The Journey of Indian Micro-Finance: Lessons For The Future

The book, "The Journey of Indian Micro-Finance: Lessons For the Future" can be ordered on the web from Aapti Publications from July 22nd 2011 at http://www.indian-microfinance-future.com/ and it will also be available at stores in major metros in India by end July/early August, 2011. If interested, please read a review of the book by Ms Sucheta Dalal, Managing Editor, Money Life, at http://www.moneylife.in/ or http://www.suchetadalal.com/

Saturday, December 4, 2010

Views, Issues and Initial Lessons on The Regulatory Front From The 2010 Andhra Pradesh and Indian Micro-Finance Crisis

Ramesh S Arunachalam
Rural Finance Practitioner

The Indian micro-finance crisis has been an excellent learning ground and here are some of the critical regulatory views, issues and lessons that are emerging from this crisis. I hope that the RBI sub-committee looking into the micro-finance crisis and related aspects does take these into account while formulating future policy. I also hope that the planning commission, which is drafting an approach paper to micro-finance for the next plan period, also looks at the emerging lessons…

First, for some diverse views…on regulation…


In common parlance, regulation is the establishment of fair rules to conduct the ‘business’ of micro-finance and supervision is ensuring compliance to these above rules. The essence of regulation is to prevent market/institutional failures and ensure stability and soundness of the financial system – in this case, the micro-finance system. According to Joseph Stiglitz[i] "Regulatory reform requires the elimination of excessive or burdensome regulations, as well as regulations whose sole purpose is to inhibit competition. At the same time, regulation is needed to promote competition, and prudential behavior, while continuing to ensure that clients are protected."

Others have also endorsed the need for regulation to prevent ‘failures’. As an international expert in micro-finance argues, “While some may argue that regulations could impede the growth of micro-finance institutions, however the fact remains that as … the microfinance sector and institutions grow, risks and chances of failure also increase… Regulation would then become imperative for the microfinance industry.”

Remarks a senior banker, “The first purpose (of regulation), which applies in all sectors of the economy, is to ensure that markets work efficiency and competitively. Regulation for this purpose includes rules designed to promote adequate disclosure, prevent fraud or other unfair practices and prohibit anti-competitive behavior such as collusion or monopolization. This type of regulation does not materially alter or prescribe the nature of products or services, but simply aims to ensure that there are fair and efficient markets. Also, there will be no room in a competitive market for non-commercial mispricing. Competitors with high cost structures will also be forced to rationalize their operations in order to remain competitive.”

Commenting on this aspect of regulation and market failure, an industry observer states, “While we clearly have to address the potential and real abuses that exist in the system…. we, also need to preserve, encourage and facilitate to the greatest extent possible, clients, continued access to credit and other financial services. This mandates that the system for delivery of financial services has adequate safeguards, checks and balances to prevent failures and foster the development of vibrant institutions that can ensure continued and sustained access to financial services for the poor”

Second, let us look at some of the emerging issues…on the regulatory front…


Currently, there are many legal forms (mainly, not-for profits, mutual benefits and for-profits) through which micro-finance is delivered in India. The multiplicity of legal forms means that different acts and laws will govern the different legal forms and this has several implications for regulation and protection from institutional failures:

·        Issue # 1 – Multiple Legal Form Makes Uniform Micro-Finance Regulation Difficult: First, with existence of multiple legal forms for delivering micro-finance services, supervision and regulation are, by default, dispersed across authorities with the result that no single authority oversees the functioning of all legal forms. Hence, uniform regulation is difficult to enforce as some of the features of any legal enactment may not apply or be relevant to some legal forms. Also, no one regulatory authority can be held responsible for any crisis, as no one regulator is really in charge. This also means that many legal forms (of MFIs) could lack legitimacy in operational terms.

·        Issue # 2 – Regulatory Arbitrage Possibly Enhances Chance of Failure: Second, chances of institutional failure abound as different authorities expect each other to regulate and supervise the MFIs in their respective categories and this may result in none of them appropriately supervising/regulating MFIs in their own categories. Also, MFIs may take advantage of the presence of multiple regulators. In fact, the above is exactly what has happened in the case of many of the NBFC MFIs and they have no serious regulation or supervision as most local government authorities felt that these entities are the responsibility of the RBI. The same applies to the other legal forms as well. Thus, the quality of supervision and regulation across different legal forms is rather poor, and this again enhances the chance of failure. Further, institutions can use various laws and create newer entities to overcome specific regulations with regard to micro-finance and this is a dangerous aspect which can result in failures – legal solutions can be formulated to tackle seemingly ‘stringent’ micro-finance regulations and the prime driver for the legal solution is the presence of alternative legal forms under other laws. Lessons from the NBFCs failures of the 1990s clearly illustrate lack of appropriate coordination between several regulators.

·        Issue # 3Lack of A Comprehensive Regulatory Knowledge Data Base on Micro-Finance Failures Prevents Suitable Pre-emptive Action: Third, dispersion of supervision and regulation also means that learning from ‘early warning’ is not available with one single regulatory/supervisory body and hence, the opportunity to plug all possible loopholes related to failures becomes less likely. This again is similar to the NBFC failures of the 1990s. Without question, regulation attempts to provide for and reduce failures in functioning of institutions and when the regulatory authorities are different, a comprehensive knowledge base of likely failures is not possible as this knowledge could be spread over different regulatory bodies. Hence, suitable pre-emptive action cannot be taken by the regulators

·        Issue # 4 – Enforcement Difficult Across Multiple Legal Forms: Fourth, even if The Central Bank were to come out with a common code for regulation of all forms and models of micro-finance, the enforcement of this is difficult as different laws have different authorities who have different historical predispositions and interpretations of the law. Hence, it would be almost next to impossible to enforce legal requirements across all entities.

·        Issue # 5 – The Lack of A Level Playing Field is Not Healthy for Development of Industry: Fifth, consistent application of the regulatory norms is not possible as mentioned above and this is not healthy for the development of an industry, such as micro-finance. For example, standardised (prudential) norms regarding various operational aspects and/or characteristics of MFIs cannot be uniformly promulgated, as they would not be applicable for certain types of legal forms. This includes norms for governance, MIS, internal controls, internal audits, portfolio management, accounting methods and standards, capital adequacy and several other issues.

Third, I list some of the initial regulatory lessons from the present crisis…for all of you to ponder and will post on this in greater detail later…

Lesson # 1: Multiple Regulators Can Only Lead to Chaos and Confusion on the Ground

Lesson # 2: Self-Regulation Does Not and Will Not Work on The Ground

Lesson # 3: A Hands-Off Regulatory Approach Could Lead An Industry to A Serious
                   Crisis

Lesson # 4: Well Meaning Regulation is of No Real Use if Not Backed By Appropriate
                    Supervision

Lesson # 5: Balance in Regulation is Critical, Otherwise Regulation Could Cripple The
                   Industry. Therefore Regulation Must Also Seek To Enable and Incentivise
                   Rather Than Just Enforce…

Lesson # 6: Regulation Must First and Foremost Provide Legitimacy for The Industry

Lesson # 7: Regulation Must Have Certain Non-Negotiables Including Minimum Standards for 
                    Governance, Client Protection, Various Systems, Portfolio Management
       (Lending and Recovery Aspects Included) etc

Have a Great Weekend Folks! 







[i] Source: The World Bank, The 1998 WIDER Annual Lecture, Helsinki, Finland, January 7, 1998

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