We missed this earlier: The Reserve Bank of India (RBI) on June 14 issued a consultative document prescribing new regulatory frameworks for various lenders in the microfinance space.
Why this matters? Microfinance is a form of financial service which provides small loans to low-income households. Microfinance through mobile apps has become popular in recent years. But since this space is not well regulated, it poses various concerns (mentioned below). The proposed guidelines will address some of these concerns.
The RBI is seeking comments and suggestions on these proposed guidelines from banks, NBFCs including NBFC-MFIs, industry associations, and other stakeholders by July 31, 2021.
Who are the proposed guidelines applicable to?
Extends from NBFC-MFIs to all lenders: While the earlier guidelines specifically applied to Non-Banking Financial Company – Micro Finance Institutions (NBFC-MFIs), the new guidelines target all regulated entities (REs) under RBI. “The [current] comprehensive regulatory framework is applicable only to NBFC-MFIs, whereas other lenders, which comprise of around 70 percent share in the microfinance portfolio, are not subjected to similar regulatory conditions,” RBI stated as the reason for making this change. This means banks, all NBFCs, and any other regulated entity offering microfinance come under the purview of the proposed guidelines.
Does it apply to loan-lending apps? The consultation report does not explicitly mention loan-lending apps. These apps work on multiple models. Some have NBFC licenses of their own while others partner with banks or NBFCs to offer loans to customers. If they do offer loans or partner with a regulated entity to do so, then the proposed guidelines apply to them. However, there are many unauthorized apps that exist in app stores and these are not under the purview of the proposed guidelines. The RBI has set up a separate working group to develop a regulatory framework for digital lending including lending through online platforms and mobile apps, but most of the guidelines for microfinance are likely to extend to these apps.
What concerns are the proposed guidelines trying to address?
Over-indebtedness: While more than two NBFC-MFIs are not permitted to lend to the same borrower and there is a regulatory ceiling on the maximum amount that can be lent by an NBFC-MFI, other lenders do not have these constraints because, as stated above, the current regulatory framework is applicable only to NBFC-MFIs. Consequentially, small borrowers are able to get multiple loans from several lenders, adding to their over-indebtedness. This further leads to coercive recovery practices, the consultation document stated.
High-lending rates: Currently, there is a regulatory ceiling on interest rates applicable to NBFC-MFIs. But this has resulted in unintended consequences because other lenders for whom this ceiling is not applicable are also using this as a benchmark. As a result, banks and large NBFC-MFI’s, who have a comparatively lower cost of funds, are also charging high interest rates. Because of this, “it is the borrowers who are getting deprived of the benefits from the enhanced competition as well as the economy of scale,” RBI stated.
How do the proposed guidelines address over-indebtedness?
In order to avoid the over-indebtedness of microfinance borrowers, the report proposes regulations that purportedly address the total indebtedness of these borrowers against their repayment capacity rather than considering only indebtedness by itself or indebtedness from only NBFC-MFIs. Accordingly, the following measures are:
Common definition of microfinance: The proposed guidelines define microfinance loans as “collateral-free loans to households with an annual household income of ₹1,25,000 and ₹2,00,000 for rural and urban/semi-urban areas, respectively.” A household is further clarified as “a group of persons normally living together and taking food from a common kitchen.” This definition is now uniformly applicable to all regulated entities of the RBI so that the target borrowers are identified with an element of certainty, irrespective of the type of lenders. As for the method of assessing household income, RBI has left it to the entities to have a Board approved policy in place given the difficulties in providing a common formula.
Limit for the maximum permissible level of indebtedness: “The intention of the proposed regulation is to ensure that the household is not strained. Accordingly, the payment of interest and repayment of principal for all outstanding loans of the household at any point in time shall be capped at 50 percent of the household income. However, individual RE may adopt a conservative threshold as per their own assessments and Board approved policy,” RBI stated. For example, if a household is earning ₹1,00,000 per annum, the monthly household income is ₹8333. Therefore, the monthly outflow of repayments for all microfinance loans obtained by that family should be half that, which is ₹4166.
How do the proposed guidelines address high-lending rates?
No ceiling for the interest rate: Current regulations prescribe a ceiling for the interest rate charged by an NBFC-MFI. This has generally kept the interests rates at 24-26 percent. Since different types of lenders have substantial differences between the financing costs as well as operational costs, RBI stated that mandating any specific benchmark would have the same issues as are there with current guidelines, mainly creating a benchmark such that even lenders who can afford to charge lower interest rates do not do so. Therefore, NBFC-MFIs will have no ceiling prescribed for the interest rate and shall be guided by a board-approved policy and the fair practices code, “whereby disclosure and transparency would be ensured.” the consultation document stated. “The intention is to enable the market mechanism to bring the lending rates downwards for the entire microfinance sector,” RBI added.
Simplified fact sheet related to the pricing of microfinance loans mandatory for all lenders: “A multi-country study undertaken by World Bank has concluded that a simplified fact sheet on the pricing of financial products leads to improvement in decision making by low-income borrowers by three times in comparison to other financial literacy-related materials,” the consultation document stated. Therefore, to allow microfinance borrowers to make an informed decision, RBI will prescribe a standardised and simplified one-page disclosure format containing information only on the pricing of microfinance loans. “This format shall enable the borrowers to compare interest rates as well as other fees associated with a microfinance loan in an easy-to-understand manner,” RBI said.
Minimum, maximum, and average interest rates should be displayed: “Boards of all REs shall lay down appropriate internal principles and procedures for determining interest rates and other charges for microfinance loans so that all-inclusive interest rates charged to the microfinance borrowers are not usurious in nature,” the proposed guidelines state. Furthermore, all REs are required to display as well as submit to RBI the minimum, maximum and average interest rates charged by them on microfinance loans.
What other customer protections are offered to micro-finance borrowers?
No collateral requirement: Given that low-income borrowers often “lack the type of collateral preferred by the lenders and what they have for pledging, instead is of little value for the lenders but is highly valued by the borrower (e.g. household items, furniture, etc.),” all microfinance loans must be collateral-free, the new guidelines propose. Previously this only applied to loans offered by NBFC-MFIs. It is important “to ensure that in the event of default, the borrowers do not lose possession of assets which are essential for their continued existence,” RBI stated.
No pre-payment penalty: All microfinance borrowers will be allowed to prepay without attracting penalty, as is the case for NBFC-MFIs, according to the report.
Greater flexibility in repayment frequency: Microfinance borrowers of NBFC-MFIs are permitted to repay weekly, fortnightly, or monthly installments as per their choice. The new guidelines propose that all regulated entities must have a board-approved policy to provide the flexibility of repayment periodicity to microfinance borrowers as per their requirements.
What changes are specifically applicable to NBFC-MFIs?
No absolute cap on the loan amount: Previously, NBFC-MFIs had a loan amount limit of ₹1,25,000 (₹75,000 in the first cycle and exclusion of loans for meeting education and medical expenses from loan limit); and minimum tenure of 24 months for loans above ₹30,000. “With the proposed regulation of linking the loan amount to household income, an absolute cap on loan amount would no longer be necessary,” RBI stated.
No longer need to give half of the loans for income generation purposes: The current rules requiring NBFC-MFIs to lend a minimum of 50 percent of loans for income generation purposes, will be withdrawn. “Providing access of credit for other purposes such as repayment of high-cost loans to moneylenders, education, medical expenses, consumption smoothing, acquisition of household assets, housing, emergencies, etc., is also equally important in the Indian context,” RBI stated.
How do guidelines apply to not-for-profit companies?
New definition applies: Since January 2000, RBI has granted certain exemptions to not-for-companies that are engaged in micro-financing activities and not accepting public deposits. Micro-financing activities were defined as providing credit not exceeding ₹50,000 for a business enterprise and ₹1,25,000 for meeting the cost of a dwelling unit to any poor person. According to the proposed guidelines, the new definition for microfinance will apply to not-for-profit companies.
Larger not-for-profits might not receive exemption: RBI is also contemplating whether a blanket exemption should be provided to all not-for-profit companies. It is considering bringing “companies above a certain threshold in terms of balance sheet size (say, an asset size of ₹100 crore and above) under the regulatory ambit of the Reserve Bank,” the consultation document stated. “As per information available in Bharat Microfinance Report, 2020, around 90 percent of Section 8 companies engaged in microfinance activities shall continue to enjoy the exemption from the registration requirement,” RBI stated.