The microcredit providers in India have come full circle.
A decade of growth in the early 2000s, bringing microloans into the commercial mainstream. Worries about excessive lending, followed by stricter regulations from 2011. And now, ten years later, a new liberalized framework.
The Reserve Bank of India’s new microfinance rules could open the door to another burst of growth for microcredit providers across the country, even as borrowers, in turn, may face higher interest rates. The rules, finalized by the RBI on March 14, will remove price caps for these lenders, change the definition of microloans and set new benchmarks for who can get this credit and how much is appropriate.
According to India Ratings & Research Pvt. the rules will help improve the viability of small and medium-sized microfinance institutions. It may also enable microcredit providers to penetrate newer geographies “because prices can now be differentiated and cover higher operating costs for the same,” analysts Amit Rane and Jindal Haria wrote in a March 15 note.
One major change brought about by the new rules is the removal of price caps, which were put in place to prevent lenders from charging excessively high interest rates.
While the previous rules said lenders can only charge a margin of 10-12% over their cost of funds based on size, the new guidelines leave pricing to individual lenders. The councils will oversee and the regulator will keep an eye out to prevent “usurious interest” charges.
How easy will it be to make sure lenders don’t raise rates to unreasonable levels?
“70% of the sector was already free, yet rates were not usurious,” said Alok Misra, chief executive officer and director of the Microfinance Institutions Network, pointing out that the previous limits applied to MFIs, but not on banks. Misra added that the pricing formula should now be in the public domain. There are enough players in the market to ensure healthy competition, Misra said.
That’s not to say the risk isn’t there.
“There is a real risk that borrowers will be charged high rates. Responsible lending is a necessary condition for microfinance,” said Alok Prasad, former CEO of MFIN. “While reasonableness of pricing is an important principle of government policy, the basis and principles for control have not been specified. More clarity on this would be desirable,” Prasad said.
According to Misra, it is important that microcredit providers charge a reasonable profit margin. MFIs assume the financing costs and build in operating costs and a profit margin to regulate the interest at which they lend.
“There has to be some margin because it’s a business and there has to be something for investors. If someone charges something exorbitant, the regulator comes into the picture and actions can be taken,” said Misra.
What would be considered “extortionate” borrowing? “A margin of 15-20% without any explanation can be considered usury, which is not possible in such a transparent market,” Misra said.
Boards of individual MFIs will also remain critical, said Manoj Nambiar, managing director of Arohan Financial Services. “This reduces the chance of any excesses.” In addition, all pricing information must be shared with borrowers and published on the company’s website, Nambiar said.
While rates are likely to rise, not all lenders will feel the need to raise them immediately.
“About 35% of MFIs with high operating costs are able to raise interest rates,” said Udaya Kumar Hebbar, CEO of CreditAccess Grameen Ltd.
Under the new rules, all unsecured loans to households whose annual household income does not exceed Rs 3 lakh can be classified as microloans. In addition, lenders must ensure that the monthly EMI or payment does not exceed 50% of the monthly household income.
In the past, lenders could only lend to people with incomes up to Rs 1.25 lakh in rural areas and Rs 2 lakh in urban areas. There was also a limit to the amount of loan that could be provided and to the debt burden.
Misra explained that the new rules will allow MFIs to cover borrowers previously deemed to be over-earning this group of lenders. However, these borrowers were too small to be covered by banks and thus fell between the cracks.
“About 10 million additional households will now be covered by MFIs, 75% of which will be from deep rural areas and 35% from semi-urban areas,” Hebbar said.
Some interpretation issues remain, Prasad said.
For example, the definition of household income will pose challenges as it is not clear whether the income cap applies to gross income or net surplus after the costs of the micro-enterprise/enterprise have been covered, he explained. Also because the maximum loan amount is not specified, it will have to be derived based on the requirement that the monthly payment should not exceed 50% of the household income, Prasad said.
The definition of what a household is may also require some clarity.
A common framework for evaluation and income assessment must be established, India Ratings said in its report. “If not carefully executed from a credit risk perspective, the purpose of microfinance could be diluted and the group structure unable to withstand high debt defaults,” the analysts said.
The more liberal rules will allow for faster expansion, according to the industry.
With the ability to cover higher operational costs, microcredit providers may be able to target areas where they have been reluctant to venture until now.
According to MFIN data, as of September 2021, East and Northeast India accounts for 39% of the microcredit portfolio, according to MFIN data. South India accounts for 26% while West, North and Central India contribute 15%, 12% and 8% respectively.
The new regulations herald the next phase of growth for the MFI industry, Nambiar said. “If one considers the first phase as before the Andhra Pradesh Microfinance Ordinance in 2010, then the second phase started with specific RBI regulations for MFIs. Now, with deregulation and harmonization of rules, the third phase starts – MFI version 3.0.”
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