India: An Analysis of Recent Proposals. March Finance and Private Sector Development Unit South Asia Consultative Group to Assist the Poor

Transcription

1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized India: March 2006 DRAFT: NOT FOR CIRCULATION An Analysis of Recent Proposals Finance and Private Sector Development Unit South Asia Consultative Group to Assist the Poor THE WORLD BANK

2 CONTENTS EXECUTIVE SUMMARY... i I. Introduction... 1 II. Overview of Microfinance in India Introduction Three Models of Microfinance Delivery in India SHG-Bank Linkage Model Free-Standing MFI Model Bank Agency Model... 9 III. Overview of Current Legal and Regulatory Treatment of Microfinance in India Introduction Legal and Regulatory Bases of the SHG-Bank Linkage Model Legal and Regulatory Bases of the Free-Standing MFI Model MFIs Unregulated by the RBI MFIs Regulated by the RBI Legal and Regulatory Bases of the Bank Agency Model IV. Proposals for and Positions on Regulatory Reform Introduction Reform Proposals and Positions Related to the Free-Standing MFI Model Overview Proposals Aimed at Formal Government Recognition of Credit-Only MFIs not Regulated by the RBI Proposals Aimed Primarily at Enhancement of Transparency in the Microfinance Sector Proposals Aimed at Permitting Voluntary Savings Mobilization by MFIs not Regulated by the RBI Proposals Aimed at Easing Eligibility Requirements for Operating as a Deposit-Taking Microfinance NBFC or Microfinance Bank Proposals Aimed at Accomplishing Substantially all the Foregoing Objectives Through New Microfinance-Specific Legislation V. Foreign Experience with Specialized Regulatory Treatment of Microfinance Applied in the Indian Context Introduction Regulation of Non-Depository Institutions Encouraging Formation of and Transformation into Regulated Depository MFIs through Less Stringent Licensing Requirements Lowering Minimum Paid-In Capital Requirements to Encourage Formation of Depository Microfinance Adding Tiers to Banking Regulation to Permit/Facilitate NGO Transformations Umbrella Legislation Imposed Over Existing Heterogeneous Financial System Parallel Frameworks for Microfinance... 41

3 5.6 Bank Agency Relationships VI. Summary Analysis of Legal and Regulatory Reform Proposals Introduction Proposals Aimed at Formal Government Recognition of Credit-Only MFIs Not Regulated by the RBI Proposals Aimed at Enhanced Transparency in the Microfinance Sector Proposals Aimed at Permitting Limited Voluntary Savings Mobilization by MFIs Not Regulated by the RBI Proposals Aimed at Establishing a Form of Specialized Deposit-Taking Microfinance NBFC with Less Stringent Licensing Requirements Proposals Aimed at Accomplishing Substantially All the Foregoing Objectives Through New Microfinance-Specific Legislation Bibliography Annex 1: Persons Consulted during India Mission Annex 2: Persons Consulted regarding Foreign Experiences... 59

4 ACKNOWLEDGEMENTS This note was prepared by a team led by Niraj Verma (Finance and Private Sector Development, South Asia Region, World Bank) and Timothy Lyman (Consultative Group to Assist the Poor) and including Kate Lauer (Consultant) and Lee Byrd (Consultant). The contribution of the Indian legal counsel, Trilegal (Consultant), is acknowledged, particularly in terms of ensuring legal accuracy with respect to Indian laws and regulation in the discussion in the note. The peer reviewers were Bikki Randhawa (Financial Sector Operations and Policy Department), Mohini Malhotra (World Bank Institute) and Richard Rosenberg (Consultative Group to Assist the Poor). The report was prepared under the overall guidance of Barbara Kafka (Director, Finance and Private Sector Unit, South Asia Region) and Simon Bell (Manager, Finance and Private Sector Unit, South Asia Region), Priya Basu (Lead Economist, Finance and Private Sector Unit, South Asia Region) and Stephen Rasmussen (Lead Specialist, Finance and Private Sector Unit, South Asia Region). Heather Fernandes and Lizy Mathew (South Asia Finance and Private Sector Development Unit) provided administrative support. The team expresses its appreciation to all the persons consulted during the primary research mission as well as during follow up consultations. The team would especially like to acknowledge the various discussions with and inputs from the Financial Sector division in the Ministry of Finance, the Reserve Bank of India, the National Bank for Agriculture and Rural Development and the main network for microfinance in India, Sa- Dhan. The note also draws on the growing body of analytical material on the subject of microfinance regulation and supervision that is available on the international stage, as well as on the experience of experts who have been involved with other countries consideration of similar issues. The team expresses its appreciation to these persons for the time they spent discussing various countries' experience. And last but not least, funding support from the Swiss Agency for Development and Cooperation is also gratefully acknowledged.

5 ABBREVIATIONS & ACRONYMS AP Andhra Pradesh BAM Banque-Al-Maghrib BKD Village Credit Board BoG Bank of Ghana BOU Bank of Uganda BPR Bank Perkreditan Rakyat BRI Bank Rakyat Indonesia CBA Central Bank of Armenia CCI Cooperative Credit Institution ECB External Commercial Borrowing FFP Private Financial Fund FMFB First MicroFinanceBank GOI Government of India GTZ German Gesellschaft für Technische Zusammenarbeit ICAI Institute of Chartered Accountants of India KYC Know-your-Customer LAB Local Area Bank LDKP Rural Fund and Credit Institution MACS Mutually Aided Cooperative Society M-CRIL Micro-Credit Ratings International Ltd. MDI Microfinance Deposit-Taking Institution MFDC Microfinance Development Council MFI Microfinance Institution MIS Management Information Systems NABARD National Bank for Agriculture and Rural Development NBFC Non-Bank Finance Company NB-MFI Non-Bank Microfinance Institution NCAER National Council of Applied Economic Research NGO Non-Governmental Organization PACS Primary Agricultural Cooperative Society POS Point-of-Sale ProFI Promotion of Small Financial Institutions RBI Reserve Bank of India

6 RCB Rural and Community Bank ROSCA Rotating and Savings Credit Association RRB Regional Rural Bank SBP State Bank of Pakistan SEBI Securities and Exchange Board of India SHG Self Help Group SIDBI SME Small Industries Development Bank of India Small and Medium Enterprise

7 CURRENCY EQUIVALENTS As of January 31, 2006, US$1 = Rs

8 EXECUTIVE SUMMARY Background The Indian microfinance community has been pushing for legal and regulatory reform for several years, motivated primarily by two desires: (i) formal legal recognition and legitimization of the various types of microfinance institutions (MFIs) operating in India and (ii) legal permission to engage in deposit-taking with lower and fewer entry barriers. Members of the microfinance community have engaged with the Government of India in a dialogue regarding the regulation of microfinance service delivery, arguing that there is a need for reform to facilitate expansion of outreach through microfinance to the millions of Indians who currently do not have access to financial services. Various stakeholders have proposed a range of possible reform measures, which vary in their approaches and in their potential effects on the microfinance sector. Through an analysis and presentation of the pros and cons of various reform proposals, this note aims to provide a tool with which decision-makers can assess these proposals (summarized below) without being prescriptive. And while the note focuses on proposals pertaining to the microfinance sector only, this emphasis is driven by the need for additional input into the on-going dialogue regarding microfinance regulation and is not indicative of a view that regulatory issues are the most significant constraint to scaling up microfinance in India. Indeed, other constraints specifically, limited institutional capacity and a lack of appropriate financing may in fact be more fundamental for the microfinance sector and would ideally be addressed before undertaking any regulatory reform. Furthermore, the proposals discussed in this note would affect institutions that currently account for only a small (albeit growing) part of the overall financial sector. There are likely to be future proposals for reform pertaining to the broader financial sector reducing government ownership of banking institutions, restructuring and revitalizing rural finance institutions, revisiting directed credit schemes which may have a greater impact on improving access to financial services for the poor and which therefore merit greater attention from policy makers. Nonetheless, the reform proposals discussed in this note have been accorded attention by the Government and are important to examine for several reasons, including the stated rationale for reform (to increase access to financial services for the poor), the fast growth rate of microfinance and its potential for future expansion, and the intensity of the discussions between the Government and the microfinance sector. There are currently four models for microfinance delivery in India although, as discussed below, the reform proposals focus on only one of the models. The four models are: the direct provision of microfinance by banks, the free-standing MFI model, the self-help group (SHG)-bank linkage model and the bank agency model. The direct provision of microfinance services by banks is by far the most prevalent means of microfinance delivery in India; however, it is not addressed in this note because it does not raise i

9 significant legal and regulatory issues and has not been a significant topic in the current dialogue. The note discusses the legal and regulatory framework for the other three models but analyzes only proposals that relate to the free-standing MFI model. The SHG-bank linkage model, which provides microfinance services through India s vast network of formal financial institutions, operates largely within the existing legal and regulatory framework and currently does not raise any significant regulatory issues and there are no proposals for reform currently being discussed. The bank agency model, pursuant to which banks engage agents to carry out various financial activities, has recently been the subject of a major reform measure a January 2006 Reserve Bank of India (RBI) circular that permits banks to use Non-Governmental Organizations (NGOs), Self Help Groups (SHGs), Microfinance Institutions (MFIs) and other civil society organizations as agents for conducting such activities on the micro level. In contrast, significant proposals are currently being debated with respect to the free-standing MFI model. Proposals for Reform Many stakeholders feel that the free-standing MFI model, which encompasses a wide array of institutional types, including institutions that are unregulated and institutions that are regulated by the RBI, is constrained by significant regulatory barriers that limit outreach and the provision of a comprehensive range of financial services. In particular, there is dissatisfaction among many MFIs with the current regulations that (i) permit only those MFIs registered as non-bank finance companies (NBFCs) to mobilize voluntary deposits from the public and (ii) pose significant obstacles financial and operational for MFIs wishing to transform into an NBFC, especially the required minimum entry capital levels, which are perceived to be too high. Other MFIs not interested in deposittaking are seeking an operating environment in which they have greater, legally recognized legitimacy. These MFIs recognize that increased transparency is also desirable, both to develop a healthier sector and to provide a clearer picture of the sector and its participants to the world at large (including commercial lenders). In response, various stakeholders have proposed reforms addressing one or more of the following topics: i) formal legal recognition of MFIs not regulated by the RBI; ii) enhanced transparency in the microfinance sector; iii) limited voluntary savings mobilization by MFIs not regulated by the RBI; iv) creation of a form of deposit-taking microfinance NBFC, which would be subject to less stringent requirements than those applicable to other NBFCs, and v) adoption of a microfinance-specific legislation encompassing all of the foregoing attributes. Summary Observations on the Proposals The following text summarizes the note's observations with respect to the five reform proposal topics listed above: i. Formal government recognition of credit-only MFIs. Formal government recognition of credit-focused MFIs that are not regulated by the RBI may help to clarify the legal situation of these MFIs and legitimize their activities. However, a few points ii

10 need to be kept in mind. First, these institutions already have significant access to commercial funds, suggesting that their legal status may not be a significant operational limitation in this respect. In addition, international experience demonstrates that a formal legislative definition of the microfinance sector is rarely, if ever, possible without limiting MFIs' operational flexibility. As a consequence, implementation of the idea in India may result in a trade-off for practitioners: clearer legal recognition of their legitimacy, but diminished operational flexibility. Also, when considering the practical effects of legislative recognition by the central-level Government, it is important to keep in mind that such recognition will likely neither be a sufficient condition to make MFIs impervious to interference by state-level governments (one key concern behind the demand for such recognition), nor will it be a full substitute for increased dialogue and better transparency in discussions with state-level governments. Although overall, there are advantages to such government recognition, it will be important to ensure that the implementing legislation does not unduly impede MFI operational flexibility. It will also be important to minimize possible disharmonies with state-level laws and regulations and to maximize buy-in by state governments. ii. Transparency. Increased transparency would clearly benefit the microfinance sector by exposing inefficiencies, enhancing competition, improving access to information for investment and, ultimately, expanding outreach. Hence, the ideas behind the transparency-related proposals are well-founded. However, transparency mandated by law or regulation will impose costs on both MFIs (which must pass such costs to clients, if they operate sustainably) and the responsible regulatory body. And although it can be argued that even efforts to improve transparency outside of law or regulation will entail costs, it is nonetheless important that those responsible for setting the standards carefully weigh the benefits of proposed transparency measures against the costs of compliance and validation (these may be high, given the generally limited capacity of MFIs to prepare, analyze and report on their operations, together with the fact that many MFIs are multi-service organizations with mixed accounts, making segregation of data difficult). Nonetheless, a consensus exists in India with respect to the general idea of promoting improved transparency in the microfinance sector and this idea needs to be supported, perhaps initially focused on building MFIs' capacities to collect and report data. iii. Limited Unregulated Deposit-Taking. Allowing MFIs that are not regulated by the RBI to engage in limited voluntary savings mobilization could extend a much needed service to unserved poor clients. However, this may also place the clients' deposits at risk. In considering the various proposals on this count as well as the regulatory concerns that the RBI may raise, careful consideration should be given to the readiness of the microfinance sector as a whole to respond to such an enabling measure. A majority of Indian MFIs are not profitable and cannot at present safely absorb the additional costs of mobilizing voluntary deposits, especially small balance deposits, which are difficult to offer profitably. (Indeed, this raises a question whether any regulatory reform needs to be preceded by institutional and financial strengthening of MFIs.) Apart from consideration of these issues, an analysis of the benefits of limited deposit-taking MFIs needs to be viewed in light of the January 2006 RBI circular that endorsed the use of bank agents (which may be MFIs) to provide savings services. By allowing deposit collection through MFIs (acting as agents), a key rationale for the microfinance sector's proposal that largely unregulated MFIs be permitted to provide deposit services to the poor may in fact have iii

11 been satisfactorily addressed. In overall terms, although the intent underlying this proposal is laudable, the potential drawbacks may outweigh the benefits (particularly when the expansion of access to deposit services through the bank agency model made possible under the RBI circular is factored in). iv. Deposit-taking Microfinance NBFC. Creating a form of deposit-taking microfinance NBFC with relaxed qualification requirements may have the effect of extending access to savings services through the formation of new depository institutions, as demonstrated by certain other countries' experiences. However, international experience also demonstrates that reduced minimum capital requirements may lead to supervisory challenges and a risk of regulatory arbitrage; these potential risks will need to be carefully considered by policy makers before taking a decision. Moreover, the newly created National Bank for Agriculture and Rural Development (NABARD) Microfinance Development and Equity Fund can provide some of the capital, the lack of which has been cited as a critical constraint for MFIs seeking to transition to an NBFC due to the high minimum capital requirement. This fund has the potential to assist MFIs wishing to transition to deposit-taking NBFCs without requiring changes to existing regulations. Finally, as mentioned above, the RBI's endorsement of the use of bank agents to provide savings services may substantially address the unmet demand for such services. Given the closely balanced arguments in favor of and against this proposal, the final decision should probably hinge on whether there is willingness and capacity on the part of the RBI to assume the larger supervisory responsibilities that would be entailed and whether the risk of regulatory arbitrage can be satisfactorily addressed. v. Central-level Microfinance Legislation Addressing All Issues. The adoption of central-level microfinance-specific legislation aimed at addressing all of the foregoing topics would carry each of the potential advantages and disadvantages described above, as well as potentially more significant harmonization challenges with existing centraland state-level legislation. Consequently, existing concerns may be better addressed through targeted proposals that do not pose such harmonization challenges. And if the Government elects to propose such more targeted legislation addressing a limited menu of the foregoing issues, then the salient considerations will depend upon the content of the legislation: specifically, the issues covered and the approaches for addressing them. If the legislation is intended to bestow increased legal legitimacy upon MFIs, then this must be handled with due concern not to limit unnecessarily their operational flexibility. The significant arguments against permitting even limited deposit taking by small, unregulated or lightly regulated MFIs counsel against including this in the proposed legislation (particularly in light of the new opportunities for MFIs to mobilize deposits as agents for banks under the January 2006 RBI circular). Finally, if the Government is intending that the legislation create a new apex body for the microfinance sector, then before vesting such a body with regulatory and supervisory responsibilities, the Government should carefully consider the potential downsides of adding another regulatory body to the variety of financial regulators currently operating in India. Instead, it may be more prudent especially given the large number of financial regulators already operating in India to establish an apex institution that primarily serves a developmental and policy coordination role for promoting the microfinance sector. iv

12 I. Introduction There is an increasing body of literature, including by the World Bank, 1 demonstrating that access to financial services is an effective instrument in the fight against poverty and that inclusive financial systems are associated with higher growth and better income distribution. Over the last few decades, and in particular over the last ten years or so, microfinance -- the provision of a range of financial services to the poor -- has been making increasingly important contributions towards improving access to financial services for the poor. The Indian microfinance sector, despite as yet being small in comparison to the formal banking system, 2 has witnessed very rapid growth, particularly during the last few years, and is now starting to assume more significant proportions (Figure 1). With the rapid growth of microfinance in India, it is perhaps not that surprising that regulation of microfinance service delivery to India s poor has emerged as a topic of significant debate, especially since the late 1990s. The debate has originated from the microfinance sector which has produced various proposals for reform, primarily motivated by the two issues of legitimization and deposit-taking. The former factor is viewed as important by the microfinance sector to give recognition to microfinance practitioners and also perhaps to protect them from interference from state governments, while the latter is viewed as necessary to satisfy demand for savings products as well as provide Microfinance Institutions (MFIs) with a needed source of funds for onlending. 3 The sector has consistently underscored its view that regulations should serve to increase access and that existing regulations pose barriers to this objective through high entry (minimum capital) barriers that prevent microfinanciers from transforming into entities that are able to accept deposits from their clients. To provide additional input and an analysis of the pros and cons of various proposals in the on-going microfinance regulation dialogue, this note focuses on these proposals made by the microfinance sector. 1 See for example, Finance, Inequality and Poverty: Cross Country Evidence, The World Bank, The total outstanding credit from microfinance amounts relative to outstanding credit of the entire banking system is a mere 0.5% in end-march As discussed in Section IV, the proposals on deposit-taking take two distinct approaches: permitting unregulated institutions to accept small deposits and permitting MFIs to form as Non Banking Finance Companies (NBFCs, or another type of deposit-taking institution, as presented by a proposed draft microfinance law prepared and submitted by the microfinance sector to the Ministry of Finance in December 2005) that would be subject to less stringent regulatory requirements, including in particular lower minimum capital requirements and no rating requirement for qualification to take deposits. 1

13 However, this note's emphasis on microfinance regulation does not imply a view that regulatory reform in microfinance is the most significant constraint to scaling up microfinance in India nor that such reform is the most fundamental financial sector reform that policy makers need to consider. Indeed, perhaps more fundamental constraints, including institutional capacity constraints of microfinanciers and a lack of appropriate financing, would ideally be addressed before undertaking any regulatory reform. Furthermore, this debate regarding microfinance regulatory reform needs to be viewed in the larger context of financial sector reform, because the proposals discussed in this note relate to institutions that currently account for only a small (albeit growing) part of the overall financial sector. There are likely to be future proposals for reform pertaining to issues related to the broader financial sector reducing government ownership of banking institutions, reforms of rural finance institutions, review of directed credit schemes which may have a greater impact on improving access to financial services for the poor and which therefore merit greater attention from policy makers. Indeed, there is considerable literature that demonstrates a link between such broader financial sector reform and impact on access to financial services and poverty alleviation. 4 Nonetheless, the microfinance reform proposals discussed in this note have been accorded attention by the Government and are important to examine for several reasons, including the stated rationale for reform (to increase access to financial services for the poor), the fast growth rate of microfinance and its potential for future expansion, and the intensity of the discussions between the Government and the microfinance sector. Discussion of regulatory issues related to microfinance has gained considerable momentum following the February 2005 Budget Message of the Minister of Finance in which the Minister outlined a commitment to consider specialized regulatory treatment of the microfinance sector, which was reasserted in the Minister s February 2006 speech. In this past year alone, the Reserve Bank of India (RBI), the National Bank for Agriculture and Rural Development (NABARD, an apex rural development financial institution owned by the RBI and the Government of India, GoI) and Sa-Dhan (India s foremost network of MFIs), among others, have made significant pronouncements on the topic of specialized microfinance regulation. And, as discussed in more detail below, following the Minister's speech in 2005, an internal working group of the RBI had conducted a study of the sector, recommended reform supportive of the bank agency model and, in January 2006, issued a circular permitting banks to use Non-Government Organizations (NGOs), Self Help Groups (SHGs) and MFIs as agents to conduct various financial activities on the micro level. 5 However, each pronouncement has evinced an importantly different idea of the scope of specialized microfinance regulation and the objectives that such regulation might serve. 4 For literature that demonstrates such a link between stronger, deeper, broader, more market-oriented financial sectors and impact on poverty alleviation, see for example, Finance, Inequality and Poverty: Cross Country Evidence, The World Bank, 2004, and Doing Business in 2005, The World Bank, It is possible that the demand for savings products will be satisfied, at least in part, by the increase in deposit-taking services offered by banks using the bank agency model authorized by the circular (described in detail in Section 2.2.3). 2

14 Notwithstanding the complexity of the existing legal and regulatory picture and the heterogeneity of the actors and interests involved, there is value in an impartial disentangling of the issues and possible avenues of regulatory reform. Without this, there is a risk that debate may evolve based on incorrect comparisons and misunderstandings among the variously interested parties. Moreover, separating out the issues at play and the facts regarding the current legal and regulatory picture for the development and operation of microfinance in India makes it possible to draw analogies to, and learn from, the experiences of other countries that have experimented with microfinance-related regulatory reform. This note 6 aims to make just such a practical contribution to the discussion of specialized regulation for microfinance in India: Sections II and III explain the major models currently used to carry out microfinance in India, the actors involved in each of the models and the salient features of the existing legal and regulatory picture for the major legal forms carrying out microfinance in India, with an emphasis on significant regulatory constraints they face currently in delivering the full range of financial services that poor people need; Section IV summarizes the key features of the major reform topics, including both formal proposals and issues under discussion by relevant stakeholders; Section V identifies specific issues of key importance to the proposals summarized in Section IV and describes various foreign countries' experiences with those issues; 7 and Section VI analyzes the reform proposals for India summarized in Section IV, informed, to the extent applicable, by foreign experiences but also fully considering features of the Indian situation that may defy convenient analogies to other countries (Section VI). The objective of this note, therefore, is to provide a tool for stakeholders interested in microfinance-related legal and policy reform and is not intended to be prescriptive. Moreover, this note does not intend to suggest that existing regulatory barriers are the most important limitation to outreach and the provision of financial services by MFIs or that the topics underlying the various reform proposals are necessarily the most important factors in increasing access to financial services for India's poor. This note builds on a significant volume of previous analysis of regulatory issues facing microfinance in India. 8 Experienced Indian legal counsel has been engaged to assist in 6 Primary research for this note was conducted during a research mission conducted in Delhi, Mumbai and Hyderabad in October 2005, as well as during follow-up consultations. The authors express their appreciation to the persons consulted, who are listed alphabetically in Annex 1. 7 The inherent challenges of drawing meaningful comparisons among countries in widely differing political and economic situations and with widely varying financial systems, legal and regulatory frameworks and regulatory traditions are discussed in the introduction to Section V. 8 The authors express their appreciation for these resources, which are included among the resources consulted in the Bibliography list. 3

15 updating and fleshing out these previously developed sources. 9 The note also draws on the growing body of analytical material on the subject of microfinance regulation and supervision that is available on the international stage, as well as on the experience of individuals who have been involved with other countries consideration of similar issues The Mumbai office of Trilegal, an Indian law firm has assisted in the development of Section III of this note, as well as researching targeted questions posed by the authors. They have also reviewed the entire note for legal accuracy and completeness. 10 The authors express their appreciation to these persons listed in Annex 2 for the time they spent discussing various countries' experiences. 4

16 II. Overview of Microfinance in India 2.1 Introduction Since the early years of independence, the GOI has actively sought to alleviate poverty through the provision of access to financial services. Government-led measures to broaden and deepen financial access have included: (i) the promotion and development of the cooperative system during the 1950s and 1960s; (ii) the requirements, imposed after the nationalization of 14 major private banks in 1969 (which was followed in 1980 by the nationalization of six more banks), that commercial banks open branches in rural areas and lend to specified priority sectors, primarily, agriculture and the poor; and, (iii) the creation in 1976 of a new form of banks focused on rural areas the Regional Rural Banks (RRBs) which are majority government owned. As evident from these measures, India has used a multi-agency approach with particular emphasis on rural finance to meet its policy objectives of increasing access to finance for the poor. And although these measures have resulted in an unusually extensive financial system with a network of branches throughout India, they have also had several unintended consequences for the financial sector, including an inefficient distribution of credit and, especially among cooperatives and RRBs, high numbers of non-performing loans and weak institutions. As a result of the Government's active role in financial sector policy, state-owned institutions dominate the financial system. 11 Notwithstanding this, in recent years the Government has begun to liberalize financial sector policy and, for example, has deregulated interest rates and eased priority sector lending requirements. Partly as a result of these reforms, competition has increased and many new actors have entered the market. Despite India's past efforts to extend financial services to the poor through its vast branch network, 12 demand from the poor for financial services remains largely unmet. 13 To address this continuing problem, the Government, together with the microfinance sector and the private sector, for several years has supported developing new and innovative models of microfinance service delivery to the poor. The results of these efforts can be grouped into four broad categories: (i) provision of financial services to the poor directly 11 Indeed this factor, together with the need for improved prudential regulation and supervision of RRBs as well as credit cooperatives, is an important topic for policy makers to consider. This note, however, focuses on the microfinance sector and related proposed regulatory reforms and does not include a discussion of possible reform measures of RRBs or credit cooperative banks. 12 India s banking system compares well in international comparisons in terms of indicators such as area per branch and, to a lesser extent, population served per bank branch. See also Scaling-up Access to Rural Finance in India (2004). 13 See for example, "A Financial System for India's Poor," p. 4009, citing a World Bank-NCAER survey that showed that 59% of rural households do not have a deposit account and 79% of rural households do not have access to credit from a formal source. 5

17 by banks; (ii) the SHG-bank linkage model; (iii) the free-standing MFI model and (iv) the bank agency model. 14 The first category involves the direct provision of financial services by banks, particularly rural branches of public sector banks, RRBs and cooperative banks, to individuals this includes, amongst other kinds of small financing, agricultural credit. Although this is by far the most prevalent model, 15 it is not addressed in this note because provision of microfinance services by these banks does not by itself raise significant legal and regulatory issues 16 and has therefore not been a significant topic in the current dialogue regarding legal and regulatory reform for microfinance. Instead, this note addresses the legal and regulatory issues pertaining to the remaining three categories, each of which is described below, 17 and in particular emphasizes the free-standing MFI model, which has been the focus of proposals for regulatory reform. 2.2 Three Models of Microfinance Delivery in India SHG-Bank Linkage Model SHGs in India. SHGs in India are informal groups mostly of between members, typically of women, that act as a channel for savings and credit services for their members. SHGs are the most common channel for the provision of microfinance in India, and the Government hopes to extend their reach further. These groups are assisted by "promoters" which help to organize, train and strengthen the capacity of SHGs. Various types of organizations, including government agencies and banks, act as promoters, but promoters are most commonly NGOs. Increasingly, SHGs aggregate into larger networks. Typically, SHGs join into "clusters" of 15 to 30 SHGs, which in turn join into federations of 5 to 15 clusters. Federations are intended to help member SHGs build capacity, develop governance and internal control mechanisms and access and manage external financial resources with better economies of scale. In addition, these federations, particularly when formed as cooperative institutions, potentially allow SHGs to pool savings on a large scale These models are not always mutually exclusive and some significant actors in microfinance in India employ more than one of the models. 15 In fact, the pioneering Indian MFI, SEWA Bank, is an urban cooperative bank. 16 This is not to say that there are no other legal and regulatory issues pertaining to these excluded categories. Indeed, for example, legal, regulatory and governance reform with respect to cooperative banks (with their three tiered structure at the state, district and village levels) is a topic of considerable discussion although peripheral to the current discussion of specialized regulation for microfinance in India. 17 As noted in Section IV of this note, although the SHG-bank linkage model presents potential regulatory issues, there are currently no reform proposals specifically addressing this model. The discussion of the SHG-bank linkage model is therefore limited to a description of its components and the model's legal and regulatory framework. Similarly, in light of the January 2006 RBI circular permitting banks to use agents to conduct financial activities, there are no other reform proposals with respect to this model discussed in this note. 18 As discussed further in Section 3.2 and Section 3.3 below, recent efforts to federate SHGs under statelevel cooperative legislation raise potentially significant legal and regulatory issues. 6

18 SHG-Bank Linkage Model. Since 1992, the GOI, largely through NABARD's SHG-bank linkage program, has sought to promote linkages between SHGs and banks (commercial banks, RRBs and cooperative banks) in order to link SHGs with the formal financial system. Under this program, NABARD offers refinancing of bank loans to SHGs and provides technical support to participating banks. 19 In addition, the RBI (i) allows participating banks to treat loans to SHGs as part of their priority sector lending requirement (pursuant to which banks are required to direct a certain percentage of their net bank lending, currently 40%, to specified sectors) and (ii) allows an SHG to open a group savings account with a participating bank. Banks typically lend to an SHG after assessing its operations, discipline and capacity. Less commonly, a bank itself acts as the promoter of the SHG and forms and trains the partner SHG prior to extending a loan. As of end-march 2005, NABARD data reported that cumulatively, since 1992, 1.6 million SHGs, 20 estimated to include 24 million women members, had been linked with banks through a credit account. As many as 573 banks had cumulatively extended loans totaling approximately Rs.69 billion (approximately US$1.6 billion). In 2005 alone, banks disbursed approximately Rs.29 billion (US$680 million) to SHGs Free-Standing MFI Model Various types of institutions broadly characterized as free-standing MFIs provide microfinance services in India. In terms of both number of clients and the outstanding microfinance loan portfolio, the outreach of free-standing MFIs is around one half the outreach of the SHG-bank linkage program, although the difference between the outreach of the two models has been declining over time. 21 These MFIs are formed (i) at the state level as societies, public trusts, and Mutually Aided Cooperative Societies (MACS) 22 and (ii) at the central (or national) level as public trusts, 23 NBFCs, Section 25 companies and Local Area Banks (LABs). 24 Following is a general description of each type of freestanding MFI and the extent and nature of their involvement in providing retail microfinance services in India Historically, bank lending to SHGs has been facilitated by NABARD refinancing, though the proportion of loans refinanced by NABARD has recently been declining. Between 2001 and 2005, the share of NABARD refinancing of total annual bank lending to SHGs declined from 83 percent to 43 percent. 20 This is an aggregate number of all SHGs that received financing from banks between 1992-March 2005 and likely overestimates the number of active/functional SHGs in India. During the financial year ending March 2005, about 800,000 SHGs (of the cumulative 1.6 million figure) actually received financing from banks and only 25 percent of the SHGs existing at the beginning of the year received loans during the year. 21 For example, data from NABARD on the SHG-bank linkage program and from ICICI Bank and other industry sources shows that the estimated share of MFIs annual loan disbursements to total microfinance loan disbursements has increased from around one fifth to one third between March 2001 and March This note does not discuss the three tiered cooperative bank structure nor cooperatives registered under the state cooperative acts. 23 All trusts must, if carrying out public charitable activities, register with the Commissioner of Charities established in the state in which the trust operates. 24 MFIs may be also formed as societies governed by central level legislation: the Societies Registration Act, 1860 (Societies Registration Act). However, several states have enacted state level legislation that overrides the Societies Registration Act, thus making central societies largely an academic issue. 25 More information regarding the legal and regulatory requirements applicable to each type is provided under Section 3.3 which deals with the legal and regulatory bases of the free-standing MFI model. 7

19 NGO MFIs. MFIs formed as societies and trusts (NGO MFIs) primarily provide credit services to their clients. However, quite a few also engage in at least some deposit-taking. Estimates by a well-established microfinance rating agency, Micro-Credit Ratings International Limited (M-CRIL), indicate that of those NGO MFIs that accept deposits, approximately 80% of the deposits held by them are compulsory deposits (or "forced savings") that serve as collateral for loans. The balance represents voluntary savings, which are not strictly permitted under the RBI Act, 1934 (RBI Act). 26 MACS. MACS are incorporated bodies and are used in practice to carry out a wide variety of financial transactions, including deposit-taking. 27 MACS are permitted to accept term and demand deposits from members and term deposits, but not demand deposits, from non-members. MACS are widespread within particular states that have enacted MACS legislation, particularly in Andhra Pradesh (AP), which has approximately MACS 28 according to NABARD data. NBFCs. NBFCs are registered with the RBI. Although an NBFC may accept term deposits upon meeting certain requirements (including having a specified minimum investment grade rating from specified credit rating agencies), no microfinance NBFC is currently mobilizing deposits from the public. 29 Approximately ten NBFCs are now engaged in microfinance. Section 25 Companies. Section 25 companies are non-profit companies formed under the Companies Act. Section 25 companies engaged in microfinance activities are NBFCs for purposes of the RBI Act, but are exempted from several requirements of the RBI Act provided that they have met certain conditions. 30 Importantly, Section 25 companies that wish to take advantage of these exemptions are not permitted to accept deposits. Only an estimated ten Section 25 companies are providing microfinance services currently. LABs. LABs are private banks permitted to operate in three contiguous districts. They are able to deliver credit and provide savings and insurance. Currently, only one LAB, established by BASIX, provides microfinance on a significant scale. Free-standing MFIs lend directly to individual clients and to SHGs. They typically receive external funding for their lending operations from donor organizations, apex 26 Senior level officials at the RBI, however, have unofficially indicated a tolerance for the acceptance by NGO MFIs of compulsory deposits that are used as collateral. 27 States have adopted MACS legislation largely in response to concerns about state influence over the governance of state and district level credit cooperative banks and their grass root level constituents, the Primary Agricultural Cooperative Society (PACS), all of which are partly state-owned and operate under significant state control. 28 Each of these may have a tiered structure, meaning that there is a much larger number of constituent, smaller size MACS. 29 Only one NBFC engaged in microfinance activities had, in 2003, received the requisite investment grade rating for mobilizing term deposits from the public. However, even this MFI is currently not mobilizing deposits. 30 These conditions are described further below in Section 3.3 which deals with the legal and regulatory bases of the free-standing MFI model. 8

20 institutions (including, among others, the Small Industries Development Bank of India (SIDBI), which has for many years promoted and funded MFIs, NABARD and Friends of Women's World Banking), as well as from public and private banks. 31 Onlending by MFIs of this external funding is referred to by some, including the RBI, as "bulk lending." 32 Given the large number of apex institutions and banks and the fact that the RBI allows banks to treat such lending to NGO MFIs as part of their priority sector lending requirement, both wholesale and commercial borrowing are now widely available to MFIs even unprofitable ones for onlending. In fact, much of the growth of MFIs over the last few years has been funded through borrowings from commercial banks. In terms of numbers, according to estimates by NABARD, there are approximately 800 free-standing MFIs in India at present. Approximately of these MFIs are formed as cooperatives and MACS and approximately 500 are formed as state-level societies or trusts. The remaining MFIs are NBFCs and Section 25 companies, except for one that is a LAB. The great majority of the societies and trusts originated as civil society organizations and have various socially-oriented programs that are complemented by small but often growing microfinance programs. Of the estimated 800 free-standing MFIs, only an estimated 30 to 40 are profitable 33 and, of these, a substantial number are formed as RBI-registered NBFCs, Section 25 companies and LABs. In this context, a few commercially-oriented MFIs, most of which now operate as RBI-regulated institutions (having mostly evolved or transformed from NGO MFIs), have grown extremely quickly and have come to dominate the sector. Today, the eight largest free-standing MFIs serve more than 50 percent of microfinance clients Bank Agency Model A third broad model for microfinance delivery the "bank agency model" has gained increasing importance in recent years. Pursuant to this model, organizations primarily free standing MFIs act on behalf of banks to facilitate their microfinance operations. Banks in India have been using this model for several years, although primarily to provide credit services. Pursuant to this model, an MFI evaluates, recommends and originates loans, helps in disbursal and subsequently tracks and collects on loans. The MFI receives a service charge and typically provides a first loan default guarantee to the bank. This model differs from direct lending in that banks utilize MFIs as agents in order to reduce bank transaction costs. It also differs from "bulk lending" (to MFIs) in that the loans sit on the books of the bank rather than the MFI, as they would if the MFI were borrowing from the bank in question for onlending. In January 2006, the RBI issued a circular (described further in Section 3.4) specifically permitting banks to use the services of NGOs, SHGs, MFIs and other civil society organizations as intermediaries for banks in providing a wide range of microfinance 31 Currently, many commercial banks offer lines of credit to MFIs in addition to term loans. 32 Some free-standing MFIs are also using the bank agency model (discussed below), whereby they facilitate retail transactions on behalf of banks without serving as a legal intermediary. 33 Extrapolation of data from M-CRIL, a specialized rating agency for microfinance. 9

21 services. As stated in the circular, the RBI's objective in supporting the bank agency model is to extend banks' outreach to microclients. 10

22 III. Overview of Current Legal and Regulatory Treatment of Microfinance in India 3.1 Introduction India's financial system is complex and includes a large number of different institutional types and thousands of institutions. This complexity creates significant regulatory challenges for the RBI, which is primarily responsible for regulation of the entire financial system, including banks and NBFCs. In recent years, particularly in the 1990s, India's financial system has experienced the failure of a number of significant NBFCs of different types 34 as well as fraud under micro-deposit schemes. 35 As a result, the RBI has implemented reforms aimed at strengthening prudential regulation of NBFCs and increasing the attention given to the prevention of fraud in retail deposit-taking. 36 The RBI also has been an active party in the current dialogue over proposals for microfinance related legal and regulatory reform, as is evidenced, for example, by the appointment of an internal working group charged with examining regulatory issues raised by each of the models for microfinance delivery discussed in this note and the issuance in January 2006 of a circular permitting banks to use NGOs, SHGs and MFIs as agents. 37 The RBI has broad responsibilities for the safety and development of the Indian financial system. However, it must share some of its powers with state-level authorities because India's federal system of government allows for state-level legislation that impacts institutions that provide financial services and thereby allocates to state-level institutions some control over financial system policy and supervision. 38 Central and state-level legislation often overlap, and this sometimes creates ambiguity with respect to jurisdiction. This overlapping authority at times creates opportunities for regulatory arbitrage. 39 It also complicates the dialogue surrounding microfinance-related legal and 34 Since the late 1990s, in response to the discovery of significant scams involving NBFCs, RBI regulations have tended to become increasingly more stringent and have led to a fall in the number of deposit taking NBFCs over time. 35 These deposit schemes involved daily or weekly collections by banks, through local agents, at the homes of depositors. Cash leakage, fraud and accounting problems were prevalent. 36 Specifically, a 1997 amendment to the RBI Act prohibited the taking of deposits by unincorporated bodies; 1998 RBI Directions set forth various prudential norms applicable to NBFCs. 37 The internal working group s report, entitled Report of the Internal Group to Examine Issues Relating to Rural Credit and Microfinance, is discussed below in Section 4.2 dealing with the reform proposals related to the free-standing MFI model. 38 For example, both the RBI and state governments have regulatory authority over cooperative banks. The RBI, however, has expressed its concern regarding its inability to ensure that the cooperative banks comply with the "relatively diluted" (in the words of an RBI Task Force on Cooperative Credit Institutions) prudential regulations applicable to them and to enforce punitive measures against those that are in poor health. This lack of enforcement power is, according to the report of the Task Force, due to the "shared" control. 39 For example, some MFIs recently have taken advantage of state-level MACS legislation, which allows them to avoid central-level restrictions on deposit-taking. These MACS are largely unregulated and weakly monitored and, without adequate oversight, could eventually result in depositor risk. 11