RBI's Proposed Microfinance Norms Negative For Banks, Say Analysts

RBI recommends removing MFI interest rate caps, product of the 2010 crisis.

<div class="paragraphs"><p>Micro loan borrowers attending a joint lending group session.</p></div>
Micro loan borrowers attending a joint lending group session.

The Reserve Bank of India, in a consultation paper, has suggested removing the pricing caps on micro loans introduced after the 2010 microfinance crisis. The recommendation is part of a broader attempt to ensure a level-playing field between banks, non-banks and microfinance firms, with the regulator suggesting that each category of lender be subjected to similar rules.

The suggestions, if implemented, could be negative for banks who doing a substantial amount of micro lending, said analysts. Standalone micro lenders, however, may benefit.

The board of each MFI can create an interest rate model, considering the cost of funds, margin and risk premium and determine the rate of interest to be charged for loans and advances. "Appropriate internal principles and procedures" should be laid down, the consultation paper said, adding that this should be guided by the Fair Practices Code.

The freedom in pricing will be a departure from the current rules.

At present, a margin cap of 10% over cost of funds exists for MFIs with Rs 100 crore outstanding loans or more. For the rest, the margin cap is 12%. A separate formula which uses the average base rate of five largest public sector banks can also be used but a cap exists there too.

These pricing restrictions were introduced in 2014 by the regulator following recommendations by a committee led by YH Malegam. The committee had found that high pricing, questionable recovery methods and excessive lending to unworthy customers had led to a crisis in the microfinance sector in 2010.

Should the recommendations in the consultation paper be approved, microlenders will be free to price loans as per internal cost structures.

In order to protect vulnerable borrowers, the regulator mostly suggests improved disclosures.

"The rates of interest and the approach for gradation of risks shall also be made available on the website of the companies or published in the relevant newspapers (for borrowers)," the RBI said in its paper.

Borrowers must be provided clear details of the interest rate pricing mechanism through loan agreements written in their vernacular language and lenders must disclose any penalty interest charged for late repayments.

Focus On Indebtedness

The consultative paper also recommends a broader definition of microfinance loans, which will apply to all regulated entities, including banks doing the business of microfinance.

The annual income criteria for a loan to qualify as a microfinance loan does not change but is recommended for all entities.

A collateral-free loan extended to rural households with a maximum annual income of Rs 1.25 lakh and to urban or semi-urban households with an annual income of Rs 2 lakh can classify as a microloan. "Same criteria shall be extended to all REs for the purpose of the common definition," the paper said.

There will be a limit for maximum permissible level of indebtedness for microfinance borrowers, which will again apply to all entities.

The paper suggests that the payment of interest and repayment of principal for all outstanding loans of the household at any point of time shall be capped at 50% of the household income.

Considering the low savings of these households, at least half of their income should be available to meet their other expenses. This is even more critical for the households at lower level of the prescribed income threshold.
RBI Consultation Paper

The current stipulation that limits lending by not more than two NBFC-MFIs to the same borrower shall no longer be required. The paper further suggests that board approved policies be put in place to help households avoid over-indebtedness.

Among other recommendations, the regulator has proposed remove prepayment penalties on microfinance loans.

The RBI has sought comments and suggestions from stakeholders by July 31.

Analyst View

The proposals in the consultative paper are marginally negative for universal banks and positive for microfinance institutions, said Kotak Institutional Equities in a report on Tuesday.

According to the report, the cap on household income prescribed in the consultation paper will restrict growth in average ticket size of micro loans for banks engaging in the microfinance business.

"In our view, there is likely to be pushback on the income level caps from banks as the evidence on the ground suggests a much higher income at household level," Kotak Institutional equities said in its report.

In case of microfinance institutions, the proposal to remove pricing caps is a positive, as it relaxes the tight business conditions they have been operating in.

Analysts at Edelweiss Research said the caps on annual household income would ensure that the maximum indebtedness of a rural household would be limited to Rs 75,000 and at Rs 1 lakh for urban or semi-urban households

"This is much lower than what we anticipated and will pose challenges (if implemented literally) for banks/small finance banks whose liability strengths favour ticket size enlargement," Edelweiss Research said in its report on Tuesday.

According to the research house, proposals such as removal of pricing caps and inclusion of penal interest will be good from a product economics perspective, but could add to higher cost for customers.

While the proposed guidelines are onerous for banks and small finance banks, they are positive for microfinance institutions, Edelweiss Research said.

Nishant Shah of Macquarie Research sees the proposed norms as a long-term negative for the microfinance industry, though it may be positive in the near term.

The research house, in a report titled “The Sisyphean Task Of MFI Regulation”, on Tuesday said the RBI’s decision to remove the pricing caps are based on two observations. First, lenders other than microfinance institutions were using the pricing mechanism as a benchmark for pricing their own loans. Second, actual operating expenses for microfinance firms have turned out to be higher and therefore a higher margin cap was necessary.

“While we agree with the latter, we do not understand how the removal of the spread cap (instead of imposing a higher spread cap on all lenders) will prevent this benchmarking practice by banks / SFBs,” Shah said in the report.

These proposed regulations are much more lenient than what we as well as the market expected. Rather than spread caps being imposed on banks/ small finance banks too, they have been removed entirely in the document. Rather than absolute indebtedness caps being extended to banks/SFBs, ‘assessed income’ based caps have been imposed on all lenders instead. This is negative from the industry’s point of view in the long term in our view, but will be a near-term positive.
Nishant Shah, Analyst, Macquarie Capital