Ramesh S Aruanchalam
Rural Finance Practitioner
Given the present crisis, how do we go forward and get micro-finance in India back on track? In the present circumstances, the implications of which for various stakeholders have already been outlined in parts I and II, increased (appropriate) regulation and client protection practices are surely required and will help. Among other things, this would call for a clear regulatory structure that
a) provides legitimacy to organizations (different legal forms) working as MFIs through a registration process as per a national regulatory framework – such registration is expected to provide immunity to the MFIs from various state level laws on usury and client protection as well as other access to a host of benefits
b) has certain non-negotiables – enforceable minimum standards - with regard to governance, systems (HR, Portfolio Management, MIS, Finance and Accounting, Internal Audits, Internal Controls etc), client protection/literacy and other aspects (as may be required from time to time) for affording this legitimacy. Such a regulatory framework must try to get rid of conflicts of interest, so prevalent today in Indian micro-finance and bring in REAL TIME accountability and enforceability. Two issues deserve mention here: i) First, let us recognize that MFIs are professional organisations and they cannot and should not shy away from proper and minimum regulatory standards - they are no longer the informal organisations that they were and we need regulation to keep pace with their growth and life cycle. That is where we have failed today...; and ii) Second, as financial institutions, MFIs cannot afford to compromise on governance including related party transactions and they need minimum systems when they intermediate public money. We cannot and should not have a compromise on that...If we do not do this, mark my words, we will have a greater crisis later including more satyam like happenings...
c) is enabling in nature with the right kind incentives for the concerned stakeholders including MFIs and clients
However, regulation apart (points A and B above[i]), I think the most important aspect is to get the incentives (subject matter of point C) for the sector right as an industry expert identifies correctly in an interview: “So it was basically a situation where the sector’s incentive structures had gone wrong…”. While I think he is right in identifying the cause, a deeper analysis of the incentives of the key players outlined in parts I and II indicates that more needs to be done to get the incentives for the key players in the sector right. Here are some (suggested) proposals towards that:
For MFIs:
1. Dividend and Bonus Share Issue Cap[ii]: The framework would specify a permanent specified cap on dividends (e.g. it could be 10-15% on shareholder equity and decided through consensus among industry stakeholders) and issue of bonus shares for any MFI that wants to registered under the new national regulatory framework (NRF). The NRF will provide such MFIs with access to priority sector loan funds from a bank, the complete freedom to act as a banking correspondent[iii] and immunity from state level client protection/usury laws. Additionally, the MFI will be required to meet certain minimum standards with regard to governance, systems (HR, Portfolio Management, MIS, Finance and Accounting, Internal Audits, Internal Controls etc), client protection/literacy and other aspects as per the regulatory framework. The framework will also utilize various means (on site and off site supervision etc) to ensure that these non-negotiable minimum standards are indeed met in a dynamically changing micro-finance environment, quarter after quarter.
2. Compensation Caps: All stakeholders (from senior management upto field level staff and directors/board members, if appropriate) at registered MFIs should be forced to adhere to compensation caps as per the regulatory framework. At any cost, the compensation should not exceed that of similar positions in Public/Private Sector Banks whichever is higher. Further, for salaries/compensation above a certain limit (to be fixed in the regulatory framework) and certain key positions (like managing director, CEO, CFO etc), approval of the regulatory authority would be required
3. Disclosure by Promoters/Directors/Senior Management of their Personal Assets and Shareholding in MFI: All registered MFIs would require their promoters, directors and senior management to provide yearly statements of their assets and liabilities as also transparently list their and their family/friends’ investment in the MFI. This would be mandatorily required.
If any MFI does not want to accept the dividend cap, bonus share issue cap, compensation cap and disclosure norms, then they are free to raise funds from banks and/or other sources at commercial rates and carry on the business. In such a case, the loan will not be from a bank’s priority sector quota and so a bank can lend to an MFI at a higher interest rate after factoring in the appropriate risks of this sector. Thus, such MFIs, who would not be eligible to register under the national regulatory framework, will not: a) gain access to priority sector funds; b) be able to act as banking correspondents; and c) enjoy the benefits and/or immunity provided by this national regulatory framework against state level usury and/or customer protection laws
For Banks:
1. Focus on All Kinds of MFIs: Encourage banks to lend to large and small MFIs (with different models) so that overall risk for the banking sector is minimized. Also, no MFI becomes too big to fail. Thus, it will also minimize the material impact on a bank’s balance sheet in case a large MFI fails.
2. Loans Made to MFIs – who have a dividend, bonus share issue and compensation cap in place, agree to have certain minimum standards with regard to governance, systems and client protection and provide the mandatory disclosures as per the NRF - will come under their priority sector targets. That these loans have to be reasonably priced also follows naturally. As noted earlier, banks would be free to set a true risk based price for loans made to MFIs who do not have a dividend, bonus share issue and compensation cap in place, reflecting the level of operational and other risks (including political risks)
If we get these incentives right, here is what I foresee for each of the players:
Banks:
1. Their systemic risk is considerably reduced as their lending is now spread across a much bigger portfolio of MFIs – different types, sizes, scale etc
2. Political risk is also reduced somewhat – especially for MFIs operating as part of the NRF
MFIs:
1. Some large MFIs may borrow from banks under priority sector lending while others may not. But that is a choice that each MFI will have to make, based on its vision and mission and the perceived benefit of operating under a national regulatory framework
2. Large MFIs that do not accept dividend, bonus share issue and compensation caps are likely to become pure play financial institutions. They will be able to give reasonable returns to their investors but they may be more prone to operational and political risks and something, that they may choose to live with...
3. Large MFIs who have accepted a dividend, bonus share issue and compensation cap and who remain pure financial institutions will start getting surpluses. Thus, they will be able to build their reserves and over a course of time will be able to offer cross-subsidization across different kinds of products to clients - e.g., An Income generating loan at 24% or less, education loan at 8 % etc
4. Socially focused MFIs will now get adequate funding and be able to become true livelihood supporters where credit is one of the products they offer. They may also offer additional support like health advisory services etc. Thus, these organizations will be able to work on poverty reduction as well as financial inclusion.
Clients:
1. Their interests will be protected. They will have true choice. If they want only credit they will perhaps get it from a large registered MFI at a relatively lower rate. If they want livelihood support with credit they will get it from a socially focused MFI.
2. If they want to increase their loan size slowly they can approach a socially focused/small MFI. If they want to increase a loan size faster, then they go to larger MFIs.
Investors:
1. They will now have wider choices. They can either invest in truly commercial for-profit MFIs or they can invest in and/or support MFIs that have capped dividends, bonus share issue and compensation that avail priority sector funding and that can act as banking correspondents. It would entirely depend on their social and commercial goals.
2. Investors who believe that all problems can be solved only commercially can invest in non-dividend capped MFIs. Investors who believe in the double bottom line can invest in dividend capped MFIs. Donors can support NGO MFIs.
Hope I am clear on my suggestions...and please do write back…I believe a crisis should never be wasted and I also believe that Micro-finance will not die, irrespective of whatever happens now. It is my optimism that makes seek a proper regulatory framework...one that can enable MFIs to grow and flower, one that can protect clients and one that can safeguards public and peoples' money (loans which are public deposits) - all three are important and there can be no compromise on that. I hope the powers that be understand this and attempt to save the industry with such a clear enabling regulatory framework.
Tomorrow’s post would be on governance standards required in the regulatory framework…and I will continue with similar standards for systems, client protection/literacy etc and the actual regulatory framework...All, of course, for the benefit of the RBI Board Sub-Committee...and other stakeholders
[i] Points A and B will be elaborated through a series of separate posts in the coming days and aspects covered in point C are the subject of this post
[ii] Return on Assets and Return on Equity caps are possible but there will be workarounds to that by bundling products along with the loan. Thus, the MFI will be able to show that their income is now coming from other income streams.
[iii] Dividend capped MFIs with their primary social orientation should be allowed to become banking correspondents since there is minimized conflict of interest. Further they should be encouraged to open savings banks accounts with banks and eventually the loan size to the borrower by the MFI should be linked to the savings of the borrower with the bank (perhaps the NRF can come with prudential guidelines for ratio of loan to savings). This in essence will do several things: (a) Encourage savings for clients; (b) Simplify regulation: One will be able to allow savings to clients without creating deposit taking MFIs in the short and medium term; and (c) Loan size linked to savings amount will reduce chances of over indebtedness.
hi Ramesh, this is Vasudevan of Equitas Micro Finance, Chennai. i am beginning to become a serious fan of your writings! the above piece you have written is an excellent piece and brings the diverse interests of stakeholders to a common platform. i totally agree with your points and in Equitas, we have many of these practices in place such as:
ReplyDeletea. While our target RoE is around 18-20%, we have an internal policy of a cap on RoE of 25%. 25% is arrived at as most of the State owned banks in India have a RoE of between 20 and 25%
b. we have a cap on managerial compensation at 40 times the lowest level field staff salary. thus if a field staff salary is around Rs.9000 p.m i.e Rs. 1.1 lacs p.a then the max salary that the CEO or any other management staff in the company can get is Rs. 45 lacs p.a. this ensures that we dont go overboard in doling out fat salaries or bonusses to MD/CEO or other staff. 40 times is arrived at based on an article of Narayanamurthy in Business India 29th Nov 2009 issue where this is held to be a golbal benchmark for fair compensation level.
3. we have a pricing philosophy wherein we dont reckon the current cost of operation to arrive at our lending rate but we assume the cost of operation which we will have when we wold have scaled up and become stabilised with about 20% annual growth. this ensures that the cost of starting and cost of scaling up is borne not by the clients but by the investors. as on date, our actual cost has still not reached this assumed level of cost on steady state basis because of which, though we have a targeted RoE of around 20% our actual RoE remains around 14-15%. we will reach around 20% only when we get into a steady state of growth and the cost of operation really comes further down
ReplyDelete4. I also believe there must be a cap on interest rate which is reasonable enough to ensure that there are enough suppliers of credit but prevents profiteering. Bangladesh recnelty has capped MFI lending at 27%. i believe this is a fair rate and we could also look at a lending rate cap of between 27 to 30%
Thus, many of what u are saying resonates very strongly with our own philosophies and we would be very happy to support to improve these practices and governance issues further with further ideas.
i also have another point to add to the new regulatory framework that u are talking about.
ReplyDeleteThe poor borrow money from 4 differnet sources viz SHG-Bank, NBFC-MFI, NGO-MFI and individual money lenders. even if any one of these 4 are careful while lending to ensure she does not end up over borrowing, but some one else may end up funding her beyond her ability to pay. hence it is important that we integrate all the people who give loan to the poor. thus there must be a credit bureau created where all the lenders to the poor are legally required to share the data so that any one who wants to lend to the poor can check the bureau and get a full detail of all her earlier borrowings from any differnt source.
How much shoudl the poor be allowed to borrow:
given the fact that all these 4 type of lenders give unsecured loans, she may tend to overborrow and end up in distress. hence the Government must undertake the exercise of determing the household income level for each of the household of the poor and register it on the ration card as well as in the credit bureau data base. all lenders, before lending money to this person, should check the total monthly outgo on instalments and only if this monthly outgo, including the outgo on the proposed loan, is less than 40% of the monthly income, the lenders should be allowed to lend. if this would exceed 40%, then no lender should be allowed to lend, as the family will never be able to pay back and land up in highly stressed situation.
i also believe there must be a strong central legislation on this but implementation should be through the State Government as well as the SHG division of the Government, using other agencies such as Nabard, Lead Banker and District Collectors/local authorities and representatives of the other 3 type of lenders should be jointly required to monitor and ensure implementaiton of the above
Dear Ramesh, this is a response from Ben Simmes, Oikocredit.
ReplyDeleteThanks for this constructive proposal to learn important lessons out of the present crisis. However, I still think that your proposal does not address a fundamental choice. We should ask ourselves what is basis of microfinance? To our opinion in Oikocredit the primary goal is to achieve a real social return, render financial (possibly also other) services that enable poor people to get out of poverty. This objective should be reached by building up microfinance institutes that are financially sustainable. They should indeed aim to make a profit BUT should not aim for profit maximization. We should therefore not make a distinction between pure play financial institutions and socially oriented MFIs. The objective should be that whoever is active in microfinance should always go for the double bottom line. Achievement of the double bottom line (where social return is the primary objective) is why microfinance is existing and where it shows its difference from the regular banking. Let's try with all actors to become committed to that cause: use financial resources to improve the lives of so many that have no access to financial services. Do it indeed in a professional and sustainable way. Make sufficient profit to guarantee covering of costs, guarantee continuity of operations and possibilities to expand and reach out to more and offer investors a reasonable return on investment (to justify an investment, to make it sufficient attractive to invest but never to maximize returns). If we allow for purely profit oriented MFIs we will continue to see aggressive lending, indebtedness..most of all...it will be business as usual but now with the poor as target group! Besides, socially oriented MFIs will be affected, will be forced to go along if they want to keep some market share. there will be the temptation for CEOs of socially oriented MFIs to adjust their salaries. Most of all, all MFIs will be affected if the reputation of microfinance becomes negative!
Kind regards, Ben Simmes, director social performance and financial analysis