There is a crisis in the micro-finance sector every few years. The same allegations on micro-finance institutions (MFIs) surface each time: excessive interest rates; resorting to coercive recovery practices and multiple lending.
The response of the MFIs is also to put the self-regulatory organisations (SRO) – Sa-Dhan and M-Fin at the forefront and assure that fair practices would be followed through the SRO. However, this promise is not long lasting and the players slip back when the crisis is over. Like the Andhra Pradesh government did in 2010, the Karnataka government has also promulgated an ordinance on February 12 this year to address the issue.
But will it address the problem adequately?
The problem of plenty
The MFIs lend to joint liability groups of women (only). The concept of joint liability is conveyed during group meetings through prayers and oaths. This is also reinforced during collection meetings held in the open and the message, that there is no tolerance for default, is conveyed repeatedly. With this structure in place, the MFIs give loans easily without much of an assessment.
The task of assessment is outsourced to the borrower herself. Before borrowing, she will have to think if she will be able to pay the installments on time. Such a self-assessment is not objective; the borrower may be lulled into believing that she would be able to repay and there is no check on the belief.
This model works if the loan amounts are small. With the MFI interest rates ranging from 20% to 30% per annum, it is possible to service a small loan, but as the loan tenor and the amounts increase, it becomes unsustainable. This is when the interest rates start biting.
Each MFI has its risk appetite and limits its exposure to a certain amount per borrower. However, there is a problem – even if an MFI rejects a client, the next MFI might be willing to risk exposure with them. Easy access to credit provided by these MFIs is the source of the crisis.
RBI’s regulatory architecture
In 2010, following the Andhra Pradesh micro-finance crisis, RBI set up the Malegam Committee to examine issues pertaining to micro-finance. The committee’s report was accepted and several recommendations were implemented in 2011. The spirit of those recommendations is still being followed.
These regulations require MFIs to be registered with RBI; they should upload the loan details of individual customers to the recognised credit bureaus. This process captures the indebtedness of the MFI borrower from multiple sources.
As per current regulations, micro-finance loans are to be given to families having an annual income of less than Rs 3 Lakh; the installment amounts should not exceed 50% of the borrower’s monthly income; total indebtedness (from all sources) of the borrower should not exceed Rs 3 Lakhs; the interest rates must be clear, transparent and in local language; no other hidden charges should be levied; and they should follow fair practices to recover the amounts.
The self regulatory organisations Sa-Dhan and M-Fin will be the appellate institutions in case of violations. While these regulations recognise the current practices, they are not sufficient. There is no science in determining the limits as there are data limitations.
When the first set of guidelines were released in 2011, the upper limit of income to recognise a micro-finance loan in rural areas was Rs. 60,000. This has now increased to Rs 3 lakhs. The total indebtedness limit too increased from Rs 50,000 to Rs 3 lakhs. Both these changes represent a 5 and a 6-fold increase respectively, without much justification. The incomes of the clients have not gone up by this magnitude. As the model outsources the appraisal process to borrowers themselves, the external limits must be more stringent to prevent customers from walking into an unserviceable loan.
For data, the RBI can mandate organisations under its control to upload loan data to the credit bureaus. But there are several institutions that do not fall under the RBI regulation. The borrowings of MFI customers from these sources is recorded.
The limitations of the ordinance
While the current ordinance may have laudable objectives, it does not serve the intended purpose as it rightly excludes RBI controlled entities from its purview. The ordinance enables the state to collect data but it does not have the architecture to process or act on it. The ordinance will only harm the genuine organisations and provide temporary reprieve to borrowers by allowing them to default. It is not a lasting solution for the sector.
What can the government do?
The government must think differently. It needs to have adequate structures to achieve the objectives enunciated in the ordinance. The same expert committee set up to consider the formation of Kerala Bank had also suggested the formation of a state level financial sector regulatory authority. This idea was proposed by former RBI governor Y.V. Reddy during the consultations.
While the Kerala government did not implement the recommendation, it can pick it up now and get all organisations outside RBI’s purview – like cooperatives, societies, trusts, self-help groups, chit funds and moneylenders – under this authority.
This authority can direct all agencies to upload data to the bureaus, filling the remaining gaps. The annual returns filed by various entities and their business practices could be used to make informed policy and regulatory decisions. This will provide the institutional structure to achieve the objectives set out in the ordinance. The current band-aid is not going to fundamentally help the sector and will only increase the defaults. The current model of micro-finance is broken. It needs to be reimagined.
The piece was originally published in Kannada in Prajavani dated February 15 2025.
M.S. Sriram is a Professor at the Centre for Public Policy, Indian Institute of Management Bangalore.
