MFIs have access to collateral free, soft interest loans that comes with almost no conditionalities on an unlimited scale today. The money mela of MFIs in the rural areas looks more than a trifle scary.

P. Devarajan

SHOULD micro finance institutions (MFIs) be policed? Some would wait while others want regulation today. A recent paper (May 2005) by Mr Y.S.P. Thorat (Managing Director, Nabard) and Mr Ramesh S. Arunachalam, styled "Regulation and areas of potential failure in micro-finance" has argued for a single regulatory authority for all models and forms of micro-finance.

"It will also help overcome the problem of using alternative legal forms to overcome micro-finance regulations," they write. The authors prefer a special cell or unit in the RBI which "could then be moved to a separate regulatory authority, if required."

And they cite three factors (to back themselves) which are: a) significant proportion of loan funds to the sector are coming from commercial banks - in ways, these are indeed public deposits being on-lent and the sector virtually has unlimited access to `condition less' collateral free loans at `soft' interest rates; b) the sector has grown considerably and should continue to grow even more and perhaps at a more scorching pace. The volume of money invested in the sector and institutions (individuals) is therefore by no means small by any standards; and c) there are some striking similarities to the NBFC failure scenario of 1990s and the early warning signals available point to several potential areas where market failure could indeed occur."

Their study has found quite a few infirmities in the MFI sector: several entities under a promoter group offering funds; possibility of opaque transactions between group entities not ruled out; no single serious regulator multiple regulators with different levels of supervision and no serious co-ordination among regulators and supervisors; ghost clients are possible along with ghost branches and ghost fieldworkers; same clients are shown as borrowers for loans from multiple lenders; financial intermediaries in micro-finance tend to have weak governance, management information systems and controls and perhaps, very weak risk management functions; by and large collateral free, soft interest, condition less (no personal guarantee) loans virtually on an unlimited scale today. The money mela of MFIs in the rural areas looks more than a trifle scary.

With the MFIs driven by profits (is that a sin?), suppliers of finance to the sector have grown in terms of funds and stakeholders (Nabard, SIDBI, private and public sector banks, private investors, semi-wholesalers and many others).

Most of them seem to be chasing an available pool of 20-30 larger and medium MFIs and for the authors, "there is a serious risk of rapid and burgeoning growth fuelled by the supply (wholesaler) side and not backed by appropriate growth in MFI systems and administrative capacity to manage that growth - this could result in portfolio quality problems. With growth, the systems are being severely tested and may have to be re-designed. Also, while general design of systems tend to be good on paper, implementation in terms of consistency needs to be enhanced.

In many ways, systems and procedures are non-negotiables and minimum requirements for MIS, internal control, internal audit, human resources and other systems need to be prescribed, adhered to and also verified through loan portfolio and system audits by third party auditors."

Firing away, the authors are for inscribing KYC (Know Your Customer) norms on a rising client base and use of agents to expand outreach.

But has the MFI sector to be hurried into a corral? The fetching faith of the authors in the efficacy of regulators is understandable though hard to share when a large swathe of rural and urban poor exist outside the financial system.

Importantly, the MFI sector works on three key models - the Nabard-Self Help Group- Bank Linkage scheme; the institutional MFI model supported by SIDBI, ICICI, banks and others; the partnership securitisation model of ICICI and other banks. These models work "through a complex array of institutional forms - including not-for-profit entities, mutual benefit organisations and for-profit institutions - that perform social and financial intermediation in different degrees. There is lack of clarity with regard to legal aspects in the Indian environment both with regard to appropriate form and associated legal compliances," explains the study.

All these players regularly come under the scanner of the RBI and should by now be aware of the financial and legal trapdoors; perhaps, the risks are no different from that inherent in corporate loans. Would it not be better if RBI and Nabard discreetly nudge the big players to be circumspect for the sake of sustaining the MFI movement, instead of collaring the poor who will be hurt the most? Why should the organised banking industry blindly cater to just about 20 or 30 MFIs and not spread the risks and aid the MFI movement across the country? Tough and intrusive laws have not averted financial scams, at least not in India.

(This article was published in the Business Line print edition dated October 1, 2005)
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