the context of the total assets of the banking system, it is increasing
rapidly.

3.7 Finally, given the need to encourage the growth of the Microfinance
sector and the vulnerable nature of the borrowers in the sector, there
may be a need to give special facilities or dispensation to NBFCs
operating in this sector, alongside an appropriate regulatory framework.
This will be facilitated if a separate category of NBFCs is created for this
purpose.

3.8 We would therefore recommend that a separate category be created for

NBFCs operating in the Microfinance sector, such NBFCs being
designated as NBFC-MFI.

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4 Definition
4.1 Once a separate category of NBFC-MFI is created, it becomes necessary
to provide in the regulations a definition for such NBFCs. This definition
must incorporate the distinctive features of a NBFC-MFI.

4.2 The Sub-Committee therefore recommends that a NBFC-MFI may be

defined as
“A company (other than a company licensed under Section 25 of the
Companies Act, 1956) which provides financial services pre-dominantly
to low-income borrowers with loans of small amounts, for short-terms, on
unsecured basis, mainly for income-generating activities, with
repayment schedules which are more frequent than those normally
stipulated by commercial banks and which further conforms to the
regulations specified in that behalf”.

5 Regulations to be specified
5.1 A study of 9 large and 2 small NBFC-MFIs shows that loans constitute an
average of 95% of total assets (excluding cash and bank balances and
money market instruments). We may, therefore, accept that a NBFC pre-
dominantly provides financial services to the Microfinance sector if its
loans to the sector constitute not less than 90% of its total assets
(excluding cash and bank balances and money market instruments). It is
also necessary to specify that a NBFC which is not a NBFC-MFI shall not
be permitted to have loans to the Microfinance sector which exceed
10% of its total assets.

5.2 Most MFIs consider a low-income borrower as a borrower who belongs to

a household whose annual income does not exceed Rs.50,000/-. This is a
reasonable definition and can be accepted.

5.3 a) Currently, most MFIs give individual loans which are between Rs.
10,000 and Rs. 15,000. However, some large NBFCs also give larger loans,
even in excess of Rs.50,000 for special purposes like micro-enterprises,
housing and education.
b) It is important to restrict the size of individual loans as larger loans
can lead to over-borrowing, diversion of funds and size of

6
 repayment installments which are beyond the repayment
capacity of the borrower.
c) It is, therefore, suggested that the size of an individual loan should
be restricted to Rs.25,000. Further, to prevent over-borrowing, the
aggregate value of all outstanding loans of an individual
borrower should also be restricted to Rs. 25,000.

5.4 a) MFIs normally give loans which are repayable within 12 months
irrespective of the amount of the loan. However, the larger the
loan, the larger the amount of the repayment installment, and a
large installment may strain the repayment capacity of the
borrower and result in ever greening or multiple borrowing. At the
same time, if the repayment installment is too small, it would
leave cash with the borrower which could be directed to other
uses and not be available for repayment when repayment is
due.
b) There has, therefore, to be a linkage between the amount of the
loan and the tenure of the loan. It is, therefore, suggested that for
loans not exceeding Rs. 15,000, the tenure of the loan should not
be less than 12 months and for other loans the tenure should not
be less than 24 months. The borrower should however have the
right of prepayment in all cases without attracting penalty.

5.5 a) Low-income borrowers often do not have assets which they can
offer as collateral, and it is important to ensure that in the event of
default, the borrower does not lose possession of assets which s/he
may need for her/his continued existence.
b) It is, therefore, suggested that all loans should be without
collateral.

5.6 a) It is often argued that loans should not be restricted to income

generating activities but should also be given for other purposes
such as repayment of high-cost loans to moneylenders,
education, medical expenses, consumption smoothing,
acquisition of household assets, housing, emergencies, etc. A
recent study by Centre for Microfinance of borrowers in
Hyderabad indicates that Microfinance is useful in smoothening
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 consumption and relieving seasonal liquidity crises that visit poor
families and that it obviates the need for high-cost borrowing from
informal sources.
b) The need for loans for the above purposes cannot be denied. At
the same time there are powerful arguments why loans by NBFC-
MFIs should be confined to income-generating activities.
i. Firstly, the main objective of NBFC-MFIs should be to
enable borrowers, particularly women to work their way
out of poverty by undertaking activities which generate
additional income. This additional income, after
repayment of the loan and interest, should provide a
surplus which can augment the household income,
enable consumption smoothing and reduce dependence
on the moneylender.
ii. Secondly, if the loans are not used for repayment of high-
cost borrowing, but are used for consumption, they will in
fact add to the financial burden of the household as there
will be no additional source from which the loan and
interest thereon can be repaid.
iii. Thirdly, borrowing for non-income generating purposes
may tempt borrowers to borrow in excess of their
repayment capacity.
iv. Finally, if there is no identified source from which interest
and installment can be paid, the rate of delinquency will
increase. This additional cost will push interest rates
upwards and may even result in the use of more coercive
methods of recovery.
c) Therefore, a balance has to be struck between the benefits of
restricting loans only for income-generating purposes and
recognition of the needs of low-income groups for loans for other
purposes.
d) According to “Access to Finance in Andhra Pradesh, 2010,
CMF/IFMR, Chennai” the usage of loans given by JLGs and SHGs
is as under:

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 Sr.No. Particulars JLG% SHG%
i) Income generation 25.6 25.4
ii) Repayments of old 25.4 20.4
debt
iii) Health 10.9 18.6
iv) Home 22.1 13.0
improvement
v) Education 4.4 5.7
vi) Others 11.6 7.9

e) We would however suggest that not more than 25% of the loans
granted by MFIs should be for non-income generating purposes.

5.7 a) Currently, some MFIs recover loans by weekly installments while

other MFIs recover loans by monthly installments. The rules made
under the Ordinance issued by the Andhra Pradesh Government
specify that recovery should be made only by monthly
installments.
b) In a representation made by the Government of Andhra Pradesh
to the Sub-Committee it has been argued that borrowers often
have uncertain levels of income flows and they are put to great
hardship to mobilize, accumulate and service a weekly
repayment commitment. It has also been stated by some MFIs
that they are able to reduce costs by moving from a weekly
system of repayment to a monthly system of repayment.
c) On the other hand, others have argued that some income-
generating activities provide a constant flow of cash and leaving
idle cash in the hands of borrowers increases the risk that the cash
may be diverted to purposes other than repayment of loans. A
weekly repayment schedule also means that the effective interest
can be reduced. However, N. Srinivasan in the 2010 Microfinance
India Report argues that there is enough evidence to suggest that
repayment rates do not materially suffer if the repayments are set
at fortnightly or monthly intervals.
d) In our opinion, each purpose for which a loan is used would
generate its own pattern of cash flows. Therefore, the repayment
pattern should not be rigid but should be so designed as to be
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 most suitable to the borrower’s circumstances. We would,
therefore, suggest that while MFIs should be encouraged to move
to a monthly repayment model, freedom should be given to the
MFI to fix a pattern of repayment which can be weekly, fortnightly
or monthly depending upon the nature of the loan. The choice of
a weekly, fortnightly or monthly repayment schedule should be
left to the borrower to suit his/her individual circumstances.

5.8 We have observed that some MFIs operate not merely as providers of
credit but also provide other services to the borrowers and others. These
services include acting as insurance agents, acting as agents for the
suppliers of mobile phones and telecom services, acting as agents for
the sale of household products, providing agricultural advisory services
etc. While these service can profitably be provided by MFIs along with
the supply of credit, there is a risk that given the vulnerable nature of the
borrower and his/her inadequate negotiating power, an element of
compulsion may creep in unless the provision of these services is
regulated. It is, therefore, necessary that the regulator limit the nature of
services which can be provided, as also the income which can be
generated from such services, the latter as a percentage of the total
income of the MFIs.

5.9 We would, therefore, recommend that a NBFC classified as a NBFC-MFI

should satisfy the following conditions:
a) Not less than 90% of its total assets (other than cash and bank
balances and money market instruments) are in the nature of
“qualifying assets.”
b) For the purpose of (a) above, a “qualifying asset” shall mean a
loan which satisfies the following criteria:-
i. the loan is given to a borrower who is a member of a
household whose annual income does not exceed Rs.
50,000;
ii. the amount of the loan does not exceed Rs. 25,000 and
the total outstanding indebtedness of the borrower
including this loan also does not exceed Rs. 25,000;
iii. the tenure of the loan is not less than 12 months where the
loan amount does not exceed Rs. 15,000 and 24 months in
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 other cases with a right to the borrower of prepayment
without penalty in all cases;
iv. the loan is without collateral;
v. the aggregate amount of loans given for income
generation purposes is not less than 75% of the total loans
given by the MFIs;
vi. the loan is repayable by weekly, fortnightly or monthly
installments at the choice of the borrower.
c) The income it derives from other services is in accordance with
the regulation specified in that behalf.

5.10 We would also recommend that a NBFC which does not qualify as a
NBFC-MFI should not be permitted to give loans to the microfinance
sector, which in the aggregate exceed 10% of its total assets.

6 Areas of Concern
The advent of MFIs in the Microfinance sector appears to have resulted in
a significant increase in reach and the credit made available to the
sector. Between 31st March 2007 and 31st March 2010, the number of
outstanding loan accounts serviced by MFIs is reported to have
increased from 10.04 million to 26.7 million and outstanding loans from
about Rs. 3800 crores to Rs. 18,344 crores. While this growth is impressive,
a number of studies both in India and abroad have questioned whether
growth alone is effective in addressing poverty and what the adverse
consequences of a too rapid growth might be. In particular, in the
Indian context, specific areas of concern have been identified: These
are:
a) unjustified high rates of interest
b) lack of transparency in interest rates and other charges.
c) multiple lending
d) upfront collection of security deposits
e) over-borrowing
f) ghost borrowers
g) coercive methods of recovery

7 Pricing of Interest

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7.1 There is universal agreement that the pricing of interest charges and
other terms and conditions should be affordable to clients and at the
same time sustainable for MFIs.

7.2 The difficulty in maintaining a balance between the two arises because
the costs of credit delivery are relatively flat, that is, the delivery cost per
loan remains more or less the same, irrespective of the size of the loan,
whereas the income generated by the loan varies with its size. Therefore,
when a uniform rate of interest is used, larger loans will yield a profit while
smaller loans will show a loss. In the circumstances the options before a
regulator are limited.

7.3 Given the vulnerable nature of the borrowers, it becomes necessary to

impose some form of interest rate control to prevent exploitation. The
easiest and simplest form of control would be an interest rate cap but this
has its own drawbacks, as it could result in MFIs not providing services
where the loss is unsustainable, or the mix of services being skewed in
favour of larger loans. Moreover, it would be unfair to the MFIs when cost
of funds is volatile and forms a large part of the interest cap. However, to
prevent exploitation in individual cases, a ceiling on the rate of interest
charged on individual loans is desirable.

7.4 Another system is to have a margin cap which provides a cap on the
difference between the amount charged to the borrower and the cost
of funds to the MFI. While this, too, suffers from the drawbacks of an
interest cap, it is fairer to the MFI since it is not exposed to the risk of
volatility of cost of funds. It also recognizes that the cost of funds can vary
between different MFIs. We would, therefore, suggest that such a cap be
mandated.

7.5 For the purpose of determining what would be an appropriate margin

cap, we have examined the financials for the year ended 31st March
2010 of nine large MFIs which collectively account for 70.4% of the clients,
and 63.6% of the loan portfolio of Microfinance provided by all MFIs. We
also examined the financials for the same year of two smaller MFIs. The
results of that analysis are as under:-

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 a) For the larger MFIs the effective interest rate calculated on the
mean of the outstanding loan portfolio as at 31st March 2009 and
31st March 2010 ranged between 31.02% and 50.53% with an
average of 36.79%. For the smaller MFIs the average was 28.73%.
b) For the larger MFIs, the average cost of borrowings calculated on
the mean of the borrowings as at 31st March 2009 and 31st March
2010 ranged between 10.10% and 12.73% with an average of
11.78%. For the smaller MFIs the average cost was 11.71%
c) For the larger MFIs, the average cost of borrowings calculated on
the mean of the outstanding loan portfolio as at 31st March 2009
and 31st March 2010 ranged between 8.08% and 17.72% with an
average of 13.37% For the smaller MFIs it was 11.94%
d) For the larger MFIs, the staff cost as a percentage of the mean
outstanding loan portfolio as at 31st March 2009 and 31st March
2010, ranged between 5.94% and 14.27% with an average of
8.00%. For the smaller MFIs it was 4.46%
e) For the larger MFIs, the overheads (other than staff costs) as a
percentage of the mean outstanding loan portfolio as at 31st
March 2009 and 31st March 2010, ranged between 2.46% and
8.87% with an average of 5.72%. For the smaller MFIs it was 3.63%.
f) For the larger MFIs, the provision for loan losses as a percentage of
the mean outstanding loan portfolio as at 31st March 2009 and
31st March 2010 ranged between 0.09% and 7.23% with an
average of 1.85%. For the smaller MFIs it was 1.07%.
g) For the larger MFIs, the profit before tax as a percentage of the
mean outstanding loan portfolio as at 31st March 2009 and 31st
March 2010 ranged between 4.66% and 17.02% with an average
of 10.94%. For the smaller MFIs it was 9.40%.
h) For the larger MFIs, the debt/equity ratio, as at 31st March 2010
ranged between 2.24 and 7.32 with an average of 4.92. For the
smaller MFIs it was 5.61. If we assume a capital adequacy of 15%,
the resultant ratio would be 5.67.

7.6 a) In considering the staff and overhead costs, three factors need to
be noted:
i. While the cost of the field staff may be largely variable
with the size of the loan portfolio, the cost of the other
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 overheads may not vary in the same proportion.
Therefore, with increase in scale, the cost as a percentage
of the outstanding loan portfolio should decline in the
future.
ii. The last few years have witnessed a very rapid growth in
the operations of the MFIs. Thus, in 2009-10 alone, the
outstanding loan portfolio of MFIs grew by 56%. To achieve
this growth, there has been a rapid expansion in the
branch network and development costs have been
incurred before the branches broke even. This
development cost is included in the staff and overhead
costs. If these are excluded, the costs as a percentage of
the mean outstanding loan portfolio would be lower.
iii. Several MFIs have assigned/ ecuritized a significant
portion of their portfolio. Therefore, while the size of the
portfolio is reduced, the costs remain the same as the MFIs
continue to operate as agent for collection for the
purchasers of the securitized paper. Consequently, if the
rates are to be calculated on the gross portfolio, both the
rate of interest on lending as also the cost percentage
would be lower.
b) The factors referred to in (a) (ii) and (a) (iii) above may partly
account for the fact that the study referred to in para 7.5 above,
shows that the overhead costs as a percentage of outstanding
loans is higher in the case of larger MFIs as compared to smaller
MFIs.

7.7 Based on the above study, we have attempted a normative cost

structure which can form the basis for a mandated margin cap as under:

14
 % of Loan
Portfolio
(a) Staff Costs (say) 5.00
(b) Overheads (other than staff costs) say 3.00
(c) Provision for loan losses, say 1.00
Sub-total 9.00
(d) Return on Equity (say):
15% post tax i.e. 22.6107% pre-tax on 3.39
15% of Loan Portfolio
Total internal cost 12.39
(e) Cost of Funds (say)
12% on borrowings i.e. 85% of 12% on 10.20
Loan Portfolio
Total of internal and external costs 22.59
Rounded off to 22.00

7.8 It may, therefore, be mandated that the margin cap should be 10% over
the cost of funds for the larger MFIs i.e. those with a loan portfolio
exceeding Rs. 100 crores and 12% over the cost of funds for the smaller
MFIs i.e. those with a loan portfolio not exceeding Rs. 100 crores. This cap
will be calculated on the average outstanding loan portfolio. While this
margin cap may be considered slightly low in the context of the present
cost structure, it can be justified on the following grounds:-
a) There is no reason why the cost of development and expansion
included in the present costs should be borne by current
borrowers.
b) As the size of the operations increase, there should be greater
economies of scale and consequent reduction in costs in the
future.
c) In the last few years, not only has the growth of MFIs been
financed out of interest charged to borrowers but they have also
made profits which are in excess of what can be considered as
reasonable, given the vulnerable nature of the borrowers. They,
therefore, have the capacity to absorb these higher costs till the
growth rates stabilize and they achieve the desired scale of
operations.

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7.9 The margin cap must be considered on an aggregate level and not as
applicable to individual loans. The MFIs must be given the freedom to
devise individual products and price them differently as also apply
different rates in different regions so long as the aggregate margin cap is
maintained. This will also facilitate monitoring by the regulator on the
basis of the Annual Financial Statements. If the regulator finds on
examination of the Annual Financial Statements that the average margin
has exceeded the “margin cap” the regulator can take such action as is
considered necessary. Several options are available. For example,
a) The MFI may be allowed to keep the excess income apart and
adjust this in determining the interest rate structure in the
succeeding year
b) The regulator can create a Borrower Protection Fund and the MFI
may be asked to transfer the excess income to the Fund. The
Fund can be used for such purposes such as financial literacy,
etc.
c) Penalty could be imposed on the MFI.
d) Access to priority sector loans may be suspended for a period of
time during which commercial loans could still be available to the
MFI to keep its business going.

7.10 However, in addition to the overall margin cap, there should be a cap of
24% on the individual loans.

7.11 We would, therefore, recommend that there should be a “margin cap” of

10% in respect of MFIs which have an outstanding loan portfolio at the
beginning of the year of Rs. 100 crores and a “margin cap” of 12% in
respect of MFIs which have an outstanding loan portfolio at the beginning
of the year of an amount not exceeding Rs. 100 crores. There should also
be a cap of 24% on individual loans.

8 Transparency in Interest Charges

8.1 MFIs generally levy a base interest charge calculated on the gross value
of the loan. In addition, they often recover a variety of other charges in
the form of an upfront registration or enrolment fee, loan protection fee,
etc. They also recover an insurance premium. It is important in the interest
of transparency that all stake-holders in the industry including borrowers,
16
 lenders, regulators, etc. should have a better understanding of
comparative pricing by different MFIs. This requires the use of a common
format.

8.2 It is, therefore, suggested that MFIs should levy only two charges apart
from the insurance premium. These two charges should consist of an
upfront fee towards the processing of the loan which should not exceed
1% of the gross loan amount, and an interest charge.

8.3 To promote transparency and to make comparisons possible, the

borrower must know what is the effective interest rate on the loan which
s/he takes as also the other terms like repayment terms, etc. S/he should,
therefore, be given a loan card which records all these terms and which
is in the local language which s/he can understand. The card should be
used to record acknowledgements for each installment paid by the
borrower and the final discharge, duly authenticated by the lender, as
also sufficient details to identify the borrower as also the SHG/JLG to
which s/he belongs. It is also necessary that the effective interest rate
charged by the MFI is prominently displayed in its offices and in literature
issued by it and on its website.

8.4 The purpose of the insurance premium is to protect the MFI in the unlikely
event of the death of the borrower during the pendency of the loan.
Insurance to serve this purpose may be mandatory but beyond this
purpose should be optional. The premium should also be recovered as a
part of the loan repayment installment and not upfront and there should
be regulations for the proper disposal of the policy proceeds in the event
of the death of the borrower or maturity of the policy or for its assignment
on the settlement of the loan. We have also noticed that some MFIs levy
an insurance administration charge. We see no reason why such a
charge should be levied. MFIs should recover only the actual cost of
insurance.

8.5 We have observed that some MFIs recover a security deposit in cash
from the borrowers. We are informed that no interest is paid on this
deposit. As this deposit is recovered up front from the amount of the
loan, this amounts to charging interest on the gross value of the loan
17
 when only the net amount is disbursed. The practice of security deposit,
therefore, distorts the interest rate structure and should be discontinued.
Further, the acceptance of such deposit is not permissible by the RBI Act.

8.6 Transparency and comparability would be considerately enhanced if

MFIs use a standard form of loan agreement.

8.7 We would, therefore, recommend that:-

a) There should be only three components in the pricing of the loan,
namely (i) a processing fee, not exceeding 1% of the gross loan
amount (ii) the interest charge and (iii) the insurance premium.
b) Only the actual cost of insurance should be recovered and no
administrative charges should be levied.
c) Every MFI should provide to the borrower a loan card which (i)
shows the effective rate of interest (ii) the other terms and
conditions attached to the loan (iii) information which adequately
identifies the borrower and (iv) acknowledgements by the MFI of
payments of installments received and the final discharge. The
Card should show this information in the local language
understood by the borrower.
d) The effective rate of interest charged by the MFI should be
prominently displayed in all its offices and in the literature issued
by it and on its website.
e) There should be adequate regulations regarding the manner in
which insurance premium is computed and collected and policy
proceeds disposed off.
f) There should not be any recovery of security deposit. Security
deposits already collected should be returned.
g) There should be a standard form of loan agreement.

9 Multiple-lending, Over-borrowing and Ghost-borrowers

9.1 The problems connected with multiple-lending, over-borrowing and
ghost-borrowers are interlinked and can be considered collectively.
There is considerable evidence that these practices are widely prevalent
and various reasons have been advanced for the same.

18
9.2 It has been suggested that with the development of active competition
between MFIs there has been a deluge of loan funds available to
borrowers which has fuelled excessive borrowing and the emergence of
undesirable practices. It is also claimed that the emergence of ring
leaders as key intermediaries between MFIs and potential customers has
distorted market discipline and good lending practices. There are reports
that ghost loans have become epidemic in some states. Finally, it is
believed that in consequence of over-borrowing, default rates have
been climbing in some locations but these have not been disclosed
because of ever-greening and multiple lending.

9.3 There can be several other reasons for multiple-lending and over-
borrowing. However, three major reasons may be noted.
a) The loans are given for income-generation but often there is
inadequate time given to the borrower between the grant of the
loan and the commencement of the repayment schedule. This
gives her/him insufficient time to make the institutional
arrangements necessary to be in a position to generate income.
In the absence of such a period of moratorium, it is likely that the
first few installments, particularly when the repayment is weekly,
would be paid out of the loan itself, thus reducing the amount
available for investment or paid out of additional borrowing. It is,
therefore, suggested that borrowers should be given a
reasonable period of moratorium between the disbursement of
the loan and the commencement of repayment. This period
should not be less than the frequency of repayment. Thus, a loan
repayable weekly would have a moratorium period of not less
than one week while a loan repayable monthly would have a
moratorium period of not less than one month.
b) MFIs often use existing SHGs as the target to obtain new
borrowers. This not only increases profit but also reduces their
transaction costs. These borrowers are, therefore, tempted to take
additional loans beyond their repayment capacity.

9.4 Many of the above adverse features would be minimized if borrowers are
allowed to become members of only one SHG/JLG and also if MFIs are

19
 not allowed to give loans to individuals except as members of a JLG.
Such a regulation would have two advantages namely,
a) Multiple lending and over-borrowing can be avoided as the total
loans given to an individual can be more easily ascertained and
b) The risk is shared by other members of the JLG who can impose
some peer pressure against over-borrowing.

9.5 Over borrowing can also be reduced if not more than two MFIs lend to
the same borrower.

9.6 It is also necessary to provide that if a MFI gives an additional loan to a

borrower who already has an outstanding loan from a SHG/MFI, whereby
the prescribed aggregate borrowing limit is exceeded or gives an
additional loan when existing outstanding loans have been given by two
MFIs, then recovery of the additional loan shall be deferred till the earlier
loans are fully repaid.

9.7 We would, therefore, recommend that:-

a) MFIs should lend to an individual borrower only as a member of a
JLG and should have the responsibility of ensuring that the
borrower is not a member of another JLG.
b) a borrower cannot be a member of more than one SHG/JLG.
c) not more than two MFIs should lend to the same borrower.
d) there must be a minimum period of moratorium between the
grant of the loan and the commencement of its repayment.
e) recovery of loan given in violation of the regulations should be
deferred till all prior existing loans are fully repaid.

9.8 Ghost borrowers generally arise in two sets of circumstances:-

a) when the borrower on record is a benami for the real borrower
and
b) when fictitious loans are recorded in the books.

9.9 The first type of Ghost Borrower is often used as a device for multiple
lending or over- borrowing. This can be cured only by a better discipline in
the system of identification and data base of borrowers and better follow-
up by the field worker.
20
9.10 The second type of Ghost Borrower can pose a much greater systemic
problem as it would create fictitious assets and is often used to record
fictitious repayments and thus hide the actual level of delinquencies.

9.11 One of the ways by which the problem of Ghost Borrowers can be
minimized would be by better control in the structuring and disbursement
of loans. These functions should not be entrusted to a single individual but
should need the collective action of more than one individual and should
be done at a central location. In addition, there should be closer
supervision of the disbursement function.

9.12 We would, therefore, recommend that

all sanctioning and disbursement of loans should be done only at a
central location and more than one individual should be involved in this
function. In addition, there should be close supervision of the
disbursement function.

10 Credit information Bureau

10.1 An essential element in the prevention of multiple-lending and over-
borrowing is the availability of information to the MFI of the existing
outstanding loan of a potential borrower. This is not possible unless a
Credit Information Bureau is established expeditiously.

10.2 The function of the Bureau should not be to determine the credit
worthiness of the borrowers. Rather, it should provide a data base to
capture all the outstanding loans to individual borrowers as also the
composition of existing SHGs and JLGs. When more than one bureau
discharges the role, adequate co-ordination between the bureaus will
need to be established.

10.3 Micro Finance Institution Network (MFIN) formed in November 2009 is an

industry association of MFIs which claims it has 44 members (with another
5 in pipeline) who collectively constitute 80% of the MFI business. Similarly
Sa-Dhan is an association of community development finance institutions
which also includes MFIs within its membership. Both institutions have a
Code of Conduct for their members. Both institutions have represented
21
 to us that they are actively working with a Credit Information Bureau to
build up a system whereby MFIs can report to the Bureau the status of all
loans granted by them. Once such a Bureau starts functioning there is no
reason why multiple lending and over borrowing cannot be controlled.

10.4 The issue is what can be done until such a Bureau starts functioning. We
believe that until that time, MFIs should have the responsibility to make
reasonable enquiries to find out a prospective borrower’s outstanding
loans. Given the fact that most loans are given to borrowers in a village
and the fact that MFIs have field staff who have sources of information,
this should not be too onerous a task.

10.5 We would therefore recommend that

a) One or more Credit Information Bureaus be established and be
operational as soon as possible and all MFIs be required to
become members of such bureau.
b) In the meantime, the responsibility to obtain information from
potential borrowers regarding existing borrowings should be on
the MFI.

11 Coercive Methods of Recovery

11.1 There are reports that MFIs or their employees and agents have used
coercive methods of recovery and similar complaints have been made
by many of the organisations which have made representations to us.
While we did not seek any specific evidence about the extent of this
malpractice, the very fact that such claims are widely made makes it
obvious that the matter needs attention.

11.2 Coercive methods of recovery are, to some extent, linked with the issues
of multiple lending and over-lending. If these issues are adequately
addressed, the need for coercive methods of recovery would also get
significantly reduced.

11.3 The primary responsibility for the prevention of coercive methods of

recovery must rest with the MFIs. They have to accept responsibility for
the good conduct of their employees and if employees or outsourced
workers misbehave or resort to coercive methods of recovery, severe
22
 penalties must be levied on the MFIs and their management. If this is
done, the managements of MFIs, in their own interest, will establish a
proper Code of Conduct for field staff and make greater investments in
the training and supervision of the field staff to prevent such occurrences.

11.4 Coercive methods of recovery also surface when the growth of the MFI is
faster than its ability to recruit the required staff of the right quality and to
provide them adequate training. It also surfaces when the systems of
control and inspection are inadequate. These are areas which will have
to be monitored by the regulator.

11.5 It has been suggested that coercive methods of recovery have been
encouraged by the practice of enforcing recovery by recovery agents
visiting the residence of the borrowers. The Andhra Pradesh Micro
Finance Institutions (Regulations of Money Lending) Act 2010 drafted by
the State Government includes a list of actions which constitute
“coercive action”. This includes “frequenting the house or other place
where such person resides or works, or carries on business, or happens to
be”. It also provides that “all tranches of repayment shall be made by
the SHG or its members at the office of the Gram Panchayat or at a
public place designated by the District Collectors only”.

11.6 We agree that recovery should not be made at the borrower’s place of
residence or business as that may encourage coercive methods of
recovery. At the same time we believe if the designated place of
recovery is the Gram Panchayat office or any other place distant from
the borrowers’ place of residence or work s/he would need to incur
avoidable time and cost. There are advantages in requiring recovery
from the group as a whole at a central location and this may be
specified by the MFI. This will ensure that the privacy of the group is
respected and that there is sufficient peer pressure on the borrower to
make the repayments.

11.7 It is interesting in this context to consider the experience of banks which

in respect of their retail portfolio had in the past faced similar problems of
coercive recovery. We believe this problem was significantly reduced by
the following measures:-
23
 a) The size of their portfolio was reduced to the levels which they
could adequately control.
b) The use of out-sourced recovery agents was reduced and more
of their own employees were used for recovery particularly in
sensitive areas.
c) The types of products were examined and recovery methods
were fine tuned to recognize the variances in these products.
d) Training and supervision were greatly enhanced
e) Compensation methods for staff were reviewed and greater
emphasis was given to areas of service and client satisfaction
than merely the rate of recovery.
Some of these methods can be profitably used by MFIs.

11.8 It is also necessary that MFIs are sensitive to the reasons for a borrower’s
default. If this default is of a temporary nature or willful, the MFI may
enforce recovery from other members of the Group but if there are
external factors beyond the control of the borrower, some time for
recovery may need to be given.

11.9 A key component in the prevention of coercive recovery is an adequate

grievance redressal procedure. It is necessary that there should be a
grievance redressal system established by each MFI and for this to be
made known to the borrower in the literature issued, by display in its
offices, by posting on the website and by prominent inclusion in the Loan
Card given to the borrower. In addition, it is necessary that there should
be independent authorities established to whom the borrower can make
reference.

11.10 It has been represented to us that Sa-Dhan has at the national level an
Ethical Grievance Redressal Committee. Similarly MFIN has an
Enforcement Committee for dealing with Code of Conduct violations.
While these initiatives are commendable it is necessary that there should
be an institution like the Ombudsman to whom aggrieved borrowers can
make reference. These Ombudsmen should be located within easy
reach of the borrowers.

24
11.11 One suggestion made is that an officer of the lead bank in each district
could be designated as the Ombudsman. This is justified since the
banking sector has a large exposure to MFIs and also since the lead bank
has the responsibility to promote financial inclusion in the district. Another
suggestion is that there should be a system of mobile Ombudsmen who
would visit each village by rotation on specified days. Both these
suggestions need further examination.

11.12 We would, therefore, recommend that:-

a) The responsibility to ensure that coercive methods of recovery are
not used should rest with the MFIs and they and their
managements should be subject to severe penalties if such
methods are used.
b) The regulator should monitor whether MFIs have a proper Code of
Conduct and proper systems for recruitment, training and
supervision of field staff to ensure the prevention of coercive
methods of recovery.
c) Field staff should not be allowed to make recovery at the place of
residence or work of the borrower and all recoveries should only
be made at the Group level at a central place to be designated.
d) MFIs should consider the experience of banks that faced similar
problems in relation to retail loans in the past and profit by that
experience.
e) Each MFI must establish a proper Grievance Redressal Procedure.
f) The institution of independent Ombudsmen should be examined
and based on such examination, an appropriate mechanism may
be recommended by RBI to lead banks.

12 Customer Protection Code

12.1 Between the MFIs and the borrowers, the MFIs have an immeasurably
superior bargaining power. It is, therefore, essential that MFIs are
committed to follow a Customer Protection Code.

12.2 The Consultative Group to Assist the Poor (CGAP) established by the
World Bank and supported by the 30 development agencies and private
foundations who share a common mission to obviate poverty has
published six core principles for client protection in microfinance. The
25
 Small Enterprises Education and Promotion (SEEP) network has also
designed a template for a consumer protection code of practice to
increase transparency in microfinance consumer policies and practices.

12.3 Using the material already available from these sources, it should be
possible to prepare a Customer Protection Code which MFIs are
mandated to adopt and follow. This code could have the following core
principles.
a) Commitment
A statement to be made by the MFI which articulates the MFI’s
commitment to transparency and fair lending practices.
b) Avoidance of over-indebtedness
The commitment to take reasonable steps to ensure that credit is
extended only if borrowers have demonstrated an adequate
ability to repay the loans and the loans will not put borrowers at
significant risk of over-indebtedness.
c) Capacity Building and empowerment
The commitment to capacity building and empowerment
through skill training and hand holding.
d) Appropriate marketing
The assurance that non- credit financial products marketed are
appropriate.
e) Transparent and Competitive Pricing
Pricing and terms and conditions of the financial product
(including interest charges, insurance premia, fees etc.) which are
transparent and disclosed in a form and language easily
understood by the customer and pricing which is reasonable, that
is, affordable to the customer and sustainable for the MFI.
f) Appropriate Collection Practices
Debt collection practices which are not abusive or coercive.
g) Ethical Staff Behaviour
The commitment that staff will comply with high ethical standards
in interaction with customers and that there are adequate
safeguards to detect and correct corruption or unacceptable
behaviour.
h) Accountability

26
 A declaration that the MFI will be accountable for strictly
complying with prudential regulations and preventing
inappropriate staff behavior together with details of a timely and
responsive mechanism for grievance redressal.
i) Privacy of Client Data
The assurance that privacy of client data will be respected.

12.4 The Reserve Bank has already prescribed on September 28, 2006 broad
guidelines on fair practices to be framed and approved by the boards of
directors of all NBFCs. The relevant provisions of this Fair Practices Code
need to be incorporated in the Customer Protection Code which NBFC-
MFIs should adopt.

12.5 Similar provisions should also be made applicable to banks and financial
institutions which provide credit to microfinance sector.

12.6 We would, therefore, recommend that the regulator should publish a

Client Protection Code for MFIs and mandate its acceptance and
observance by MFIs. This Code should incorporate the relevant provisions
of the Fair Practices Guidelines prescribed by the Reserve Bank for
NBFCs. Similar provision should also be made applicable to banks and
financial institutions which provide credit to the microfinance sector.

13 Improvement of efficiencies
13.1 The purpose of regulation should not be confined merely to the
prevention of abuses but should also examine methods by which the
efficiency of operations can be improved. This will benefit both the MFIs
and the borrowers as it will reduce costs and consequently interest
charges and also increase the volume of business.

13.2 The key areas in improving efficiency are:-

a) better operating systems
b) simplification of documentation and procedures
c) better training
d) better corporate governance

27
13.3 The operations of MFIs can be broadly divided into two areas, namely,
operations at the field level and back office operations. While efficiency
at the field level will result in better service to borrowers and greater
protection from abuse, efficiency in the back office can result in a
greater saving in costs as also better control on the field staff. Information
Technology is a powerful tool in building operating systems for
identification of borrowers and communication of data and needs to be
fully exploited. It will help in the operation of the Credit Information
Bureau, reduce over-borrowing and control delinquency without
resorting to coercive methods. The use of bio-metrics and the Unique
Identification Programme hold great prominence in this area.

13.4 Early availability of credit is as important to the borrower as the terms on

which credit is given. Therefore, there is also the need to re-examine the
regulatory and other requirements to simplify documentation and
reduce delays. Given the small amount of individual loans and the
consequent spread of exposure, the cost saving will more than
compensate for the risk of loss of control and consequent defaults.

13.5 We would, therefore, recommend that MFIs review their back office
operations and make the necessary investments in Information
Technology and systems to achieve better control, simplify procedures
and reduce costs.

14 Support to SHGs/JLGs
14.1 The purpose of the formation of SHGs and JLGs cannot be merely to
share the liability. More importantly the group is to be seen as the vehicle
through which skill development and training are imparted to the
members of the group. A SIDBI sponsored study over a seven year period
from 2001-2007 records that there was a unanimous demand from group
members in all villages visited that skill development and training was
required for undertaking any income generating activity and that they
felt that a loan alone would not help in improving their livelihood.

14 .2 It is also necessary as pointed out in Microfinance India 2010 report, that,

after the formation of groups, handholding is required to ensure that the
group functions within the framework of group discipline and financial
28
 discipline. The report records that the past success of the SBLP was largely
due to NGOs who worked with missionary zeal and motivation but that
there is evidence that in recent times, this handholding is conspicuous by
its absence in both the SBLP and the MFI model. Groups formed without
professional inputs and without the requisite handholding cannot sustain
the financial content of either model and can lead to an increase in
defaults and consequent abuses in the system.

14.3 In a communication dated November 22, 2006 to the banks, the Reserve
Bank has also noted that many MFIs supported by banks were not
engaging themselves in capacity building and empowerment of the
groups to the desired extent and as a result, cohesiveness and a sense of
purpose were not being built up in the groups formed by these MFIs. This
would be in addition to and complementary to the efforts of the State
Governments in this regard.

14.4 In a submission made to us by the Ministry of Rural Development, it has

been suggested that in order to make branchless banking models work,
banks need to re-engineer front end processes and establish a support
architecture to provide back-stopping support for cash management,
technical training and trouble shooting, back-end business processing
and channel control functions. This architecture should comprise of
service branches operating the CBS platform and network of counseling
centers. The National Rural Livelihood Mission has offered to co-invest in
this concept.

14 .5 We would, therefore, recommend that under both the SBLP model and
the MFI model greater resources be devoted to professional inputs both
in the formation of SHGs and JLGs as also in the imparting of skill
development and training and generally in handholding after the group
is formed. This would be in addition to and complementary to the efforts
of the State Governments in this regard. The architecture suggested by
the Ministry of Rural Development should also be explored.

15 Corporate Size
15.1 As indicated earlier, transaction costs can only be decreased if
economies of scale can be achieved. Also, to improve efficiency and
29
 improve control, significant back office investments are needed. It is,
therefore, in the interest of the borrowers that MFIs should attain an
optimal size and consolidation within the industry appears inevitable.

15.2 The representation made to us seem to suggest that MFIs which have an
investment portfolio of Rs.100 crores or less are considered as small MFIs.
Given a Capital Adequacy ratio of 15% of risk weighted assets, this
translates to a networth of Rs.15 crores. Currently an MFI being a NBFC is
required to have a minimum capital of Rs.2 crores. We would suggest for
a NBFC MFI this should be increased to a minimum Net Worth of Rs.15
crores.

15.3 We would, therefore, recommend that all NBFC-MFIs should have a

minimum Net Worth of Rs.15 crores.

16 Corporate Governance
16.1 MFIs have twin objectives, namely to act as the vehicle through which
the poor can work their way out of poverty and to provide reasonable
profits to their investors. These twin objectives can conflict unless a fair
balance is maintained between both objectives. This makes it essential
that MFIs have good systems of Corporate Governance.

16.2 Some of the areas in which good corporate governance can be

mandated would be:-
a) the composition of the board with provision for independent
directors

b) the responsibility of the board to put in place and monitor

organisation level policies for:-
(i) the growth of the loan portfolio including its dispersal in
different regions
(ii) the identification and formation of joint liability groups
(iii) borrower training and education programmes
(iv) credit and assessment procedures
(v) recovery methods
(vi) employee code of conduct
(vii) employee quality enhancement programmes
30
 (viii) compensation system for employees including limits on
variable pay and the limit therein on weightage for
business development and collection efficiency
(ix) customer grievance procedures
(x) internal audit and inspection
(xi) whistle blowing
(xii) sharing of information with industry bodies

c) disclosures to be made in the financial statements including:

(i) the geographic distribution of the loan portfolio, both in
terms of number of borrowers and outstanding loans
(ii) analysis of overdues
(iii) the average effective rate of interest, the average cost of
funds and the average margin earned
(iv) analysis of the outstanding loans by nature of purpose for
which loans were granted
(v) composition of shareholding including percentage
shareholding held by private equity

16.3 We would, therefore, recommend that every MFI be required to have a

system of Corporate Governance in accordance with rules to be
specified by the Regulator.

17 Maintenance of Solvency
17.1 While NBFC-MFIs do not accept public deposits, they have a very large
exposure to the banking system. It is estimated that more than 75% of
their source of funds comes from the banking system. It is, therefore,
necessary to ensure that there are adequate safeguards to maintain
their solvency. This may be examined in three areas.

17.2 Firstly, there should be appropriate prudential norms. Currently, since MFIs
are not considered as a separate class of NBFCs, no separate set of
prudential norms have been prescribed. Thus, loans are classified as NPAs
if interest or repayment is overdue for 180 days. This means that a loan
where repayment is weekly becomes an NPA only when 24 installments
are overdue.
31
17.3 Given the small size of individual loans, their large number, their short
tenure, the frequency of repayment and the lack of collateral, it is clear
that the existing prudential norms for the provision for loan losses are
inadequate and must be replaced by simpler norms which apply to the
universe of loans and not to individual loans.
We would, therefore, recommend that provisioning for loans should not
be maintained for individual loans but an MFI should be required to
maintain at all times an aggregate provision for loan losses which shall
be the higher of:
i. 1% of the outstanding loan portfolio or
ii. 50% of the aggregate loan installments which are overdue for
more than 90 days and less than 180 days and 100% of the
aggregate loan installments which are overdue for 180 days or
more.

17.4 Secondly, currently all NBFCs are required to maintain Capital Adequacy
Ratio to Risk Weighted Assets of 12%. Considering the greater risks in the
Microfinance Sector, the high-gearing, and the high rate of growth, it is
necessary that this ratio should be suitably increased. It is also necessary
that subject to our comments in para. 21.3 below the total Net Owned
Funds should be in the form of Tier I Capital.

17.5 We would, therefore, recommend that NBFC-MFIs be required to maintain

Capital Adequacy Ratio of 15% and subject to our comment in para. 21.3
below all of the Net Owned Funds should be in the form of Tier I Capital.

18 Need for Competition

18.1 While regulations are important, they cannot by themselves be the sole
instruments to reduce interest rates charged by MFIs or improve the
service provided to borrowers. Ultimately, this can only be done through
greater competition both within the MFIs and without from other
agencies operating in the Microfinance sector.

18.2 The agencies operating in the Microfinance Sector can be broadly

grouped in two classes namely
a) The SHG-Bank Linkage Programme (SBLP) and
32
 b) MFIs including NBFC-MFIs, trusts, societies, etc. whereof NBFC-MFIs
hold more than 80% of the outstanding loan portfolio.

18.3 The relative share of these two classes in the last three years as reported
by ACCESS is as under:-
Particulars FY 2008 FY2009 FY2010 % Growth
over 2
years
No. of Customers
(million)
SBLP 50.8 59.1 64.5 26.96
MFI 14.1 22.6 26.7 189.36
Total 64.9 81.7 91.2 140.52
Portfolio Outstanding
(Rs. Billion)
SBLP 166.99 226.79 272.66 63.27
MFI 59.54 117.34 183.44 308.09
Total 226.53 344.13 456.10 201.34
Incremental Loans
Outstanding (Rs.
Billion)
SBLP 46.33 56.80 45.87 (0.01)
MFI 24.98 57.80 66.10 246.61
Total 71.31 114.60 111.97 157.01

18.4 Though there may be some duplication in the number of customers, the
following needs to be noted:
a) The share of SBLP in terms of customers has dropped from 78.27%
in 2008 to 70.72% in 2010. Even more significantly its share of
outstanding loans has dropped from 73.71% to 59.78%.
b) The share of SBLP in incremental loans has dropped from 64.96%
to 40.96% and in actual terms is lower in 2010 than in 2008.

33
 c) While the total number of customers between 2008 and 2010
increased by 140.52%, the outstanding portfolio increased by
201.34%. This shows that the average size of the loan per borrower
has increased by 43.28%. This suggests that there is either an
increase in the size of the average individual loan given to the
borrower or is an indication of multiple lending/over borrowing
resulting from more than one loan being given to the same
borrower.

18.5 The reasons for the increasing dominance of the MFI Group vis-à-vis bank
linkage need to be examined. Five possible reasons have been
suggested.
a) First, it is believed MFIs have been able to achieve a deeper
reach as they tend to have a more informal approach as
opposed to banks which still operate through traditional
branches.
b) Second, MFIs are said to be more aggressive in securing business
as they use more of the local population as field workers which
gives them better access to borrowers as opposed to banks
which still largely use traditional staff.
c) Third, the procedures used by MFIs are said to be simpler and less
time-consuming whereas the procedures used by banks tend to
be bureaucratic and laborious.
d) Fourth, bank loans to SHGs have a longer repayment period and
during that period if SHG members need loans, they approach
MFIs.
e) Finally, it is believed that banks find it easier to use MFIs to meet
their priority-sector targets. This is particularly true near the year
end where banks invest in securitized paper issued by MFIs to
meet targets.

18.6 Given the lower cost of funds which banks enjoy, there is no reason why
banks cannot acquire a larger share of the market and thereby provide
more effective competition to the MFIs. This could result in a general
reduction in interest rate for borrowers.

34
18.7 Reserve Bank has recently taken a number of steps for furthering financial
inclusion through mainstream financial institutions by offering a minimum
of four financial products, namely, (a) a savings cum overdraft account,
(b) a remittance product, (c) a pure savings product-ideally a recurring
deposit, and (d) a general purpose Credit Card or Kisan Credit Card.

18.8 In addition, banks have been advised to put in place a board-approved

Financial Inclusion Plan to be rolled out over the next three years. The
plans and the self-set targets are being closely monitored by the Reserve
Bank.

18.9 To facilitate this programme of financial inclusion, Reserve Bank has also
announced the following measures:-
a) Banks are permitted to utilise the services of intermediaries to
extend penetration outreach by providing financial and banking
services through the use of business facilitators and business
correspondents, including SHGs.
b) Domestic scheduled commercial banks including Regional Rural
Banks have been permitted to freely open branches in Tier 3 to
Tier 6 centres with population of less than 50,000 persons.
c) In the North Eastern States and Sikkim, domestic scheduled
commercial banks are permitted to open branches in rural, semi-
urban and urban centres.
d) 2012 to 72, 825 un-banked villages which have population in
excess of 2000 persons.
These measures should give the necessary opportunity to banks to treat
financial inclusion as a viable business proposition and to increase their
penetration in the microfinance sector.

18.10 We would therefore recommend that bank lending to the Microfinance

sector both through the SHG-Bank Linkage programme and directly
should be significantly increased and this should result in a reduction in
the lending interest rates.

19 Priority Sector Status

19.1 Currently all loans to MFIs are considered as priority sector lending. It has
been suggested that there is no control on the end use of these funds
35
 and that there is significant diversion of these funds from the purposes
intended to other purposes. It is also suggested that in determining
priority sector lending what needs to be considered is not the availability
of credit but rather the availability of affordable credit. Considering the
high rates at which MFIs lend funds, it has been suggested that advances
to MFIs should not qualify as priority sector lending.

19.2 As at 31st March 2010, the total funds made available by banks and
Financial Institutions including SIDBI amounted to Rs. 18,000 crores. This
includes the securitized portfolio of these institutions amounting to Rs.
4200 crores. In the context of the total outstanding loans and advances
of all scheduled commercial banks at Rs.34,97,054 crores as at March 31,
2010, this is not a significant amount.

19.3 However, removal of “priority sector” lending to loans given to MFIs

would not, in our opinion be advisable for the following reasons:-
a) If the recommendations made by us are accepted, there should
be significant reduction, both in the diversion of funds and in the
rates of interest.
b) Even though “priority sector” loans are not made available at
concessional rates, banks are under some pressure to meet
targets of priority sector lending. There is therefore competition
among the banks to find MFI customers for securitisation or
lending. This competition could drive down borrowing costs and
with the ceiling on “margin gap” recommended, could reduce
interest rates.

19.4 There are existing Reserve Bank guidelines for lending to the priority
sector. It may be necessary to revisit these guidelines in the context of
the recommendations.

19.5 We would, therefore, recommend that bank advances to MFIs should

continue to enjoy “priority sector lending” status. However, advances to
MFIs which do not comply with the regulation should be denied “priority
sector lending” status. It may also be necessary for the Reserve Bank to
revisit its existing guidelines for lending to the priority sector.

36
20 Assignment and Securitisation
20.1 We have noted that in addition to the direct borrowing by MFIs from
banks, financial institutions and SIDBI, significant portions of the loan
portfolio have been assigned to or securitised to banks, mutual funds and
others with the MFI remaining as an agent for recovery. While the exact
amount of such assignments and securitisation is not available, the
assigned and securitised portfolios held by banks as at 31st March 2010
are believed to aggregate to around Rs. 4200 crores.

20.2 Assignment and securitisation can be in two forms namely (a) with
recourse and (b) without recourse. When the assignment/securitisation is
with recourse, the MFI remains fully exposed to the risk of default of the
underlying loans though the loans themselves are not reflected in its
financial statements. When the assignment or securitisation is without
recourse, the MFI has no exposure on the loan portfolio but it is customary
for the MFI to offer credit enhancement in the form of a dedicated fixed
deposit or in other forms.

20.3 It is, therefore, necessary that for the purposes of calculation of the
Capital Adequacy Ratio, when the assignment or securitisation is with
recourse, the full value of the portfolio assigned or securitised is
considered as a risk weighted asset and where the assignment or
securitisation is without recourse but credit enhancement is given, the
value of the credit enhancement is deducted from the Net Owned
Funds. It is also necessary that disclosure is made of the amount of the
outstanding loan portfolio which is assigned or securitised but the MFI
continues as an agent for collection.

20.4 When banks acquire assigned or securitised loans, they become the
owners of those loans. They have therefore an obligation before they
acquire the assigned or securitised loans, to ensure that the loans have
been made in accordance with the terms of the specified regulations.

20.5 We would, therefore, recommend that:-

a) Disclosure is made in the financial statements of MFIs of the
outstanding loan portfolio which has been assigned or securitised

37
 and the MFI continues as an agent for collection. The amounts
assigned and securitised must be shown separately.
b) Where assignment or securitisation is with recourse, the full value
of the outstanding loan portfolio assigned or securitised should be
considered as risk-based assets for calculation of Capital
Adequacy.
c) Where the assignment or securitisation is without recourse but
credit enhancement has been given, the value of the credit
enhancement should be deducted from the Net Owned Funds for
the purpose of calculation of Capital Adequacy.
d) Before acquiring assigned or securitised loans, banks should
ensure that the loans have been made in accordance with the
terms of the specified regulations.

21 Funding of MFIs
21.1 It has been suggested that the entry of private equity in the microfinance
sector has resulted in a demand for higher profits by MFIs with
consequent high interest rates and the emergence of some of the areas
of concern which have been discussed earlier.

21.2 Without expressing any opinion on the matter, it is necessary to

understand the circumstances in which private equity has entered the
sector. On the one hand, there was a huge unsatisfied demand for
microfinance credit and on the other, there was a limitation on the
capacity of not-for-profit entities to meet this demand. When for-profit
entities emerged, microfinance was seen as a high-risk entity but venture
capital funds are not allowed to invest in MFIs and private equity rushed
in to fill this vacuum.

21.3 We believe it is necessary to widen the base from which MFIs are funded
in respect of the Net Owned Funds needed for Capital Adequacy and
for that purpose the following need to be examined.
a) It has been suggested that a "Domestic Social Capital Fund" may
be permitted to be established. This fund will be targeted towards
"Social Investors" who are willing to accept "muted" returns, say,
10% to 12%. This fund could then invest in MFIs which satisfy social

38
 performance norms laid down by the Fund and measured in
accordance with internationally recognized measurement tools.
b) MFIs should be encouraged to issue preference capital which
carries a coupon rate not exceeding 10% to 12% and this can be
considered as Tier II capital in accordance with norms applicable
to banks.

21.4 We would, therefore, recommend that:

a) The creation of one or more "Domestic Social Capital Funds" may
be examined in consultation with SEBI.
b) MFIs should be encouraged to issue preference capital with a
ceiling on the coupon rate and this can be treated as part of Tier II
capital subject to capital adequacy norms.

22 Monitoring of Compliance
22.1 The success of any regulatory framework ultimately is determined by the
extent to which compliance with the regulations can be monitored.

22.2 We believe the responsibility for compliance with the regulations will
have to be borne by four agencies as mentioned below.

22.3 First, the primary responsibility for compliance must rest with the MFI itself.
It will, therefore, have to make organisational arrangements to assign
responsibility for compliance to designated individuals within the
organisation and establish systems of internal control and inspection to
ensure that compliance exists in practice. Allied to this, there has to be,
as stated earlier, a system of levy of penalties both on the MFI and on
individual members of the management in the event of non-
compliance.

22.4 Secondly, (a) Industry associations must also assume greater responsibility
in ensuring compliance. A possible scheme which may be considered
would be as under:
i. The Regulator will recognize only those industry associations which
have a minimum membership, for example, in excess of 331/3 % of
the total number of MFIs registered with the Regulator for the

39
 purpose of consultation, dialogue and information sharing to
promote healthy and balanced growth of the sector.
ii. The association will have a code of conduct in accordance with
the Client Protection Code as stipulated by the Regulator.
iii. The association will have an Enforcement Committee to check
violations of the Code brought to its attention by its own
inspection system or by outsiders including the State Government
and the Regulator.
iv. The association will discipline its members by removing them from
membership if there is persistent violation of the Code and will
publicise the fact of removal
v. The members will publicly acknowledge their membership of the
association in their letter heads and in all their communications.
b) If the above steps are effectively implemented, membership of these
associations will be seen by the trade, borrowers and lenders as a mark
of confidence and removal from membership can have adverse
reputational impact. This can be a major deterrent to non-compliance.
c) There are also other organisations in the trade which cover other
functions like data gathering, assist development NGOs, etc. These can
act as “whistle blowers” to highlight violations of the regulations or the
Code of Conduct.

22.5 Thirdly, banks which lend funds to MFIs and which purchase securitised
paper also have a role to play in compliance. Reserve Bank
communication of November 22, 2006 to banks specifically states that
banks, as principal financiers of MFIs do not appear to be engaging with
them with regard to their systems, practices and lending policies with a
view to ensuring better transparency and adherence to best practices
nor in many cases is there a review of MFI operations after sanctioning
the credit facility. In the case of securitized loans, banks are the owners
of the loans and the MFIs are their agents for recovery. They can
therefore be considered as responsible for the acts and defaults of their
agents and they have therefore every right to enforce compliance. In
the case of loans, while they may not own the loans given by MFIs, as
lenders they can mandate compliance and have the right to enforce it.
Banks also have, through their branch network, the ability to supervise
the functioning of MFIs and SHGs to whom they lend funds. They must
40
 therefore accept this responsibility. Banks should also be encouraged to
give loans to MFIs and buy securitized paper largely in the districts where
they have a branch network so that compliance is made possible.

22.6 Lastly, as Regulator, the Reserve Bank has a role to play.

a) As at 31st March, 2010, the top 10 MFIs owned 64.48% of the total
loan portfolio and the top 5 MFIs owned 49.93% of the total loan
portfolio. Therefore, by supervision of the larger MFIs which are
few in number, Reserve Bank can actively supervise a large part
of the Microfinance sector financed by MFIs
b) The nature of this supervision should be both off-site and on-site.
However, given the wide geographic spread, the small value of
individual loans and the large number of operating points, it may
not be possible to do on-site inspection of the branches of MFIs,
except on sample basis. Supervision should therefore
concentrate on the existence and operation of the organisational
arrangements, the reporting systems, corporate governance etc
and a review of the financial statements to ensure compliance
with regulatory norms. To give further strength to this supervision,
the Reserve Bank should have the power to remove the CEO and
/ or the directors in the event of persistent violation of the
regulations quite apart from the power to deregister the MFI and
thereby prevent it from operating in the microfinance sector.
c) Since the industry association is one component of the
compliance system, the Reserve Bank should also inspect the
industry associations to ensure that their compliance mechanism
is functioning.
d) Another possibility which needs to be explored is the use of
outside specialized agencies for inspection of MFIs in place of or
in addition to inspection by Reserve Bank. Such agencies exist
and if they are used, the cost of these services can be recovered
from MFIs.
e) If the Reserve Bank is to adequately discharge its responsibilities to
ensure compliance of the NBFC-MFIs with its regulations, it will also
need to considerably enhance its existing supervisory organisation
dealing with NBFC-MFIs.

41
22.7 We would, therefore, recommend that:-
a) The primary responsibility for ensuring compliance with the
regulations should rest with the MFI itself and it and its
management must be penalized in the event of non-compliance
b) Industry associations must ensure compliance through the
implementation of the Code of Conduct with penalties for non-
compliance.
c) Banks also must play a part in compliance by surveillance of MFIs
through their branches.
d) The Reserve Bank should have the responsibility for off-site and
on-site supervision of MFIs but the on-site supervision may be
confined to the larger MFIs and be restricted to the functioning of
the organisational arrangements and systems with some
supervision of branches. It should also include supervision of the
industry associations in so far as their compliance mechanism is
concerned. Reserve Bank should also explore the use of outside
agencies for inspection.
e) The Reserve Bank should have the power to remove from office
the CEO and / or a director in the event of persistent violation of
the regulations quite apart from the power to deregister an MFI
and prevent it from operating in the microfinance sector.
f) The Reserve Bank should considerably enhance its existing
supervisory organisation dealing with NBFC-MFIs.

23 Moneylenders Acts
23.1 There are Acts in several states governing money lending but these were
enacted several decades ago. They do not, therefore, specifically
exempt NBFCs though they do exempt banks, statutory corporations, co-
operatives and financial institutions.

23.2 As a Technical Committee of the Reserve Bank has pointed out, despite
the legislation, a large number of money lenders operate without license
and even the registered moneylenders charge interest rates much higher
than permitted by the law, apart from not complying with other
provisions. The report states that “Signs of effective enforcement of the
legislation are absent”.

42
23.3 The Technical Committee states that in many international jurisdictions,
for example, Hong Kong, Singapore, Lesotho, there are specific
provisions in the law for exemption to certain entities. The Technical
Committee has recommended that since NBFCs are already regulated
by the Reserve Bank, they should also be exempted from the provisions
of the money lending acts. We endorse that recommendation.

23.4 We, therefore, recommend that NBFC-MFIs should be exempted from the
provisions of the Money-Lending Acts, especially as we are
recommending interest margin caps and increased regulation.

24 The Micro Finance (Development and Regulation) Bill 2010

24.1 The Central Government has drafted a 'Micro Finance (Development
and Regulation) Act 2010’ which will apply to all microfinance
organisations other than:
a) banks;
b) co-operative societies engaged primarily in agricultural
operations or industrial activity or purchase or sale of any goods
and such other activities;
c) NBFCs other than licensed under Section 25 of the Companies
Act, 1956;
d) co-operative societies not accepting deposits from anybody
except from its members having voting rights or from those
members who will acquire voting rights after a stipulated period of
their making deposits as per the law applicable to such co-
operative societies.

24.2 The proposed Act provides that the Central Government will constitute a
Micro Finance Development Council to advise NABARD on the
formulation of policies, schemes and other measures required in the
interest of orderly growth and development of microfinance services.

24.3 The proposed Act also provides that a microfinance organisation which is
providing thrift services or which intends to commence the business of
providing thrift services should be registered with NABARD.

43
24.4 NABARD has the responsibility under the proposed Act to promote and
ensure orderly growth of microfinance services provided by the
organisations covered by the Act. In furtherance of this responsibility it
has the power to issue directions to such organisations and to carry out
inspection of such organisations.

24.5 In our opinion, the following matters need consideration:

a) We are in agreement with the purpose of the proposed Act "to
provide for promotion, development and regulation of the micro
finance organisations in rural and urban areas." In this context, it is
necessary to note, as we have earlier pointed out, that it is
estimated that 58% of the outstanding loan portfolio in the micro
finance sector is owned by the SHG- Bank linkage model and 34%
of the portfolio is owned by the NBFC-MFIs. Both banks and NBFCs
are outside the scope of the proposed Act, and are infact
regulated by Reserve Bank.
b) Therefore, the organisations which are not regulated by the
Reserve Bank account for an estimated 8% of the outstanding
micro finance loan portfolio. Since co-operative societies which
have voting rights to members are excluded from the provisions of
the proposed Act, this percentage may be even lower.
c) These residual entities will have a wide variety of constitutional
forms, namely, trusts, societies, partnership, sole proprietorship,
etc., each governed in some form by different regulatory
authorities. They would also represent a large number of entities,
with many entities being of very small size.
d) If these entities are not regulated, a regulatory gap would be
created and therefore we support the proposal in the proposed
Act that these entities be regulated. In order that this regulation is
in place, there should be a specific provision in the proposed Act
for such entities to be registered with the regulator. However
given the large number of entities, we would suggest registration
should be made mandatory only for entities which have an
outstanding micro finance loan portfolio of Rs.10 crore or more. In
calculating this limit, care needs to be taken to ensure that the
outstanding loan portfolios of associated entities are aggregated.

44
 e) The proposed Act provides that NABARD shall be the regulator for
the entities covered by the Act. In our opinion, the following need
consideration.

i) NABARD currently is not only the agency responsible for

the
development of the micro finance sector but is also a
participant, in that it finances the sector. There may be a
perceived conflict of interest if NABARD is also a regulator.
If therefore, NABARD is to act as a regulator, it may be
required not to participate in the financing of the sector.
ii) If NABARD is to remain the regulator as provided in the
proposed Act, then it is necessary that there should be
close co-ordination between Reserve Bank and NABARD
in the formulation of the regulations issued by each
regulator. This is very necessary to ensure against the risk of
entities taking advantage of regulatory arbitrage.
f) We have serious concerns regarding permitting entities to carry
on the business of providing thrift services and thereby attracting
public deposits. At present, the size of the loan portfolio owned by
such entities is small but there is a real risk that microfinance
institutions which are currently NBFCs may use this facility to do
business through non-NBFC entities and gather large public
deposits. This could in time create a systemic risk. There is also the
risk that once this facility is given to entities governed by the Act,
pressure will build up from NBFC-MFIs that they must also be given
similar facilities and it may prove difficult to resist this pressure.

24.6 Disagreeing with the Sub-Committee Smt. Rajagopalan feels that given
the small number of entities likely to be brought within the ambit of such
a law, union government may reconsider introducing such a law. It may
recommend to state governments instead to introduce grievance
redress mechanisms in state moneylending laws, for all such MFI entities
that are currently proposed to be covered by the draft Bill - that is, MFIs
that do not fall in the ambit of RBI regulation or state cooperative laws.
Further, as moneylending and cooperatives are matters for states to
legislate on, she felt that it might be inappropriate for Parliament to
45
 enact a law in this matter. At any rate, she is in full agreement with the
Committee that public savings ought not to be accessed by any such
entity and that a regulator cannot also be a market player.

24.7 Subject to Smt.Rajagopalan's reservations as expressed in para.24.6

above, we would, therefore, recommend the following:
a) The proposed Act should provide for all entities covered by the
Act to be registered with the Regulator. However, entities where
aggregate loan portfolio (including the portfolio of associated
entities) does not exceed Rs. 10 crores may be exempted from
registration.
b) If NABARD is designated as the regulator under the proposed Act,
there must be close co-ordination between NABARD and Reserve
Bank in the formulation of the regulations applicable to the
regulated entities.
c) The micro finance entities governed by the proposed Act should
not be allowed to do the business of providing thrift services.

25 The Andhra Pradesh Micro Finance Institutions (Regulation of Money

Lending) Act.
25.1 The Andhra Pradesh Micro Finance Institutions (Regulation of Money
Lending) Act was passed by the Andhra Pradesh Legislative Assembly on
14th December 2010. It replaces the Ordinance in the same matter issued
on 15th October 2010. The Act applies to NBFCs.

25.2 In terms of this Act:-

a) every MFI has to register before the Registering Authority of the
district.
b) no member of an SHG can be a member of more than one SHG.
c) all loans by MFIs have to be without collateral
d) all MFIs have to display the rates of interest in their premises.
e) the recovery towards interest cannot exceed the principal
amount
f) no MFI can give a further loan to a SHG or its member without the
approval of the registering authority where there is an
outstanding bank loan.
g) there has to be a standard form of the loan contract
46
 h) every MFI has to give to the borrower a statement of his account
and acknowledgements for all payments received from him.
i) all repayments have to be made at the office of the Gram
Panchayat or at a designated public place
j) MFIs cannot use agents for recovery or use coercive methods of
recovery.
k) all MFIs have to submit to the Registering Authority a monthly
statement giving specified details
l) in each district, a Fast-Track Court is to be established for
protection of debtors and settlement of disputes.
m) These are penalties for failure to register and for coercive acts of
recovery.
n) Loan recoveries have to be made only by monthly installments.

25.3 The statement of Objects and Reasons states that the MFIs
a) are using SHGs to expand their borrowers
b) are charging usurious rates of interest
c) are using weekly recovery system, recovery agents and coercive
methods

It also refers to a letter dated 19th July 2010 of the Governor, Reserve
Bank of India which has confirmed certain malpractices in MFI
functioning for which banks have been asked to take corrective actions
and which also states “State Government is the best agency for
regulation of the interest rates.”

25.4 It will be noticed from the preceding paragraphs of this report that we
have recognized and addressed the issues which are mentioned in the
Statement of Objects and Reasons. Our recommendations offering
solutions for these issues are also not inconsistent with the provisions of the
Act except in certain areas where the procedures we have suggested
are perhaps simpler to operate than the provisions of the Bill but which
nonetheless achieve the same results. We cannot of course provide for
punishment for coercive recovery as provided in the Act but we believe
we have recommended sufficient safeguards to minimize this risk. In any
event, if in the process of coercive recovery, criminal acts are
committed, action can always be taken under the criminal laws and if
47
 the provisions in the existing laws are not adequate to deal with those
situations, those laws can be amended.

25.5 As regards the reference in the Reserve Bank letter to the fact that the
State Government should control irregularities in regard to coercive
interest rates, we believe it could not have been the Reserve Bank’s
intention to declare that they have no concern with interest rates. What
is perhaps intended is to say that as a matter of policy the Reserve Bank
does not mandate interest rates charged by different entities in the
financial system. Incidentally even the Act does not make any mention
of interest rates except that the total interest cannot exceed the
principal amount of the loan. On the other hand, we have specifically
recommended a “margin cap” and a ceiling on individual loans which
will reduce the effective rate of interest to very reasonable levels.

25.6 While we can understand the circumstances in which the Andhra

Pradesh Government felt it necessary to promulgate the Ordinance of
15th October 2010, we would request that the Act be withdrawn for the
following reasons:
a) Experience has shown that the State is often not the best agency
to act as a regulator and this task is best left to an independent
regulator. This is because the actions of bureaucrats may be
subject to political pressures or seen to be subject to such
pressures even when no such pressure exists. Therefore, there is a
better acceptance of decisions of independent regulators.
b) When regulations are enshrined in legislation, they acquire a
certain rigidity and change, even when desired, is sometimes not
possible. If freedom to regulate is given to an independent
regulator, s/he can react faster to changing circumstances.
c) There are serious problems when the responsibility for regulation is
given to more than one agency and there are grave risks that
those who are regulated will take advantage of regulatory
arbitrage. The responsibility for regulating NBFCs has been given
to the Reserve Bank under the Reserve Bank Act and therefore
the Reserve Bank is already the regulator for NBFC-MFIs. While it
may be true that perhaps in the past the Reserve Bank did not
regulate this sector as vigorously as it should have done, with the
48
 lessons which have been learnt, there is no reason why it should
not adequately regulate this sector in the future. If there is also
going to be regulation of the sector by the State Government
under the Act, there will be risks of regulatory arbitrage.
d) The problems get multiplied several-fold when we consider that
the example of the Andhra Pradesh Government could be
followed by other State Governments. If there are separate
regulations governing NBFC-MFIs in individual states, the task of
regulation by Reserve Bank of MFIs operating in more than one
state will become well-nigh impossible.
e) Ideally there should be a single regulator regulating microfinance
activity in the whole country. However, given the fact that
depending upon their constitution, each type of MFI is governed
under the law by a different regulator, such a single co-ordinated
regulation may not be possible. Nonetheless, considering the fact
that banks through the SHG-Bank Linkage programme and the
NBFC-MFIs together cover over 90% of the microfinance sector
and the fact that the Reserve Bank regulates both the banks and
NBFCs, the next best approach is for the Reserve Bank to be the
sole regulator for NBFC-MFIs.
f) As we have already pointed out, our recommendations in
substance cover almost all the provisions of the Act and therefore
the need for a separate Act applicable to NBFC-MFIs will not exist
if our recommendations are accepted.
g) If there still remain some areas of concern, we would recommend
that these can be resolved through a co-ordination committee
consisting of the representatives of the State Government, the
Reserve Bank and NABARD. Such a co-ordination committee has
proved very effective in the case of Urban Co-operative Banks
and is largely responsible for improvement in their health.

25.7 We would, therefore, recommend that if our recommendations are

accepted, the need for a separate Andhra Pradesh Micro Finance
Institutions (Regulation of Money Lending) Act will not survive.

26 Transitory Provisions

49
26.1 We believe that if our recommendations are accepted, the MFIs, the
banks and the Reserve Bank as regulator will have to make
organisational arrangements for which they must be given time.
However, we must also recognize that the borrowers are currently
suffering some hardships for which relief must be provided at an early
date.

26.2 We would therefore recommend that:

a) 1st April 2011 may be considered as a cut- off date by which time
our recommendations, if accepted, must be implemented. In
particular, the recommendations as to the rate of interest must, in
any case, be made effective to all loans given by an MFI after 31st
March 2011.
b) As regards the other arrangements, Reserve Bank may grant such
extension of time as it considers appropriate in the circumstances.
In particular, this extension may become necessary for entities
which currently have activities other than microfinance lending
and which may need to form separate entities confined to
microfinance activities.

27 Concluding observations
27.1 There have been many surveys, both in India and abroad as to the
impact of microfinance on the lives of the poor people it is intended to
reach. The results have been both conflicting and confusing. These
surveys report many success stories, but they also create fears that
microfinance has in some cases created credit dependency and
cyclical debt. Doubts have also been expressed as to whether lending
agencies have in all cases remained committed to the goal of fighting
poverty or whether they are solely motivated by financial gain.

27.2 In a recent study commissioned by Grameen Foundation and published

in May 2010, Dr. Kathleen Odell has made a survey of several significant
microfinance impact evaluations released or published globally
between 2005 and 2010. She cautions that microfinance is not a single
tool but a combination of tools and that MFIs around the world serve
different types of clients, operate in diverse environments and offer
different combination of services. This extreme heterogeneity, therefore,
50
 requires that we appreciate that the results of these surveys have
application in a very specific context. Nevertheless, her general
conclusion is that while these studies suggest that microfinance is good
for micro business, its “over-all effect on the incomes and poverty rates of
microfinance clients is less clear, as are the effects of microfinance on
measures of social well-being such as education, health and women's
empowerment”. The lesson, therefore, to note, is that mere extension of
micro-credit unaccompanied by other social measures will not be an
adequate anti-poverty tool.

27.3 There are conflicting estimates regarding the total demand for
microfinance in the country and the extent of penetration. However, all
these estimates confirm the fact that the present amount of
microfinance provided by both SHGs and MFI is a small portion of the
total demand. ACCESS in its “Microfinance India-State of the Sector
Report 2010” gives an estimate of the distribution of microfinance
penetration in the country. For this purpose it has published a
Microfinance Penetration among Poor Index (MPPI) which measures the
share of a region in microfinance clients divided by the shares of the
region in the total population of poor in the country. The index is as
under:

Region MPPI
North 0.41
North East 0.71
East 0.74
Central 0.32
West 0.81
South 3.40

This shows that the level of penetration in the South is more than four times
the penetration in the second highest region, namely the West and over
ten times the penetration in the least penetrated region, namely the
Central.

51
27.4 This concentration of total microfinance activity in the South is paralleled
by the distribution of MFI portfolio as between the regions. This distribution
is as under:
Region % of Portfolio
North 4.27
North East 1.75
East 22.53
Central 9.88
West 6.75
South 54.81
While this also shows that the Southern region has an overwhelmingly
large share of the MFI portfolio, it also shows that this share is only a little
over twice the share of the region with the next highest share, namely
the East but significantly higher than the share of other regions. This
supports the complaint that MFIs have been concentrating in the
Southern region where SHGs are well developed while neglecting the
other regions.

27.5 However, the picture is slightly more encouraging when we look at the
rates of growth in 2010 in the different regions. These are:
Region % Growth
North 88.52
North East 163.62
East 66.42
Central 25.81
South 37.09

This index shows that while the level of penetration is high in the Southern
Region as compared to other regions, there are encouraging signs that
MFIs are diversifying into other regions at a rate of growth which is higher
than the rate of growth in the Southern Region. The relatively lower rate
of growth in the Southern Region may be due to the base effect of much
larger level of penetration.

27.6 The growth in the combined loan portfolio of both the SBLP model and
the MFI model was 51.91% in 2008-09 and 32.53% in 2009-10. The MFI

52
 model alone grew by 97.07% and 56.33% in those years. The rate of
growth of the SBLP model was therefore much smaller.

27.7 It is, therefore, obvious that (a) the over-all penetration of microfinance in
the country is inadequate (b) there is undue concentration of effort in
the Southern Region to the relative neglect of other regions and (c) in
the SBLP model a much more sustained effort is needed by banks both
through this model and directly. This is the context in which our
recommendations have been made.

27.8 It is reported that the high rate of growth achieved by the MFIs - and
perhaps because of it - has been accompanied by the emergence of
several disturbing features such as unaffordable high rates of interest,
over-borrowing and coercive recovery practices. Our recommendations
are directed towards mitigating these adverse features. While we,
therefore, see the need for moderation of the rate of growth of the MFI
model, we also see the need for greater efforts in those regions which
have hitherto been neglected.

27.9 A moderation of the growth in the MFI model must necessarily be

accompanied by a much more vigorous growth of the SBLP model. We
have earlier referred to some of the reasons why the SBLP model has
lagged behind and these need to be addressed.

27.10 In a utopian society, all microfinance credit would be extended only by

not-for-profit making entities. However, the ground realities dictate
otherwise. Both the SBLP model and the MFI mode, therefore, need to
co-exist as do co-operatives, trusts and societies. The SBLP and MFI
models must be viewed not as competitive but as complementary
models both sharing a common cause.

27.11 MFIs need to find the right balance between the pursuit of the social
objective of microfinance and the interests of their shareholders.
Responsible finance has meaning only in that context. While several MFIs
have published vision statements, not many have demonstrated their
commitment to that vision. We, however, believe that there is now a
growing acceptance within the MFI community that mistakes have been

53
 made in the past and we hope that these will translate to a desire to
learn from these mistakes. We are encouraged in this belief by the steps
taken for the formation of industry associations and the declared
agenda for these associations.

27.12 In making our recommendations, we have recognised the need to

protect the borrowers who represent a vulnerable section of society. We
must however, also, recognise that MFIs can only function effectively in a
proper business environment. This means that while the lender has a
responsibility to provide timely and adequate credit at a fair price in a
transparent manner, the borrower also has the responsibility to honour his
commitment for payment of interest and repayment of principal. A
financial system depends ultimately on the circulation of funds within the
system. If the recovery culture is adversely affected and free flow of
funds is interrupted, the system will break down. This will adversely affect
the borrowers themselves as the slow-down of recovery will inevitably
reduce the flow of fresh funds into the system.

27.13 Microfinance is an important plank in the agenda for financial inclusion.

The future cannot be left entirely to the stating of good intentions. It,
therefore, calls for strong regulation. We believe that if the
recommendations made by us are implemented and if MFIs honour the
commitments they have proposed in the agenda of the industry
associations and if these efforts are accompanied by adequate and
effective regulation, a new dawn will emerge for the microfinance sector
and the need for State intervention will no longer exist.

54
28 Summary of Recommendations
A summary of recommendations is given in the Annexure.

Y.H.Malegam
(Chairman)
Kumar Mangalam Birla Dr.K.C.Chakrabarty
(Member) (Member)

Shashi Rajagopalan U.R.Rao

(Member) (Member)

V.K.Sharma
(Member-Secretary)

55
 Annexure

Summary of Recommendations

Sl.No. Para Recommendations

.No.

1 3.8 The need for regulation

A separate category be created for NBFCs operating in

the Microfinance sector, such NBFCs being designated as
NBFC-MFI

2 4.2 Definition

A NBFC-MFI may be defined as

“A company (other than a company licensed under

Section 25 of the Companies Act, 1956) which provides
financial services pre-dominantly to low-income borrowers
with loans of small amounts, for short-terms, on unsecured
basis, mainly for income-generating activities, with
repayment schedules which are more frequent than those
normally stipulated by commercial banks and which
further conforms to the regulations specified in that
behalf”.

Provision should be made in the regulations to further

define each component of this definition.

3 5.9 Regulations to be specified

A NBFC classified as a NBFC-MFI should satisfy the

following conditions:

a) Not less than 90% of its total assets (other than cash
and bank balances and money market instruments)
are in the nature of “qualifying assets.”

b) For the purpose of (a) above, a “qualifying asset” shall

mean a loan which satisfies the following criteria:-

i. the loan is given to a borrower who is a

member of a household whose annual

56
 income does not exceed Rs. 50,000;

ii. the amount of the loan does not

exceed Rs. 25,000 and the total
outstanding indebtedness of the
borrower including this loan also does
not exceed Rs. 25,000;

iii. the tenure of the loan is not less than 12

months where the loan amount does
not exceed Rs. 15,000 and 24 months in
other cases with a right to the borrower
of prepayment without penalty in all
cases;

iv. the loan is without collateral;

v. the aggregate amount of loans given

for income generation purposes is not
less than 75% of the total loans given by
the MFIs;

vi. the loan is repayable by weekly,

fortnightly or monthly installments at the
choice of the borrower.

c) The income it derives from other services is in

accordance with the regulation specified in that
behalf.

4 5.10 Regulations to be specified

A NBFC which does not qualify as a NBFC-MFI should not

be permitted to give loans to the microfinance sector,
which in the aggregate exceed 10% of its total assets.

5 7.11 Pricing of Interest

There should be a “margin cap” of 10% in respect of MFIs

which have an outstanding loan portfolio at the beginning
of the year of Rs. 100 crores and a “margin cap” of 12% in
respect of MFIs which have an outstanding loan portfolio
at the beginning of the year of an amount not exceeding
Rs. 100 crores. There should also be a cap of 24% on
57
 individual loans.

6 8.7 Transparency in Interest Charges

a) There should be only three components in the pricing

of the loan, namely (i) a processing fee, not
exceeding 1% of the gross loan amount (ii) the interest
charge and (iii) the insurance premium.

b) Only the actual cost of insurance should be recovered

and no administrative charges should be levied.

c) Every MFI should provide to the borrower a loan card

which (i) shows the effective rate of interest (ii) the
other terms and conditions attached to the loan (iii)
information which adequately identifies the borrower
and (iv) acknowledgements by the MFI of payments of
installments received and the final discharge. The
Card should show this information in the local
language understood by the borrower.

d) The effective rate of interest charged by the MFI

should be prominently displayed in all its offices and in
the literature issued by it and on its website.

e) There should be adequate regulations regarding the

manner in which insurance premium is computed and
collected and policy proceeds disposed off.

f) There should not be any recovery of security deposit.

Security deposits already collected should be
returned.

g) There should be a standard form of loan agreement.

7 9.7 Multiple-lending, Over-borrowing and Ghost-borrowers

a) MFIs should lend to an individual borrower only as a

member of a JLG and should have the responsibility
of ensuring that the borrower is not a member of
another JLG.

b) a borrower cannot be a member of more than one

SHG/JLG.

58
 c) not more than two MFIs should lend to the same
borrower.

d) there must be a minimum period of moratorium

between the grant of the loan and the
commencement of its repayment.

e) recovery of loan given in violation of the regulations

should be deferred till all prior existing loans are fully
repaid.

8 9.12 Multiple-lending, Over-borrowing and Ghost-borrowers

All sanctioning and disbursement of loans should be done

only at a central location and more than one individual
should be involved in this function. In addition, there
should be close supervision of the disbursement function.

9 10.5 Credit Information Bureau

a) One or more Credit Information Bureaus should be

established and be operational as soon as possible
and all MFIs be required to become members of such
bureau.

b) In the meantime, the responsibility to obtain

information from potential borrowers regarding
existing borrowings should be on the MFI.

10 11.12 Coercive Methods of Recovery

a) The responsibility to ensure that coercive methods of

recovery are not used should rest with the MFIs and
they and their managements should be subject to
severe penalties if such methods are used.

b) The regulator should monitor whether MFIs have a

proper Code of Conduct and proper systems for
recruitment, training and supervision of field staff to
ensure the prevention of coercive methods of
recovery.

c) Field staff should not be allowed to make recovery at

the place of residence or work of the borrower and all

59
 individual loans.

6 8.7 Transparency in Interest Charges

a) There should be only three components in the pricing

of the loan, namely (i) a processing fee, not
exceeding 1% of the gross loan amount (ii) the interest
charge and (iii) the insurance premium.

b) Only the actual cost of insurance should be recovered

and no administrative charges should be levied.

c) Every MFI should provide to the borrower a loan card

which (i) shows the effective rate of interest (ii) the
other terms and conditions attached to the loan (iii)
information which adequately identifies the borrower
and (iv) acknowledgements by the MFI of payments of
installments received and the final discharge. The
Card should show this information in the local
language understood by the borrower.

d) The effective rate of interest charged by the MFI

should be prominently displayed in all its offices and in
the literature issued by it and on its website.

e) There should be adequate regulations regarding the

manner in which insurance premium is computed and
collected and policy proceeds disposed off.

f) There should not be any recovery of security deposit.

Security deposits already collected should be
returned.

g) There should be a standard form of loan agreement.

7 9.7 Multiple-lending, Over-borrowing and Ghost-borrowers

a) MFIs should lend to an individual borrower only as a

member of a JLG and should have the responsibility
of ensuring that the borrower is not a member of
another JLG.

b) a borrower cannot be a member of more than one

SHG/JLG.

60
14 15.3 Corporate Size

All NBFC-MFIs should have a minimum Net Worth of Rs.15

crores.

15 16.3 Corporate Governance

Every MFI should be required to have a system of

Corporate Governance in accordance with rules to be
specified by the Regulator.

16 17.3 Maintenance of Solvency

Provisioning for loans should not be maintained for

individual loans but an MFI should be required to maintain
at all times an aggregate provision for loan losses which
shall be the higher of:

(i) 1% of the outstanding loan portfolio or (ii) 50% of the

aggregate loan installments which are overdue for more
than 90 days and less than 180 days and 100% of the
aggregate loan installments which are overdue for 180
days or more.

17 17.5 Maintenance of Solvency

NBFC-MFIs should be required to maintain Capital

Adequacy Ratio of 15% and subject to recommendation
21 below, all of the Net Owned Funds should be in the form
of Tier I Capital.

18 18.10 Need for Competition

Bank lending to the Microfinance sector both through the

SHG-Bank Linkage programme and directly should be
significantly increased and this should result in a reduction
in the lending interest rates.

19 19.5 Priority Sector Status

Bank advances to MFIs shall continue to enjoy “priority

sector lending” status. However, advances to MFIs which
do not comply with the regulation should be denied

61
 “priority sector lending” status. It may also be necessary for
the Reserve Bank to revisit its existing guidelines for lending
to the priority sector in the context of the Committee’s
recommendations.

20 20.5 Assignment and Securitisation

a) Disclosure is made in the financial statements of MFIs

of the outstanding loan portfolio which has been
assigned or securitised and the MFI continues as an
agent for collection. The amounts assigned and
securitised must be shown separately.

b) Where the assignment or securitisation is with

recourse, the full value of the outstanding loan
portfolio assigned or securitised should be considered
as risk-based assets for calculation of Capital
Adequacy.

c) Where the assignment or securitisation is without

recourse but credit enhancement has been given,
the value of the credit enhancement should be
deducted from the Net Owned Funds for the purpose
of calculation of Capital Adequacy.

d) Before acquiring assigned or securitised loans, banks

should ensure that the loans have been made in
accordance with the terms of the specified
regulations.

21 21.4 Funding of MFIs

(a) The creation of one or more "Domestic Social

Capital Funds" may be examined in consultation
with SEBI.

(b) MFIs should be encouraged to issue preference

capital with a ceiling on the coupon rate and this
can be treated as part of Tier II capital subject to
capital adequacy norms.

22 22.7 Monitoring of Compliance

62
 a) The primary responsibility for ensuring compliance
with the regulations should rest with the MFI itself
and it and its management must be penalized in
the event of non-compliance

b) Industry associations must ensure compliance

through the implementation of the Code of
Conduct with penalties for non-compliance.

c) Banks also must play a part in compliance by

surveillance of MFIs through their branches.

d) The Reserve Bank should have the responsibility for

off-site and on-site supervision of MFIs but the on-site
supervision may be confined to the larger MFIs and
be restricted to the functioning of the organizational
arrangements and systems with some supervision of
branches. It should also include supervision of the
industry associations in so far as their compliance
mechanism is concerned. Reserve Bank should also
explore the use of outside agencies for inspection.

e) The Reserve Bank should have the power to remove

from office the CEO and / or a director in the event
of persistent violation of the regulations quite apart
from the power to deregister an MFI and prevent it
from operating in the microfinance sector.

f) The Reserve Bank should considerably enhance its

existing supervisory organisation dealing with NBFC-
MFIs.

23 23.4 Moneylenders Acts

NBFC-MFIs should be exempted from the provisions of the

Money-Lending Acts, especially as we are recommending
interest margin caps and increased regulation.

24 24.7 The Micro Finance (Development and Regulation) Bill 2010

Subject to Smt.Rajagopalan's reservations as expressed in

para.24.6 above, we would, therefore, recommend the
following:
63
 a) The proposed Act should provide for all entities covered
by the Act to be registered with the Regulator. However,
entities where aggregate loan portfolio (including the portfolio
of associated entities) does not exceed Rs. 10 crores may be
exempted from registration.
b) If NABARD is designated as the regulator under the
proposed Act, there must be close co-ordination between
NABARD and Reserve Bank in the formulation of the regulations
applicable to the regulated entities.
c) The micro finance entities governed by the proposed
Act should not be allowed to do the business of providing thrift
services.
25 25.7 The Andhra Pradesh Micro Finance Institutions (Regulation
of Money Lending) Act

If the Committee’s recommendations are accepted, the

need for a separate Andhra Pradesh Micro Finance
Institutions (Regulation of Money Lending) Act will not
survive.

26 26.2 Transitory Provisions

(a) 1st April 2011 may be considered as a cut- off date by

which time our recommendations, if accepted, must be
implemented. In particular, the recommendations as to
the rate of interest must, in any case, be made effective to
all loans given by an MFI after 31st March 2011.

(b) As regards other arrangements, Reserve Bank may

grant such extension of time as it considers appropriate in
the circumstances. In particular, this extension may
become necessary for entities which currently have
activities other than microfinance lending and which may
need to form separate entities confined to microfinance
activities.

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