micro finance ibr paper

8/3/2019 Micro Finance IBR Paper

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WHEN MORE MONEY IS NOT THE ANSWER. An Analysis of Indias

Microfinance Crisis and the Need for Comprehensive Regulation.Meena Aharam

International Banking Regulation, Spring 2011

TableofContents

I. IntroductiontoMicrofinance..........................................................................................3

A. Differentiating the Innovative Features of Microcredit.......................................................4

B. Inherent Challenges of Microcredit..........................................................................................7

II. INDIASMICROFINANCECRISIS.....................................................................................8

A. Background to the Crisis............................................................................................................9

B. Existing Regulatory Framework.............................................................................................11

C. Commercialization of MFIs The Case of SKS Microfinance.........................................13

D. Implementation of Andhra Pradesh Ordinance and the Collapse of the Microfinance

Bubble....................................................................................................................................................15

III. IndiasProposedMicroFinancingDevelopmentBill.........................................17

A. Deficiencies of the Proposed 2007 Bill....................................................................................18

1. Scope should include all operating MFIs......... .......... .......... ......... .......... ......... .......... .......... ......... ...18

2. MFIs should be exempt from interest rate caps in order to operate effectively....... ........ ...20

3. NABARD would face conflicting interests as both a service provider and industry

regulator............ .......... ......... .......... .......... ......... .......... ......... .......... .......... ......... .......... ......... .......... .......... ......... ...21

4. Uniform prudential requirements should be applied across all microfinance

organizations......... ......... .......... .......... ......... .......... .......... ......... .......... ......... .......... .......... ......... .......... ......... ........22

B. Looking forward to the 2010 Revision of the MFI Bill .......................................................24

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


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The practice of lending and making loans dates back thousands of years, from

rudimentary bartering systems and more modernly to capital markets to be accessed from

commercial banks

1

. At its earliest conception, lending was perceived to be a charitable act

of helping a neighbor by temporarily providing something that they were not otherwise

able to procure. To profit off of this act was deemed as usury and immoral as the lender

was considered parasitic on the borrower2. Lending combined with capitalism resulted in

the dramatic growth of the banking industry. The practice has created a wealth of

opportunities, such as creating money by lending out deposits to companies and

individuals that would invest into their futures. In addition to the creation of opportunities,

lending is a highly lucrative practice for the banking industry which at times has

provided poor incentives of deregulation in a highly volatile industry.

Perhaps as a return back to the original concept of charitable lending,

microfinancing has been devised as a tool to reach out to the poor who would be otherwise

excluded from mainstream loans. However, in order for microfinancing to be sustainable

the desire to assist the poorest communities must be balanced with profitability,

responsible lending, and the development of systems to encourage repayment. Another

danger that plagues the microfinance industry is the greed that often accompanies targeting

a vulnerable population such as the poor. This note will examine the microcredit crisis that

occurred in Andhra Pradesh, India; specifically how the lack of regulatory framework and

1Yaron Brook, The Morality of Moneylending: A Short History, The Objective Standard, Vol. 2,

No. 3 (Fall 2007). Available at: http://www.theobjectivestandard.com/issues/2007-fall/morality-of-

moneylending.asp

2Id. (Describing Aristotles views in his first book onPolitics and his argument for why charginginterest on money is considered immoral.)


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predatory lending led to financial crisis. In examining the India microcredit crisis, this

note will examine the proposed Micro Finance Development and Regulation Bill that was

presented in 2007 to Indias legislative body, and compare international regulatory

schemes, and finally make recommendations on how India can adopt international

microfinance regulatory principles into the bill so that a future crisis may be averted.

I. Introduction to MicrofinanceMicrofinancing is an umbrella that covers a multitude of financial services that are

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

particular, microfinancing provides benefits to poor women allowing them to be more

independent and productive members of their communities3. The basic concept of

microfinancing is to provide basic financial services to the poor who have little or no

collateral in an effort to allow them to break the cycle of poverty. Included under

microfinancing are: microcredit, microsaving, and microinsurance4. Examples of financial

services are micro-lending for those with no collateral, and micro-insurance policies that

would allow the poor access to health insurance and life insurance policies.

The microfinance revolution has been credited to Mohammed Yonus (Yonus) who

recently won the Nobel Peace Prize in 2006 for his efforts with the Grameen Foundation5.

3Grameen Bank states that of the 8.35 million borrowers, 97% are women. http://www.grameen-

info.org/index.php?option=com_content&task=view&id=26&Itemid=175

4Defining the scope of microfinance.

http://www.microfinancegateway.org/p/site/m/template.rc/1.26.9183/ [hereinaftermicrofinance

gateway FAQ]

5Seehttp://www.grameen-

info.org/index.php?option=com_content&task=view&id=329&Itemid=363 [hereinafterYonusBiography] (Yonus is a Bengali economics professor who in 1983 founded Grameen Bank. His


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Yonus has declared that microcredit should be considered a human right from which the

poor should be given priority6. The U.N. officially vocalized support for the use of

microcredit in order combat poverty and encourages other NGOs to provide microcredit

services7. As a result, numerous microfinancing institutions (MFIs) have been established

all over the world reaching over 152 million clients8. In conjunction with loaning money

to poor individuals, CGAP and Grameen have emphasized the importance of teaching

clients how to save while using money in a productive manner9.

A. Differentiating the Innovative Features of MicrocreditMicrocredit is a subcategory of microfinance that provides small-scale loans to

persons who would otherwise not qualify for a commercial loan due to lack of collateral10.

Collateral in normal commercial loans is essential because it: 1) indicates to the bank the

customers ability to re-pay, 2) it creates an incentive for borrowers to re-pay11

, and 3) it

protects the bank from loss in the event of customer default. Microcredit has addressed the

work with Grameen and in growing microcredit to numerous countries has won him countless

awards.)

6Seehttp://www.grameen-

info.org/index.php?option=com_content&task=view&id=28&Itemid=108 [hereinafter Grameen

credit features]

7U.N. General Assembly Res. 52/194 (Dec. 1997),seehttp://www.grameen-


8Estimation from Consultative Group to Assist the Poor (CGAP). CGAP was authorized by and is

an offshoot of the World Bank. See http://www.cgap.org/p/site/c/template.rc/1.11.1792/

9CGAP Key Principles of Microfinance availableat

http://www.cgap.org/p/site/c/template.rc/1.9.2747/

10Collateral in a most basic sense gives a lender a right to an asset until repayment is complete.

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


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first two necessities for collateral with innovative solutions. First, rather than valuing a

loan based on an asset such as a house, microcredit views the asset to be a persons

inherent potential to productively use the money to grow crops or make other goods that

may be sold12. This concept is comparable to a student loan which is not secured to

customer assets and instead repayment is based on potential future earning power. Second,

microcredit has created a powerful incentive system for borrowers by relying on social

lending in combination with access to future loans. Social lending is accomplished by

considering an entire village as a re-payment group. If loans are made to community

members who miss loan repayments, then future loans will not be made to the entire

community. This creates a powerful social responsibility among village members who

know that they may jeopardize not only their own possibilities for future loans, but also the

future of the entire community13.

These approaches have resulted in widely successful loan repayment percentages

near 97%14. Additional factors that contribute to high levels of repayment include: small

loan amounts, disciplined and short repayment requirements, and the participatory nature

of many micro-lending schemes15. Loan amounts rarely exceed the equivalent of USD

12 Is Grameen Different, January 2011see http://www.grameen-


13 Grameen Bank: Credit Delivery System, available athttp://www.grameen-info.org/index.php?option=com_content&task=view&id=42&Itemid=92 [hereinafterGrameen

Credit Delivery] (Describing the methodology of Grameen managers developing a system of trustamongst villagers. Managers are assigned to only one village and work closely with eligibleclients.)

14Reported by Grameen Bank. Grameen Bank at a Glance, January 2011 available at

http://www.grameen-info.org/index.php?option=com_content&task=view&id=26&Itemid=175

15The Secretary-General,Role of Microcredit in the Eradication of Poverty, 11-12, delivered to

the General Assembly, U.N. Doc. A/53/223 (Aug. 10 1998), available at


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$1000, and often are made for less than $100 depending on the needs ability of the

customer16. These small loans require weekly payments and usually require full repayment

within a year17. Discipline is a key component to the system and is instilled by community

managers who develop relationships with villagers while encouraging repayment, saving,

and continued development. The close participatory and community nature of micro-

lending has been credited with providing support for borrowers as well as the

aforementioned community pressure to re-pay. Community pressure has been created in

various ways; Grameen, for instance, has pioneered a system where a given communitys

ability to receive more loans is affected by current citizens outstanding loan obligations.

Another popular method was established by the National Bank for Agriculture and Rural

Development (NABARD) based in India, which links self-help groups18 to commercial

banks based on capital that has been collectively saved by the group19.

Another notable microcredit approach has been person-person lending. This

concept was introduced by Kiva as crowd source capital and harnesses the Internet to

bring together people from all over the world. Crowd source capital allow private

http://www.un.org/documents/ga/docs/53/plenary/a53-223.htm [hereinafterU.N. Report onMicrocredit]

16Is Grameen Different,supra note 7.

17Id.

18Self-Help Groups (SHGs) are community pooling of capital in order to secure a loan that will be

invested into community microenterprises. This system has been widely successful since itsintroduction in India, and is the most common way for MFIs to reach clients in India.

19This system has been widely used in India and has expanded the microcredit operations

particularly in the state of Andhra Pradesh. K.C. Badatya, BB Wadavi, Ananthi S, Evaluation

Study Series, NBARD, Microfinance for Microenterprises, An Impact Evaluation Study of Self

Help Groups (2006), http://www.microfinancegateway.org/gm/document-1.9.30422/48.pdf[hereinafterEvaluation Study of SHGs]


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individuals to make small loans (usually between $25-$300) to entrepreneurs of their

choice20. The idea is to pay it forward and loans are not made with the intention of

making a profit. Rather, people from around the world charitably contribute in a way that

empowers the poor to develop financial responsibility while creating a better future. This

approach boasts a repayment percentage of 98%21

with repaid loans often resulting in re-

investment in a new entrepreneur. Institutions such as Kiva are able to partner with

existing MFIs, which allows their lenders to disburse funds to loan requests22.

B. Inherent Challenges of MicrocreditDespite successes and affirmations that microcredit is a powerful tool to combat

poverty, it is important to consider the sustainability of lenders in evaluating microcredit

effectiveness. Challenges that threaten the sustainability of an MFI include high risk of

loan default and dis-economies of scale. To combat these challenges, MFIs must create

systems that issue loans efficiently, encourage re-payment, and charge interest to cover

administrative costs. In an effort to create a sustainable organization MFIs have taken

various approaches such as loan usage limitations and risk-adjusted interest rates. The

most common loan usage limitation requires borrowers to use loans for income-generating

activities in order to encourage repayment, however critics of this approach argue that the

poor should be given access to funds for all purposes23.

20 Investors may browse websites such as Kiva.org to select potential borrowers.

21Kiva: Facts, http://www.kiva.org/about/facts

22How Kiva Works, http://www.kiva.org/about/how

23U.N. Report on Microcredit,supra note 10, at 18. (Comparing income-generating approach to

minimalist approach. The counter-argument to the minimalist approach is that there are other

government programs that are available for the poor to access funds to pay for necessary costs suchas medical bills, funerals, household expenses etc)


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The risk-adjusted interest approach is also a widely used tool that is reinforced by

CGAP as essential to continue the long-term sustainability of MFIs to support the needs of

borrowers 24 . Recently, Yonus addressed the issue of interest rate premiums 25 by

categorizing premiums into green, yellow, and red zones26. Yonus describes the Green

Zone to be poverty focused microcredit programs while the Red Zone27

signifies profit-

maximizing MFIs. Using this evaluation method it can be concluded that although rate

ceilings should not be imposed, MFIs should evaluate the purpose of their operation while

engaging in efficient lending to cut down on operating costs28.

II. INDIAS MICROFINANCE CRISISIn October of 2010, the Indian state of Andhra Pradesh issued an ordinance aimed

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

24CGAP Key Principles of Microfinance,supra note 8, at 7. (Discussing how interest rate

ceilings are harmful to poor peoples ability to borrow due to unsustainable costs incurred byMFIs.)

25 Interest rate premium is defined as the difference between the rates charged by the MFI to theborrower and the cost of funds at the market rate paid by the MFI. Adrian Gonzalez, AnalyzingMicrocredit Interest Rates, Microfinance Information Exchange (March 2010).Available at

http://www.themix.org/publications/mix-microfinance-world/2010/03/analyzing-microcredit-

interest-rates-review-methodology- [hereinafterAnalyzing Microcredit Interest Rates]

26Analyzing Microcredit Interest Rates,supra note 16, at 1. (The Green Zone consists of interest

rate premiums (IRP) below 10 percentage points, Yellow Zone consists of IRPs below 15

percentage points, and the Red Zone consists of IRPs above 15 percentage points.)

27Id. Red Zone MFIs are also characterized by Yonus to be commercial enterprises whose main

objective appears to be earning large profits for shareholders or other investors. Loan sharks

would fall into this category of lending.

28Grameen Credit Delivery System,supra note 12. Operating costs of MFIs are often quite high

due to the administrative burdens of providing small loans as opposed to large loans. Yonuscontends that it is important for clients to meet explicit criteria in order to preserve MFI resources.

29Rama Lakshmi,India takes aim at abuse of innovative microcredit model, Washington Post,

Nov. 26, 2010. (Describing the cause of dozens of rural farmer suicides that are attributed to theshame and harassment of non-payment.)


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include predatory lending practices and harassment for non-payment, are being blamed for

more than 50 suicides30. The ordinance requires all MFIs to cease lending and collecting

on debts until they register with local officials31. Despite the best intentions of protecting

impoverished consumers, this ordinance is being blamed for the microfinance crisis that is

currently gripping India. The arguable cause rests is that the order to stop disbursing new

loans has killed the important incentive for consumers to continue with required weekly re-

payments32. As a result default on loans, which was less than 2% prior to the ordinance, is

now over 50%. India is currently considering regulatory legislation to re-instill confidence

in MFIs companies and to ensure that future lending abuses do not occur

33

.

A. Background to the CrisisIndia historically carries an impoverished class of citizens that currently accounts

for 41% of its one billion citizens34

. These citizens survive on USD $1.25 a day and often

live in areas where there is little to no infrastructure35. Given the staggering number of

30Id.

31David Roodman,Backgrounder on Indias Microfinance Crisis , Center for Global Development

(November 2010), available athttp://blogs.cgdev.org/open_book/2010/11/qa-on-indias-microfinance-crisis.php.

32Grameen Credit Delivery System,supra note 12. Weekly payments of loans are required under

the Grameen scheme for customers to receive future funds. This aspect of the Grameen plan was

considered crucial part of the high repayment rates.

33NABARD seeks feedback on Microfinance Regulation draft, Microfinance Focus, (Feb. 22,

2010), http://www.microfinancefocus.com/news/2010/02/22/nabard-seeks-feedback-on-microfinance-regulation-draft/

34Revised Poverty Estimates, What does it Mean for India?,

http://go.worldbank.org/CG39MFTA90

35Id.


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persons that would be ideal candidates for microcredit loans, there can be little surprise at

the growth rate of MFIs in India36.

Following the success experienced by Grameen Bank in Bangladesh, India began

following a similar formula of providing microcredit through group lending. The concept

of microcredit and empowering the poor in India originally began in 1992 with the

NABARD approach called the Self Help Group-Bank Linkage (SHG) program which

encouraged communities to begin saving what they could so that they could collectively

apply for loans through commercial banks37. The goal of these loans was to allow the

community to create microenterprises that would further develop and benefit the village.

This initiative proved successful especially at organizing women who were otherwise

unable to contribute. Consequently, small NGO MFIs began flourishing in India due to

lesser restrictions and oversight of smaller entities38.

Companies such as Swayam Krushi Sangam (SKS) Microfinance were founded as

NGOs in the late nineties initially reaching out to a modest 11,000 borrowers by 200339.

However, after changing to a Non-Bank Finance Company (NBFC) within 7 years this

36As of 2008, the World Bank estimates that 87% of Indias poor does not have access to formal

credit sources. Informal credit sources often charge interest rates of 48%-120% while MFIs chargeinterest rates between 15%-30%. William Langer, The Role of Private Sector Investment in

International Microfinance and Implications of Domestic Regulatory Environments, 5 B.Y.U. IntlL. & Mgmt. Rev. 1, 53 (2008).

37Evaluation Study of Self Help Groups,supra note 13, at 15.

38 However, NGO MFIs found difficulties in raising capital due to restrictions on deposit taking.Greg Chen, Stephen Rasmussen, Xavier Reille, & Daniel Rozas,India Microfinance Goes Public :The SKS Initial Public Offering, CGAP Focus Note No. 65 (Sept. 2010), available at,http://www.cgap.org/gm/document-1.9.47613/FN65_Rev.pdf. [hereinafterSKS IPO]

39David Roodman,Backgrounder on Indias Microfinance Crisis , Center for Global Development

(November 2010), available athttp://blogs.cgdev.org/open_book/2010/11/qa-on-indias-microfinance-crisis.php.


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number swelled to over 5.8 million borrowers at the end of 2010. This fast growth is

blamed for creating a microfinance bubble in India that inevitably crashed in late 201040.

Indias growth and the resulting crisis can be contrasted from the success in Bangladesh

for several factors such as a lack of regulation and the commercialization of the

microcredit sector41

.

B. Existing Regulatory FrameworkIndias lack of specific microfinance regulations was a major contributing factor to

the 2010 crisis. The minimum regulations in place oversaw the various forms of entities

that may operate as an MFI in India. MFIs have taken both not for profit and for-profit

forms with the biggest different between them being that for-profit models are regulated by

the Reserve Bank of India (RBI) and are allowed to take deposits. Thus far, non-profit

MFIs are not subject to regulations so long as they do not engage in depositing taking. The

most common forms of MFIs in India are: NGOs42 , Societies and Trusts 43 , and

40A bubble is defined as divergence of asset valuation with its true value. In India, success was

measured on by the number of people serviced by microcredit rather than focusing on creditexposure and the repayment capability of loan recipients. Vijay Mahajan & P N Vasudevan,

Microfinance in India: Twin Steps Towards Regulation, Microfinance Focus (Jan. 10 2010),

http://www.microfinancefocus.com/news/2010/01/10/microfinance-in-india-twin-steps-towards-

self-regulation-3/

41David Rooman, Understanding Indias Microcredit Crisis, AID Watch (November 2010),

available athttp://aidwatchers.com/2010/11/understanding-india%E2%80%99s-microcredit-crisis/

42Governed by the Societies Registration Act (1860)

43 Governed by the Indian Trusts Act (1882)


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

Companies44, and Non-Banking Finance Companies (NBFCs)45.

The National Bank for Agriculture and Rural Development (NABARD) was

created in 1982 as an apex development bank46 and set to take on a coordinative role

between the Indian Government, State Governments, and the RBI. NABARD additionally

has been tasked with improving absorptive capacity of the credit delivery system,

including monitoring, formulation of rehabilitation schemes, restructuring of credit

institutions, training of personnel, etc. 47 NABARD is credited with creating the

innovative SHG linkage-system providing loans through MFIs

48

.

Beyond regulations governing the structure of entities that may operate as MFIs, no

uniform oversight exists to provide prudential guidance (capital adequacy, loan limitations,

etc), nor interest rate controls to ensure that usury interest rates are not charged49. The

only areas that the RBI does provide specific oversight are deposit-taking institutes. The

44These special companies are able to operate as LLCs but are treated as non-profits therefore

foregoing onerous regulations. Section 25 of the Companies Act governs them. Langer, supranote 36, at 58.

45Until recently, NBFCs had limited oversight and were not required to register with the RBI.

However, they are now required to register with the RBI and non-deposit taking NBFCs maintain acapital adequacy ratio of 12%. Langer,supra note 36, at 57.

46

Apex development bank signifies the bank taking on a coordination role between the federalgovernment, state governments, and rural lending banks. Available at,

http://www.nabard.org/introduction.asp

47See generally, http://www.nabard.org/nabardrolefunct/nabardrole&functions.asp

48Evaluation Study of SHGs,supra note 14.

49Langer,supra note 36, at 64-5.


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inability of MFIs to gain equity through deposits has inspired several MFIs to transfer from

an NGO into a non-deposit taking NBFC in order to gain foreign investment50.

C. Commercialization of MFIs The Case of SKS MicrofinanceSKS Microfinance was originally founded as a non-profit in 1998 and was praised

as a model MFI until its IPO in July of 201051. In 2005 SKS Founder, Vikram Akula,

began implementing a for-profit MFI model in order to secure overseas investments52.

Akula changed SKS Societies to SKS Microfinance and took it from operating as an

NGO to a non-deposit taking NBFC. At this time SKSs portfolio consisted of standard

group based loans (85%), micro-insurance policies, and small supplemental loans53.

50 SKS IPO,supra note 32, at 2.

51Shloka Nath, The Indian Microfinance Lending Machine, Forbes India (Oct. 28, 2010), available

athttp://business.in.com/article/boardroom/the-indian-microfinance-lending-machine/18502/1

52SKS followed in the footsteps of Banco Compartamos which went public in 2007.



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By changing into a NBFC, SKS was able to draw commercial venture capital from

outside India to fuel growth with matching profitability. The switch from non-profit to a

for-profit model required the creation of Mutual Benefit Trusts (MBTs), which acquired

SKS assets prior to the shift to a NBFC. These MBTs named SKS clients as the

beneficiaries and were able to inject additional equity into SKS54

. After four rounds of

equity financing spanning 2006-2009, SKS was able to raise over USD$125 million in

private equity55. Since the initial investments, SKS has moved from being a 90% locally

owned enterprise to having a 72% commercial ownership prior to the 2010 IPO 56. This

influx of capital allowed SKS to aggressively expand to the rest of India reaching more

than 7.3 million women57

. By the end of 2009, prior to the IPO, SKS had a net worth of

over Rs. 1,016 crore (need to find dollar conversion)58.

In July of 2010, SKS Microfinance went public with a 10.3% interest being issued

on the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). The IPO was

hugely successful with new capital of USD $155 million being raised and a valuation 40

times greater than its fiscal year 2010 earnings. This high valuation exceeds the valuation

of Indias best performing banks and quickly raised concerns that the company was being

overvalued. However, these fears were allayed because SKS was relatively less leveraged

compared to other MFI-NBFCs in India59.

54Id. at 5.

55Id. at 7.


57Nath,supra note 42, at 1.

58Id.

59SKS IPO,supra note 32, at 9.


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Akula claimed that the switch from non-profit to profit-making would be beneficial

to the poor as it allowed for greater penetration of services to the impoverished 60.

However, the change created a stark change in culture resulting in the 2,200 branches

throughout India competing for loans. This aggressive competition led to irresponsible

lending practices with loans being disbursed without checking the ability of or other

financial responsibilities of clients. These predatory lending practices were followed by

default of many borrowers and the subsequent harassment by SKS employees to villagers.

Allegations of physical threats and verbal abuse to villagers were very prominent during

this time, and is deemed to be the cause of the rash of suicides experienced prior to the

introduction of the ordinance61.

D. Implementation of Andhra Pradesh Ordinance and the Collapseof the Microfinance Bubble

On October 15, 2010, shortly after reports of dozens of suicides resulting from

harassment for non-payment, the southern state of Andhra Pradesh (AP) issued an

60SKS IPO,supra note 32, at 3.

61 Nath,supra note 42, at 2.


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ordinance directed at curbing the abuses against clients62. The ordinance called for: the

immediate cessation of disbursing and collecting of loans until MFI firms register with

local officials, more disclosures, a ban on coercive loan recovery methods, and better

controls on the issuance of multiple loans to one individual63. Although regulation and

consumer protection was necessary, the AP ordinance had a disastrous impact on the

microcredit industry for all of India.

The microcredit model is only successful with several key factors that encourage

steady repayment from borrowers. These factors include: habitual weekly payments, peer

pressure from jointly liable borrowers, and access to new loans upon repayment of existing

loans64

. As this ordinance required the cessation of payments and disbursement of new

loans, the first and third incentives for repayment became derailed. The result that

followed was massive default on existing loans as confidence in the microcredit system

faltered among borrowers. Loan defaults that were below 2% quickly acted as a contagion

among borrowers with default rates sharply rising and an estimated default rate of 58% in

February 201165.

The collapse of the microcredit system occurred despite the Microfinance

Institutions Network (MFIN) obtainment of a temporary stay on the AP ordinance66.

62Roodman,supra note 25, at 1.

63Rama Lakshmi,India Takes Aim at Abuse of Innovative Microcredit Model, Washington Post,

Nov. 26, 2010.

64Roodman,supra note 25, at 1.

65 Nupur Acharya & John Satish Kumar,Repayment Slump Hits Indian Lender, Wall Street Journal

Online (Feb. 3, 2011), available at

http://online.wsj.com/article/SB10001424052748703652104576121741923730956.html

66 Roodman,supra note 25.


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MFIN is an organization that was created in 2009 with the intention of creating a self-

regulatory organization (SRO) aimed at developing guidelines for responsible lending and

increasing financial lending to more low-income households67 . The self-regulatory

approach has been backed by MFIs across India as the national government has been slow

to pass a proposed Microfinance Development Bill that was introduced in 2007. Critics of

the self-regulatory approach argue that this agency will lack enforcement power if MFIs do

not abide by responsible lending guidelines68.

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

the microfinance bubble, analysts agree that SKS was not the underlying cause. The most

agreed upon factor of Indias microfinance collapse was the lack of regulatory framework

that would have encouraged the growth of MFIs while ensuring protection of customers.

As the popularity of MFIs increased in the 1990s and 2000s, India created opportunities

for new MFIs to emerge69

however did little to create prudential measures because most

MFIs operated as non-deposit taking financial institutions.

67See generally, http://www.mfinindia.org/mfin-glance

68Sonali Mehta-Rao, South Asia Perspective: Fast-tracking Microfinance Regulation,

Microfinance Insights (Aug. 10, 2010), available athttp://www.microfinanceinsights.com/blog-details.php?bid=178

69Throughout this time period, MFIs were allowed to operate as Section 25 companies and

NBFCs. Both had lower entry requirements and few prudential regulations, as neither weredeposit-taking operations.


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A. Deficiencies of the Proposed 2007 BillIndia attempted to rectify the gap between MFI growth and the lack of regulatory

restrictions with the introduction of a 2007 Micro Financial Sector (Development and

Regulation) Bill (MFI Bill). The purpose of this bill was to foster growth and increased

outreach of MFIs to the poor while protecting small depositors and vulnerable clientele

from exploitation70. However the Lok Sabha71 never passed the proposed bill due to

several serious shortcomings. These shortcomings, which will be examined in greater

depth below, included a lack of defined scope that excluded Section 25 companies and

NBFCs from the purview of the bill, not expanding the bill to include micro insurance and

other financial instruments, overstretching the NABARD as both a service provider, and a

lack of prudential norms in allowing MFIs to accept deposits72.

1. Scope should include all operating MFIsAs mentioned above, Indias microfinance sector allows organizations to operate in

many forms and is subject to varying levels of regulation. The 2007 Draft MFI Bill

defined applicability as, including societies, trusts, and cooperative banks which can be

interpreted as excluding Section 25 companies and NBFCs73. In numbers this may make

sense as these institutions make up a very small percentage of the 30,000 microfinance-

70 Biswa Bandhu Mohanty, Microfinance Sector in India Developing a Supportive Policy,

Regulatory Framework, and Environment Positions and Perspectives, available at

http://www.mra.gov.bd/conference/images/speakers/bb%20mohanthy-nabard.pdf

71Lok Sabha is the lower house of the Indian Parliament.

72 Mukul Asher & Savita Shankar, Microfinance Bill: Need for Major Re-Think, School of Public

Policy National University of Singapore, available at

http://www.karmayog.org/billsinparliament/upload/8457/CFO_Article-final.doc

73Id.


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dedicated institutions74. However, this is a serious error as the top 20 firms, all of whom

fall into one of these two institution types, are responsible for 80% of Indias microcredit

outreach75. The proposed MFI Bill would therefore regulate only charitable trusts, NGOs,

and cooperative banks while the RBI would regulate NBFCs and Section 25

organizations76

.

The majority of Indias MFIs are set up as non-profits that are minimally regulated,

so the proposed Bill would have been beneficial in bridging this regulatory gap. However,

they have not been very effective at reaching Indias needy population because in order to

stay un-regulated these institutions could not take deposits or receive external private

funding77

. Through Section 25 of the Companies Act trusts were could transform78

into

formal ownership as a limited liability company but were exempted from many of the

regulations applicable to for-profit companies79. These special MFIs are able to operate

more actively and on a larger scale than traditional trusts because they are permitted to

secure traditional bank loans for lending purposes and have done so through the help of

ICICI BANKs MFI partnership program80.

74 Langer,supra note 36, at 56-7.

75Id. at 57.

76Id. at 58-9.

77B R Bhattacharjee & Stefan Staschen,Emerging Scenarios for Microfinance Regulation in India,

Deutsche Gesellschaft fr, Division 41 - Financial Systems Development, available at

http://india.microsave.org/system/files/Microfinance_Regulation_in_India_2006.pdf

78This transformation, as regulated by RBI, requires high entry barriers and thus is difficult to

achieve. Langer,supra note 36, at 59.

79Langer,supra note 36, at 56.

80Id.


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NBFCs have been even more successful than Section 25 organizations because of

their ability to attract and use foreign investment with limited prudential oversight so long

as they do not accept deposits. To operate as an NBFC an organization must be licensed

by the RBI and have minimum capital of Rs. 20 million ($450,000), which in India is an

extremely high barrier. NBFCs are the most rare form of MFI in India although they are

the most successful.

2. MFIs should be exempt from interest rate caps in order to operateeffectively

The international community is in agreement that interest rate caps are detrimental

to the microfinance industry and works to hurt the poor81. The proposed MFI Bill does not

create an exemption for MFIs in complying with Indias Usurious Loans Act82. This

would mean that MFIs would be at the whim of the courts at determining interest rates and

would ultimately hurt the MFI sustainability and growth to reach Indias poor population83.

The reason why MFIs have to charge a higher interest rate compared to

conventional loans is because the administrative costs remain constant regardless of the

81 The UN Report on microcredit expressed this assessment in addition to the Consultative Groupto Assist the Poor (CGAP). CGAP Key Principles of Microfinance,supra note 8; UN Report on

Microcredit,supra note 13.

82 The Usurious Loans Act was passed in 1918 and allows the courts to provide relief fromexorbitant interest rates. In taking account of whether interest is excessive, courts consider any

amount charged (money or in kind) for expenses, inquiries, fines, bonuses, and factors incompound interest. The Usurious Loans Act of 1918, Act No. X, Mar. 22, 1918. Available athttp://resources.lawyersnjurists.com/legal-documentations-litigations/laws-of-bangladesh/1913-1929/the-usurious-loans-act-1918/

83The World Bank estimates that over 25% of the population lives below the poverty line. Of the

290 million poor, approximately 87% do not have access to formal sources of credit or traditionalfinancial services.


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loan amount84. Therefore the costs of are inevitably much higher for MFIs, requiring a

higher interest rate. It is often hard for the general public to understand why MFIs must

charge a higher rate and often blame inefficiency or excessive profits to be the reason85.

Although this is a legitimate concern, it would be a better solution for India to require full

interest rate disclosure to customers rather than an outright limitation.

3. NABARD would face conflicting interests as both a serviceprovider and industry regulator

NABARD has been tasked by the Reserve Bank of India to provide credit,

development, and supervisory functions86. Although these functions have been critical to

the growth of Indias microfinance sector the multiple roles already pose somewhat of a

conflict of interest. Critics of the combined service provider and regulator argue that this

approach is poor governance87. The proposed MFI Bill creates a new arm of NABARD

called the Micro Finance Development Council (MFDC)88. This new arm requires that all

MFIs submit annual financial statements and if MFIs want to engage in deposit taking they

must register with NABARD in addition to securing capital of Rs. 5 lakh (about USD

$10,000), and has been in existence for at least 3 years89

. In addition to thrift activities,

84Robert Peck Christen et al.,Microfinance Consensus Guidelines: Guiding Principles on

Regulation and Supervision of Microfinance, CGAP / THE WORLD BANK GROUP, July 2003,

at 19.

85Id.

86See generally, http://www.nabard.org/introduction.asp ; Langer,supra note 36, at 60.

87Asher,supra note 69, at 5.

88See generally, Micro Financial Sector Development and Regulation Bill 2007, Bill No. 41 of

2007 as introduced in Lok Sabha on Mar. 20, 2007 (with commentary from CooperativeDevelopment Foundation). Available at, http://www.cdf-sahavikasa.net/MF%20Bill%202007%20-%20Clause-by-clause%20comments.pdf


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NABARD will be responsible for overseeing the proposed Microfinance Development and

Equity Fund, which among other things will provide loans and grants to MFIs or may be

applied to the discharge of any of its other responsibilities90.

4. Uniform prudential requirements should be applied across allmicrofinance organizations

The proposed MFI Bill does little to bring uniform regulation to Indias

microfinance industry. About 80% of current industry is regulated by minimal prudential

requirements set forth by the RBI while the new bill seeks to create prudential

requirements for the remaining 20%91. A more holistic approach would be beneficial to

the microfinance industry because by nature it is sensitive to systemic and default risks92.

Prudential regulations are important in ensuring the confidence of clients who are only

likely to re-pay outstanding loans if they believe that future loans are at risk.

Regulation is prudential in nature when it is aimed specifically at protecting the

financial system as a whole as well as protecting safety of small deposits of customers and

individual institutions93. This important kind of regulation needs to be balanced with

considerations of expenses, government oversight, and difficulties with enforcement94

.

89Id. at 10.

90Id. at 23.

91 The majority of Indias microfinance clients are reached through Section 25 and NBFC

organizations, which are outside of the scope of the proposed MFI Bill, are regulated by the RBI byrequiring them to register and maintain capital adequacy requirements. Mohanty,supra note 67, at

6.

92Bhattacharjee,supra note 73, at 23. (Explaining why a special microfinance regulation would be

beneficial to India because existing regulation is very piece-meal).

93Peck,supra note 81, at 11.

94Id.


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Therefore, the CGAP consensus has advocated for non-prudential regulation 95 to be

balanced with prudential regulation whenever possible96.

The MFI Draft Bill does little to address either prudential or non-prudential

regulations for MFIs in India. The bill does requires capital adequacy requirements of 5

Lakh rupees and a minimum operation period of 3 years for MFIs that choose to operate in

thrift97 activities. However, as demonstrated by the Andhra crisis and in conjunction with

the CGAP consensus recommendations, lending limitations are a crucial missing

component. The CGAP consensus recommends rather than setting lending limitations to

be a fixed percentage of an MFIs equity base

98

, rather lending limitations should be set

based on the soundness of an MFIs lending, tracking, and collection procedures99

. As the

recent Andhra crisis occurred in large part due to the lack of enabling regulatory

framework, these important requirements should be addressed to avoid another crisis.

95Often non-prudential regulations can be accomplished through Commercial Laws or other

administrative agencies. Two particularly relevant non-prudential issues relate to protectingborrowers against abusive lending and collection practices, and providing borrowers with truth in

lending information about the cost of loans. Both of these consumer protection issues were not

discussed in the 2007 Draft Bill.Id. at 12;Id. at 15.

96Id. at 11.

97 Thrift activities are deposit taking activities. Any monies which are collected (other than in the

form of current account or demand deposit) by a micro finance organization Development and

Regulation Bill,supra note 85, at 2(l).

98In order to minimize risk, regulations often limit unsecured lending to some percentage often

100% - of the banks equity base. Such a rule should not be applied to microcredit because itwould make it impossible for an MFI to leverage its equity with deposits or borrowed money.Peck,supra note 81, at 20.

99The most powerful source of security is derived from the soundness of an MFIs practices and

the confidence that it would instill in its customers. It is recommended that rather thanautomatically provisioning percentages of microcredit loans at the time loans are made, it would bemore prudent to instill higher lending limitations once loans are delinquent. Id. at 29.


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B. Looking forward to the 2010 Revision of the MFI BillIn light of the crisis, India is once again attempting to pass a more comprehensive

microfinance statute in order to create an enabling regulatory environment. As evidenced

from the discussion in the previous section there is much to be desired from the last

proposed bill. The 2010 crisis illuminated the obvious fact that the microfinance industry

is by its nature an unstable industry that must rely on prudent practice and regulations in

order to future success and protect the vulnerable customers it services.

As part of the enabling regulatory environment, India should remove interest rate

caps on MFIs, increase prudential requirements for MFIs, address consumer protection

concerns, and enlarge the scope of the Bill to uniformly govern all MFIs.

IV. CONCLUSIONThe crisis in Andhra Pradesh highlights the potential for disaster in this financial

sector. The targeted clients of microfinance are often the poorest and most uneducated

people in the world. As Yonus stated, access to financial services is a human right that

should be enabled. In order for this to occur, the key concept of balance must be

considered at every juncture. Balance between prudential and non-prudential

requirements. Balance between sustainability and helping those in need.

With the introduction of the last bill to Indias parliament, key factors were

neglected which are essential to a successful microfinance industry. Among these factors

are more robust prudential regulations, consumer protections against predatory lending, an

education program that empowers consumers to do more than just borrow money, and

ensure growth by not limiting interest rates. India has a huge untapped microfinance

potential with 70% of poor still without financial services. Given a proper and


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comprehensive regulatory framework, client confidence in MFIs will rebound and future

crises can be averted.

IV. International Microfinance Regulatory Guidance (not sure where/if to include

this)

With the success and popularity of the microcredit approach at combating poverty,

various international organizations have expressed support and guidance to encourage

responsible lending. Most notably are the U.N., The Basal Committee, and The World

Bank through CGAP. CGAP is arguably the most well recognized guidance with eleven

outlined key-principles that have been endorsed by the G8-Summit.

A. CGAP Key Principles of Microfinance

The Consultative Group to Assist the Poor (CGAP) was created in 1995 as a

consortium of over 30 development agencies100. It is housed at the World Bank although it

remains an independent entity whose purpose is to provide market intelligence, promote

standards, and develop innovative advisory services to governments, MFIs, donors, and

investors. CGAP takes the position that governments should create a healthy environment

for a microfinance sector to develop but maintain a limited role. CGAP further defines the

limited role to extend to: 1) creating a supportive enabling environment with

macroeconomic stability, and 2) creating a strong regulatory framework for microfinance

and boosting supervisory capacity101.

In 2004, CGAP published the key principles of microfinance with the goal of

expanding access to microfinancing opportunities to the poor. The aim of the eleven

100see generally, CGAP About Us, http://www.cgap.org/p/site/c/aboutus/

101see generally, CGAP FAQ, http://www.cgap.org/p/site/c/template.rc/1.26.1312/


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principles is to allow MFIs to strive for sustainability while balancing the needs of their

vulnerable clients. In brief, the eleven principles are as follows102:

1) The poor need a variety of financial services, not just loans.

2) Microfinance is a powerful instrument against poverty.3) Microfinance means building financial systems that serve the poor.4) Financial sustainability is necessary to reach significant numbers of poor

people.5) Microfinance is about building permanent local financial institutions.6) Microcredit is not always the answer.7) Interest rate ceilings can damage poor peoples access to financial services.8) The governments role is as an enabler, not as a direct provider of financial

services.9) Donor subsidies should complement, not compete with private sector capital.10) The lack of institutional and human capacity is the key constraint.

11) The importance of financial and outreach transparency.

In evaluating the Indian microfinance crisis Principles 4, 6, 7 and 11 are the most

relevant and will be the focus of the rest of this note.

102 CGAP Key Principles of Microfinance,supra note 8.

micro finance ibr paper

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