The Indian microfinance industry has come a long way since its beginning in the late 20th century, from operating under a “Not for Profit” structure to maturing into a regulated financing industry. The vital element in form of strong financing support from domestic as well as global financial institutions helped achieve the desired scale and inching close to the goal of financial inclusion.
Microfinance institutions (MFIs) have successfully replicated the joint-liability group (JLG) based lending model to provide door-step credit services to 5.9 crore borrowers helping create positive externalities at the community level.
In December 2011, the Reserve Bank of India introduced the NBFC-MFI licence and formulated guidelines for the microfinance industry to protect borrowers, with special emphasis on the interest rate cap, borrowing limits, and institutions allowed to operate.
In the following years, many key NBFC-MFIs transformed into a universal bank or small finance banks while some of the larger NBFCs and mainstream banks entered the microfinance space. Eventually, MFI regulations were only applicable to NBFC-MFIs, but other players accounting for around 70 per cent of the microfinance industry were outside the purview of the regulations.
To give an example, currently, NBFC-MFIs are only allowed to charge a maximum of 21.7 per cent which is lower of either 10-12 per cent above the cost of borrowing or 2.75 times the average base rate of the five largest commercial bank. This means to reap a 10 per cent interest cap benefit; the average cost of borrowing shouldn’t exceed 11.7 per cent.
This was practically possible only in the case of larger NBFC-MFIs while the smaller ones operated under squeezed margins. The NBFC-MFIs were required to function within this cap, without the ability to price based on the credit risk despite encountering three macro-economic disruptions since 2016.
The industry has matured over the years as it weathered multiple business cycles by adhering to the basic rules of lending and duly imbibing learnings along its way whether in the form of geographical diversification or adopting digital channels. The average outstanding per borrower grew at a CAGR of 21 per cent from ₹8,144 at the end of December 2012 to ₹44,729 at end of December 2021 indicating an increase in financing needs to enhance the capital formation at the bottom.
It is important for NBFC-MFIs to continue serving the growing demands of the underserved and more importantly rural borrowers to fulfill aspirations.
On the back of a strong industry foundation built over the past two decades, the RBI has ushered a host of new opportunities with the advent of new guidelines on March 14, 2022. The regulatory arbitrage has been removed by shifting the framework from entity-specific to activity-specific, making it applicable to all entities serving microfinance borrowers.
Going forward, any collateral-free loan provided to a borrower with an annual household income of up to ₹3 lakh will be considered a microfinance loan, subject to a maximum FOIR (fixed obligations to income ratio) of 50 per cent. This will ensure that the overall repayments during the year, including principal and interest, do not exceed 50 per cent of the annual household income.
The revision of the income limit to ₹3 lakh from ₹1.25 lakh in rural and ₹2 lakh in urban earlier, reflects the confidence shown by the central bank in the microfinance industry’s ability to responsibly cater to the growing credit demand, giving the much-needed impetus to cover a larger portion at the bottom of the economic pyramid. This will increase the market potential by another 10-15 per cent, the majority of which is expected to be driven from the deep rural areas.
The regulations have been designed in a manner that enables entities to become more efficient and remain relevant in the competitive market space. It clearly accentuates the need to have a board approved income assessment and pricing policy subject to regulatory scrutiny. The lending institutions will have to determine their interest rate which will be a function of the cost of funds, operating costs, risk premium, and margin wherein the risk premium will consider borrower profile, historical geographic performance, and others.
The borrowers need to be provided with a standardised factsheet prominently disclosing the minimum, maximum and average interest rates and all associated charges. This will help borrowers clearly decipher the difference in the interest rates charged by various entities i.e. on a per ₹1,000 amount basis.
The external risks posed on the account of pandemic over the past two years might lead to an increase in risk premium resulting rise in interest rates. However, over the medium to long term, the competitiveness factor will drive the lending rates downwards, benefitting the end borrower.
India, being the largest microfinance market in the world has reached a penetration level of 33-35 per cent at a market size of ₹2.64 lakh crore at the end of December 2021. A closer look at the urban-rural mix reveals that 45-50 per cent of the urban market has been penetrated while the rural market has crossed 25 per cent levels.
This depicts the potential of the deep rural markets which are expected to gain more traction and have shown resilience in the past several years owing to the self-sufficient economy. The institutions having a deep rural presence will have an advantage to source new to credit customers and serving the household needs.
The minimum requirement of microfinance loans for NBFC-MFIs being revised from 85 per cent of net assets to 75 per cent of the total assets is a big breather. This would enable the momentum of product innovation helping strengthen the balance sheet and make it future proof by keeping a healthy balance between an unsecured and secured portfolio.
The new regulations will allow the NBFC-MFIs to graduate along with the borrowers, follow their growing financing needs, support their rising aspirations, and help them catapult from livelihood supporting activities to asset creation opportunities in the next phase of the growth story.