Microfinance: Choose schematic regulation now, or face sporadic regulation
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Microfinance Focus , October 23, 2010 (By Vinod Kothari) : The Andhra Pradesh regulatory Ordinance, and consequent aftereffects news that microfinance institutions have stopped lending, leaving hundreds of thousands of borrowers stranded – would soon leave microfinance institutions in India pondering over a huge question – schematic regulation or sporadic  regulation? Perhaps, the more preliminary questions – whether regulation or no regulation, or whether imposed regulation or self regulations – have become irrelevant now. The microfinance institution in India has become so large, and so significant for such a sensitive sector of the economy, that it needs urgent regulatory attention. If centralized thinking on regulatory moves comes a day too late, more such sporadic steps as the Andhra ordinance would create complete chaos for a very sensitive sector.
 
Let us realize some very hard facts – there might be endless debate on what the microfinance institutions are exactly doing – promoting rural developing or promoting the interests of their shareholders or prospective equity buyers, serving the interest of rural India or burdening rural India which high interest rates associated with the typical money-lender syndrome that the society has hated over decades, and so on. It might be argued, and perhaps not without a reason, that microfinance is sending rural India into a snowballing debt trap, since all but few microfinance borrowers do not actually clear their loans and come out of the loan books of a lender, but end up taking a new and bigger loan, or that, the reason why a microfinance borrower repays an unsecured loan is because he sees the prospect of a new loan at the end of the cycle. It may be argued that the microfinance sector rides the back of the tiger, where let alone total exit or scaling down of business, even closure of a branch might be difficult, because as the lender stops further lending, existing borrowers start defaulting. Some of these sensitive questions were brought up in articles by Daniel Rozas and Vinod Kothari on http://www.microfinancefocus.com/news/2010/07/06/the-hidden-risks-behind-microfinance-securitization/ .
 
These larger debates notwithstanding, it is not in question that the reach of microfinance today is huge – data suggests (though with significant degree of possible overlap) that almost one of out of every 100 Indian is a microfinance borrower. If we apply this ratio to rural population, nearly one out of every 50 Indians staying in rural India, or one of every 10 rural families is a microfinance borrower. This is a tremendous outreach, and anything that affects that jots the microfinance sector is sure to have very serious implications for an extremely sensitive sector. It is too big to be taken lightly. Allowing it remain unregulated is surely a threat, and a sporadic regulatory action such as the AP Ordinance is a bigger threat even.
 
Legal sophistry such as constitutional competence of a State govt to regulate MFIs may not yield much results. It is possible to contend that  MFIs are moneylenders, and moneylending is covered by State list of the Constitution. On the other hand, it is possible to argue that Central govt had already proposed an MFI regulation initiative, and not being in the concurrent list, such regulation cannot be the subject matter of regulation by both the Central and the State government. These questions will take years for the courts to decide, but it would be far better for the MFI industry to opt for a central regulation that regulation by States. If State legislatures imitate what Andhra has done, it would be terrible situation for the MFIs. On the contrary, MFIs should urgently ponder over, and liaise with the Ministry of Finance for a move towards a central legislation.
 
The Andhra Ordinance, no doubt, comes with a very unpleasant preamble, suggesting as if MFIs are loan sharks and the gullible borrowers need to be protected against predatory lending. It refers borrowers’ impoverishment and in some cases leading to suicides. It makes an express intent of not promoting or regulating the sector, but protecting borrowers’ interest. This is clearly a negative mindset. It gives an indication as the State is not aiming at regulating an institution but taming a monster.
 
The Ordinance is hastily drafted and mindlessly conceived. For instance, it is understandable for a regulation to say that MFIs existing as on the date of the law would require registration, but it is hard to think of a regulation saying that MFIs would stop lending until they seek registration. Moving to registration requires a transition – MFI business is one where continuity of lending is most important for reasons discussed above. If lending stops, what happens to recoveries, and what happens to the loans taken by the MFIs, and ultimately, what happens to the entire institution of microfinance? It must be noted that after all, most of the money into microfinance today has come from banks, be it in form of loans or in form of portfolio purchases which are nothing but loans in disguise. If there is anything done to tilt the balance, and if the tilt becomes a shakeout, it is ultimately a cost on the banking system.
 
If allegedly exploitative interest rates charged by the MFIs was the concern of the Ordinance, the Ordinance says nothing about ceiling on interest rates. Surprisingly, it states that the total amount of interest shall not exceed the principal, which, for a 1 year loan payable per week, amounts to a whopping 158% effective interest rate. Does the legislation, therefore, permits loans upto interest rate of 158%? Of course, the ordinance requires disclosure of interest rates, but question once again would be, is it flat rate that needs to be disclosed, or the effective interest rates? Clearly, effective interest rates are not understood by most of the microfinance field workers themselves, let alone the borrowers.
 
The Ordinance prohibits lending by an MFI, without prior clearance by the regulator, to such self help group as already has a loan from a bank. There is an elaborate formality for seeking such prior approval from the regulator. This is absurd and undemocratic. Microfinance developed primarily due to the lacunae in the outreach or services of the banks- so denying access to such SHGs as have access to bank funds is questioning the freedom of choice of the borrowers.
 
In short, there are several ill-conceived and reactive provisions in the Ordinance. This goes to highlight the essential point made in this article – that MFIs should not even think of staying unregulated anymore, and should aggressively seek a central regulation, which is well-conceived, well-constructed and serves the need of protecting the borrowers’ interest as also ensuring that healthy financial inclusion gets extended.

 
About the Author:
 
Mr. Vinod Kothari, based in Kolkata, India is internationally recognised as an author, trainer and expert on securitisation, asset-based finance, credit derivatives and derivatives accounting. He offers about 20 training courses every year on credit risk, securitisation and credit derivatives all over the World. For more information Visit Author`s website: http://www.vinodkothari.com .

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