By Madhu Srinivas, Dvara Research & Akhil Mehra, Northern Arc Capital
The micro-finance sector is under considerable stress following the nationwide lockdown. While a majority of micro-finance borrowers opted for the moratorium, Non-Banking Financial Company – Micro-finance Institutions (NBFC-MFI) themselves did not get the same benefit uniformly from their lenders, namely banks and other NBFCs. This has placed NBFC-MFIs in a liquidity squeeze. Additionally, there is still uncertainty on the interest that has been accruing on the payments under moratorium. This directly affects their profitability and thus their sustainability, at least in the short term. A potential consequence is that the NBFC-MFIs’ credit rating could get downgraded and this would thereby increase their cost of funds. Unlike previous crises that the sector has faced, the current COVID-19 induced crisis is much more severe and far-reaching.
To help mitigate the problems faced by the sector, we propose some measures that the Reserve Bank of India and the Ministry of Finance could consider. Some of these measures are relevant more structurally over time and not just as an immediate measure to mitigate the impact of COVID-19 on the sector.
1. RBI should standardise the regulatory treatment of all institutions serving similar customer segments
Regulation must evolve from entity-type regulation to customer-focused regulation. If banks, including small finance banks (SFB), NBFCs, NBFC-MFIs all cater to the same customer base at the bottom of the pyramid, regulations that concern lending to that customer base must apply equally to all. Take, for example, the following differences in the regulatory treatment of NBFC-MFIs and other micro-finance lenders:
To tackle over-indebtedness of micro-finance borrowers, regulation mandates that a customer cannot borrow from more than two NBFC-MFIs. However, banks and SFBs do not have to adhere to this and can lend without restriction to the same customer, becoming the third and fourth lenders to the same customer and often leading to over-indebtedness of the borrower (even if prescribed lending limits may still be adhered to).
To prevent excessive pricing, NBFC-MFIs are subject to a spread cap of 10% over their cost of funds. This provision does not apply to banks who can lend microcredit to the same customer at rates higher than those charged by NBFC-MFIs. For instance, NBFC-MFIs lent at around 20-24% (in the last financial year) while banks lent at 25-26%.
Such differential regulatory treatment distorts the market for micro-finance loans and takes focus away from mitigating risks that Low-Income Households (LIH) face as a result of becoming over-indebted. The RBI should begin by reconsidering the effectiveness of using prescriptions for indebtedness limits and restrictions on the number of microloans at the household level. And then, having arrived at the conclusion that these regulations are ineffective, the RBI should instead consider fixing the credit information infrastructure and mandate lenders to establish processes to assess the actual debt servicing capability of households that feeds into the lending decisions by lenders.
2. RBI should revise the loan-pricing framework applicable to NBFC-MFIs given the increasing divergence between the calculated base rate linked ceiling and the actual cost of funds that NBFC-MFIs bear
In addition to the cap on spread over the cost of funds that is applicable to NBFC-MFIs, they are also subject to a regulatorily guided maximum lending rate. This lending rate is calculated as the lower of 2.75 times the average of the base lending rates of the top five commercial banks in the country and their cost of funds plus a fixed margin.
In the current scenario, banks have seen a significant lowering of their base rates, owing to reduction in repo rates. However, this has not translated into an equivalent reduction in lending rates to NBFC-MFIs. As a result, the maximum lending rates for NBFC-MFIs have dipped to around 23%, whereas the cost of funds for NBFC-MFIs has not moved downwards enough to accommodate the fixed margin spread within 23%. The maximum lending rate for October quarter of 2020 has been set at 22.33% (8.12% * 2.75), further lower than the earlier rate of 23.2%.
Many NBFC-MFIs mostly follow doorstep collections at centre meetings, and have significant costs associated with cash management. These activities considerably increase their operational costs, making it difficult to contain them within the regulatory fixed margin. While this is not a new component of costs in micro-finance, lockdown-related operational challenges have seen increases to this component particularly in order to ensure outreach of the moratorium facility and to shift to digital modes of transactions where such modes were not already in place.
RBI can therefore review the loan-pricing framework applicable on NBFC-MFIs given the increasing divergence between the calculated base rate linked ceiling and the actual cost of funds that NBFC-MFIs are bearing and likely to continue bearing in the medium term.
3. The government should modify the RBI’s special liquidity scheme to include debt of longer tenor
While the moratorium period has ended and the unlock process started, it is not certain that repayment rates would immediately bounce back to pre-COVID-19 levels. While some large NBFC-MFIs have reported that their August/September collections have crossed 90%, this is not uniform across the industry. With many surveys indicating a severe income shock to the already indebted LIH, who are the primary customers of NBFC-MFIs, it is likely that these households will take time to return to their pre-COVID-19 income levels and would thus opt for the restructuring of their debt. Thus, while NBFC-MFIs would have to restructure their assets, they will not get a similar benefit from their lenders. This would put undue strain on their liquidity situation. The current liquidity scheme, with its short window, is inadequate for NBFC-MFIs, especially the smaller entities, to accrue enough cash to meet the outflow on maturity. RBI could instead extend the window for the special liquidity scheme for tenor up to three years, along the lines of the Targeted Long-Term Repo Operations (TLTRO) 2.0. This would give these entities adequate time to resolve their liquidity issues while also freeing up managerial bandwidth to make more strategic shifts in operating models if required to remain competitive.
4. RBI to explicitly mandate that micro-finance credit bureau reporting formats be updated to allow for Credit Information Companies (CIC) to record restructuring of an NBFC-MFI loan
Current regulations on furnishing of credit information to CICs are clear on visibility of the restructured status of consumer and commercial loans. However, there is some ambiguity on visibility to other lenders of the restructured status of micro-finance loans. This could hinder loan growth in the sector. RBI can clarify whether the account status, in case of restructured accounts of micro-finance loans, would be visible to other lenders. This will help to remove any artificial differences in the treatment and transmission of information regarding restructured loan accounts across all categories of loans and boost the reliability of credit information records by lenders across the spectrum.
5. The government needs to accelerate deployment of funds under the Partial Credit Guarantee Scheme (PCGS) for bonds issued by lower-rated NBFC-MFIs and NBFCs
While good progress has been made in the deployment of PCG funding on the balance sheet for NBFCs and NBFC-MFIs in general, there has been a slowdown in deployment since the extension of the scheme to November 2020. Further, given the higher limit allocation permissible to AA/AA- rated investments as per the August 2020 circular, deployment to lower-rated institutions has slowed down more significantly while there is significant credit appetite from such mid-sized and small NBFCs/NBFC-MFIs that have a credit rating of A and below. These institutions, that cater to MSMEs, micro-loan borrowers, farmers and marginal truck drivers are unable to avail this benefit.
6. RBI should incentivise banks to support NBFC-MFIs by allowing debt investments in NBFC-MFIs to count towards Priority Sector Lending (PSL)
Current PSL regulations, while allowing bank loans to NBFC-MFIs to be classified as PSL, do not extend this benefit to banks purchasing debt from NBFC-MFIs. This is an artificial distinction and should be removed. The Committee on Comprehensive Financial Services for Small Businesses and Low Income Households (Chair: Dr. Nachiket Mor, 2013) recommended that investment by banks in bonds of institutions must qualify for PSL where wholesale lending to the same institutions already qualifies under PSL. Implementing this recommendation would also incentivise banks to avail the TLTRO 2.0 and PCGS 2.0 schemes, thereby opening more channels of funding for NBFC-MFIs.
 See Section 2.1 COVID-19 and the Debt Moratorium – The Case of Microcredit, Dvara Research (2020). Accessible here – https://www.dvara.com/blog/2020/09/28/covid-19-and-debt-moratorium-the-case-of-microcredit/
 See ‘A Practical Note on Operationalising Suitability in Microcredit’, Deepti George, Dvara Research, February 2019, accessible at: https://www.dvara.com/research/wp-content/uploads/2019/02/Operationalising-Suitability-in-Microcredit.pdf
 See Section 2.C.a Master Circular- ‘Non-Banking Financial Company-Micro Finance Institutions’ (NBFC-MFIs) – Directions, RBI 2016 – https://www.rbi.org.in/Scripts/BS_ViewMasCirculardetails.aspx?id=9827
 See Special liquidity scheme for NBFCs/HFCs, RBI – https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11925&Mode=0 . This scheme seeks to improve the liquidity position of NBFCs/HFCs by purchasing short term papers from eligible entities, who shall utilise the proceeds under this scheme solely for the purpose of extinguishing existing liabilities.
 As gleaned from conversations with practitioners.
 COVID-19 Impact on Daily Life, Dvara Research- https://www.dvara.com/research/social-protection-initiative/covid-19-impact-on-daily-life/
 See RBI’s circular on Data Format for Furnishing of Credit Information to Credit Information Companies and other Regulatory Measures, accessible at: https://www.rbi.org.in/SCRIPTs/BS_CircularIndexDisplay.aspx?Id=9932
This circular mandates CICs to modify their reporting format to include an account status reflecting restructuring of loans. However, this circular is applicable only to banks.
 RBI’s circular on Issue of comprehensive Credit Information Reports, accessible at: https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11077&Mode=0
While this circular instructs CICs to furnish all credit information in all modules, it is generally understood that CICs are still providing this information only for specific modules.
 See ‘Pass-Through of Loan-Restructuring Information: Micro-finance Loans and Credit Bureau Records’, Dwijaraj Bhattacharya & Deepti George, Dvara Blog, October 28, 2020, accessible at: https://www.dvara.com/blog/2020/10/28/pass-through-of-loan-restructuring-information-micro-finance-loans-and-credit-bureau-records/
 See Section 21 of Master Directions – Priority Sector Lending (PSL) – Targets and Classification, RBI 2020 – https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=11959#MFI_On_lending