The Reserve Bank of India (RBI) released a Consultative Document on Regulation of Microfinance in June 2021 for public comments. It includes an overview of the microfinance sector in India and the developments it has witnessed over the past two decades. The consultative document notes that the regulatory framework for microfinance is currently applicable to only Non-banking Financial Companies – Microfinance Institutions (NBFC-MFIs) constituting only 30% of the microfinance portfolio, increasingly exposing microfinance borrowers to multiple lending, over-indebtedness, and coercive recovery practices. It also observes that the present pricing cap for microfinance loans extended by NBFC-MFIs has hindered competition in the sector, created a non-level playing field, and compromised customer protection. It places the need for a review of the current regulatory framework in the context of these issues and proposes a new framework to be made applicable to all regulated entities (REs) in the sector.
The proposed framework marks a significant departure from the current approach to regulating the microfinance sector which has restrictions on pricing, loan amount per cycle, indebtedness levels, and the number of NBFC-MFIs that can lend to a borrower. These restrictions are applicable to only NBFC-MFIs although there are other entities, both regulated and unregulated by the RBI, that provide micro-credit. To address concerns of over-indebtedness, it proposes to remove these restrictions and instead require lenders to lend within the prescribed debt-to-income limit of 50% assessed at a household level. To enable competition within the sector and bring down the lending rates, it proposes to remove the cap and instead requires lenders to have a board-approved policy in place to guide their pricing, to adhere to fair-practices code to ensure disclosure and transparency of interest rates, and to introduce a simplified fact-sheet to be made available to prospective borrowers.
In this blog post, we present a summary of our response to the consultative document. We observe that the new framework continues with a prescriptive approach to addressing over-indebtedness as it proposes to replace the current indebtedness limit of Rs. 125,000 per borrower with a 50% debt-to-income limit (considering all debt) at a household level. This raises concerns around continued lending-to-limit behaviour by lenders with no primary responsibility being placed on them to ensure repayment capacity of the borrower household. Additionally, we find the 50% threshold to be too high and unsustainable for low-income households (LIHs) as defined by the RBI. However, we note that this is an improvement over the current regulations under which a LIH could be indebted even to the extent of 100% of their income depending on the number of eligible borrowers in the household. While the new framework is proposed to be made applicable to all REs, not-for-profit entities, with the exception of Section 8 companies to a limited extent, have been left outside RBI’s regulatory ambit. We also find that conduct obligations have not been uniformly applied to all REs and the regulations which are aimed at addressing over-indebtedness are applicable to only microfinance loans. These inconsistencies raise concerns on whether the new framework can be effective in protecting LIHs from over-indebtedness and in ensuring suitable outcomes.
To address the above gaps, we make the following recommendations in our response –
Measures to address over-indebtedness of low-income households
Any measure aimed at addressing concerns of over-indebtedness for LIHs, including the requirement to assess household-level income and debt, should be made applicable to all loans extended by REs to the segment. These include microfinance loans or other retail credit and secured and unsecured loans.
RBI should clarify the reasoning behind the proposed 50% debt-to-income limit to facilitate further discussion. A possible alternative could be to define a ‘debt-to-disposable income’ threshold which would be a better indicator for debt serviceability than gross income. Disposable income here would be net of routine expenses, including debt repayments, and a liquidity buffer. RBI should also require all REs to – 1) have a board-approved policy in place detailing the circumstances under which a prescribed debt-to-disposable income threshold can be exceeded, and 2) publicly disclose on a yearly basis its loan portfolio across different ‘debt-to-disposable income’ bins, including the proportion of the borrowers who fall outside the prescribed debt-to-disposable income threshold.
Since the feature of equated instalments seems to have been kept away from the definition of microfinance loans (as defined in the consultative document), RBI should clarify whether all unsecured loans lent to LIHs would fall under the ambit of microfinance loans.
RBI should clarify whether, at the point of sale, REs are required to ensure adherence to the 50% debt-to-income/ debt-to-disposable income limit on an annual basis or for each instalment of the repayments.
Applicability of conduct obligations
Conduct obligations, through Fair Practices Code of RBI or Codes of Conduct of Self-Regulatory Organisations (SRO), should be applied uniformly across all REs to ensure LIHs experience the same level of institutional conduct regardless of the type of RE they approach for their credit needs.
RBI should rationalise the distinction between guidelines contained in the main regulations and those in the FPCs. It should also provide clarity on how it intends to hold REs accountable for violation of conduct obligations.
Use of information with Credit Information Companies
RBI should track whether comprehensive credit information reports are made available to all REs at affordable prices and that the use of such comprehensive reports are becoming industry practice.
Regulation of not-for-profit microfinance institutions (MFIs)
RBI should consider whether not-for-profit MFIs, including Section 8 companies and trusts, which undertake financial activity as their primary business (or, in other words, pass the 50-50 test) should be brought within its regulatory ambit. RBI can consider applying on the not-for-profit MFIs, the scale-based approach to regulating the NBFC sector. Given their small size, not-for-profit MFIs would have to meet only the minimum Net Owned Fund (NOF) criterion and adhere to limited supervisory reporting pertaining to their capital position, credit concentration and other details of the portfolio that allow the RBI to oversee the health of the credit markets. Regardless of whether not-for-profit MFIs pass the 50-50 test, RBI should require them to adhere to the conduct guidelines as well as those intended at addressing over-indebtedness of LIHs.
Revisit the need for a separate NBFC-MFI license
Given the harmonisation of the regulations applicable to the microfinance sector across all REs and the proposal to move towards a scale-based approach to regulating the NBFC sector, RBI should consider phasing out the separate license that exists for NBFC-MFIs. Alternatively, all non-deposit taking NBFCs, regardless of the type of loan product they offer, should be regulated and supervised based on their asset-size, and for those beyond Rs. 5000 crore in asset size, based on their systemic significance.
The current cap on the microfinance loan portfolio, at not more than 10% of the total assets, applicable to non-MFI NBFCs, can be removed with phasing out of NBFC-MFI license.
The current distinction between loans provided to NBFC-MFIs and other NBFCs for on-lending to individuals/ members of SHGs or JLGs should be removed to ensure that bank loans to all NBFCs qualify for PSL credit as long as they have been established to be reaching the intended borrower segment.
Guidelines on pricing
With removal of price cap, RBI should continue to remain vigilant of any potential cartelisation among the existing lenders, specifically in regions which are served by one or very few microfinance lenders, which might keep interest rates at very high levels.
RBI should encourage microfinance lenders to employ risk-based pricing models in which cost components such as provision for expected losses are linked to individual customer level risk, to ensure borrowers who have built a clean credit history over a number of loan cycles are able to access loans at lower interest rates.
While RBI already allows banks to co-lend with NBFCs, with the removal of the price cap, it should encourage and incentivise NBFCs in the business of providing loans to LIHs to further employ these arrangements. This can help bring down the pricing for LIHs through reduced lower cost of funds from banks for NBFCs.
The cost of insurance, which is currently one of the components of pricing of microfinance loans, today mostly includes cost of credit life insurance for lenders. This should not be charged to the borrowers as no claim pay-out benefits accrue to the borrower family upon the borrower’s death, but is instead, a portfolio cover to bring down the loss given default for lenders.
For more transparency and better-informed decision making by the borrower, the simplified factsheet should also include information on the method used for interest rate calculation, i.e., whether flat or declining balance. Contingent charges such as pre-payment penalty and penalty for delayed payment should also be included in the simplified factsheet regardless of whether they are levied or not.
Move towards a modernised regulatory regime for retail lending
RBI should consider moving away from the current prescriptive approach to regulating the microfinance sector to a regulatory regime which places emphasis on responsible lending by all providers to ensure customer protection and suitability in credit. The proposed regime would require lenders to put in place processes to collect necessary information on the borrower households’ income, expense, and debt flows and carry out cashflow based underwriting based on such information to arrive at the repayment capacity. Such an assessment must differ based on whether a loan is being availed for consumption smoothing or for productive investment. For example, when a microfinance loan is proposed to be used for the latter, such as for setting up a new business or expanding an existing one, the new cashflows must be used to assess repayment capacity.
Given the cost considerations in putting in place the required frontline capacity, technical skills, and IT infrastructure, RBI can consider implementing this in phases, and lenders can be allowed to choose from different sophistication levels to build their organisational capacity depending on their operational realities. RBI should also articulate an overarching set of principles for how suitability in credit should be necessarily upheld by providers in serving LIHs. Such articulation should go beyond just microfinance loans and include principles to be considered by providers in extending any type of retail credit to LIHs, including collateralised loans, loans for productive activities, and those for consumption.
The full response is available here.