Research Paper: A framework for regulating India’s Microfinance Sector

By Savita Shankar and Mukul G. Asher,
Microfinance Focus, Nov. 27, 2009: There is growing interest in microfinance as one of the avenues to enable low income population to access financial services. India with a population of around 300 million poor people has emerged as a large potential opportunity for the microfinance sector. With only 48% of the population accessing financial services, expanding the microfinance sector is also important from the perspective of financial inclusion (World Bank, 2008). Since 2004, the Reserve Bank of India (RBI) has emphasised financial inclusion as an important goal.

The recent global financial crisis also underlines the desirability of financial sector growth by broadening access to financial products rather than by facilitating excessive leverage to a subset of the population or by increasing the complexity of financial products. While there have been various initiatives to promote microfinance in India since the 1970s, the sector witnessed rapid growth only in the 1990s. The RBI has since the mid 1990s helped in attracting funding for the sector by including microfinance in the “priority sector”, to which banks are mandated to allocate a percentage of their lending. However, no specific regulation was imposed on the sector as a whole primarily because it was felt that regulation may hamper the sector’s key strengths of informality and flexibility.
With the growth of the sector both in terms of size, scope and number of participants, there is however now a need for developing a more formal regulatory structure. First, regulation is needed to enable a number of large microfinance institutions (MFIs) to offer savings services, so as to address a major shortcoming of the sector. The largest MFIs in the country, which cumulatively account for 80% of the sector in terms of portfolio outstanding are non-banking finance companies (NBFCs), who are unable to accept savings deposits (Ghate, 2007). In order to do so, NBFCs need to obtain investment grade rating from a credit rating institution, which is difficult for the MFIs. As a result, most of the growth in microfinance in India has been concentrated on provision of loans or “microcredit”.

A number of studies have stressed the importance of savings for the poor (Rutherford, 2001). Many MFI members simultaneously both borrow and save. The lack of saving services results in their saving in less convenient, riskier and often lower yielding ways such as through purchase of ornaments. For the MFIs, this lack of access to deposits implies that they tend to be highly leveraged.

The introduction of savings services by the MFIs, has to be preceded by putting in place a frameworkfor their prudential regulation. Second, microfinance sector institutions are no longer solely socially motivated. Due to the growing perception that it is possible to earn high returns through microfinance lending, commercially driven entities are also being attracted to the sector. This further underlines the need for supervision and consumer protection. Third, some MFIs have started offering products such as insurance, remittances and pensions by tying up with mainstream providers. While this helps in broadening the scope of microfinance services, it also calls for coordinated regulation of the sector particularly in view of the limited financial literacy of its participants. Such increasing overlap between various financial institutions is expected to continue. Finally, while the diversity of legal forms in the sector has arisen due to its unplanned, entrepreneurial growth, a uniform regulatory framework would enable a level playing field and prevent regulatory arbitrage. While regulation is essential, avoiding over regulation that hampers innovation and unduly increases transaction costs is also equally important.

The rest of the paper is structured as follows. As any regulatory structure must be consistent with current and emerging characteristics of the sector, in Section 2, the current status and developments concerning microfinance sector in India are briefly discussed. The regulation of the micro finance sector presents unique challenges which need to be recognized and addressed.  Section 3 analyses these challenges. This is especially relevant because of the inadequate attention given to these challenges in the regulatory policy discussions in India.

This is followed by a brief overview of the current regulatory arrangements for the microfinance sector in India. The final section provides an outline of the suggested framework for regulating microfinance sector in India.

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Regulating India’s Microfinance Sector: A Suggested Framework

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