Ramesh S Arunachalam
Rural Finance and MSME Practitioner
One of the key questions that continues to bother a lot of stakeholders in the Indian micro-finance industry is: ‘what kind of regulation and supervision is required for the healthy development of the industry?’ A friend once told me that regulators are just like parents who have teenagers at home. The parents can handle their teenage kids in two basic ways: a) Be proactive, over-prescribe and get involved in every little activity of their children; or b) Lay out the broad desirable outcomes for their children (in terms of their education, relationships etc) and then step aside to let their natural environment take over. They are however always present in the background to act as a check and also, help their children overcome difficulties, as and when they arise.
The above is a useful metaphor for understanding two broad extremes of regulation with regard to micro-finance in India: a) We could have a super micro-finance regulator looking at every transaction of micro-finance market participants including MFIs; or b) We may choose an approach whereby the super- regulator lays out the broad desirable outcomes for their various micro-finance participants and then steps aside to let broader market and environmental forces take over, all the while being present in the background through supervisory staff and special (third party) auditors patrolling the micro-finance market.
Essentially, these two types of regulation may be defined as follows:
1. Completely rule-based regulation: one where the regulator tries to be present in each and every micro-finance transaction that takes place, through a comprehensive, extensive and rather voluminous rulebook, tight supervision/policing and a penalty system using checklist compliance. In effect, under such a regulatory framework, the regulator would have to anticipate every possibility (with regard to the micro-finance transactions), every change and innovation in the micro-finance market, and then writes rules around them. Unquestionably, this is a very tough and arduous task indeed and especially from the perspective of creating a plethora of rules in the first place.
2. Principle-based regulation: Under this type, the regulator would be more focused on the outcome (s) of the regulation. Thus, the regulator will articulate broad principles and allow micro-finance market players to innovate around them, keeping the outcomes (as defined in the principles) ABSOLUTELY and completely sacrosanct. A key point to be noted is that this approach does not totally eliminate the need for rules. There will still be rules to follow in any such micro-finance regulatory system but, most importantly, it will not foster the practice of micro-finance compliance officers using the ‘checklist’ approach to ensure staying within the spirit and letter of the law.
Plain checklist compliance can be counter-productive, as there may be no case of regulatory violation, yet there may be mis-selling and malpractice, as we have seen during the last few years in Indian micro-finance. In such an environment, compliance officers will never work towards a desired outcome of enabling the low-income client/customer to come out of poverty or lead better lives, but rather will primarily try to outwit regulators. And once a regulatory loophole is discovered, it will become a frantic race to the bottom with the rest of the micro-finance industry following the leader in a holistic fashion. This is what happened with regard to KYC norms and priority sector lending guidelines in Indian micro-finance. Therefore, the checklist compliance and penalty system, which is a strong part of rule based regulation, can be made more accountable if principles based regulation (with appropriate rules) is used.
There is a third way to look at micro-finance regulation. Here, the market incentive structure is used to take most of the reasons behind misconduct out of the market and then use a principle based approach to target an outcome. The challenge is to find the right balance that allows for market innovation, while taking away the incentive and power that the MFIs have over the low income clients, especially due to a skewed knowledge structure and associated incentives. One of the tools for such regulation is the use of financial incentives in a manner that nudges MFIs and other micro-finance market participants into doing the right things. The use of dividend caps and linking this to gain access to special (priority sector) funds is an example of this.
While I will let you make your own judgment on this, I strongly believe in a principles-based approach with incentives and some rules - even while flagging the issue that to translate principles into rules that work on the ground would indeed be a huge challenge in a micro-finance market as vast and diverse as the Indian one.