Challenges and potential for Indian banks to implement Business Facilitator and Business Correspondent Models

RURAL FINANCE PROGRAMME INDIA Challenges and potential for Indian banks to implement Business Facilitator and Business Correspondent Models A status report October 2006

microcredit Innovations Department NABARD, Head Office Plot No. C-24, G Block 2 nd Floor, E Wing, Bandra Kurla Complex Post Box No. 8121, Bandra (East) Mumbai 400051 / INDIA Rural Finance Programme L-20, Green Park Main New Delhi 110 016 / INDIA Phone +91-22-2653 9244 Phone +91-11-2652 6024 Telefax +91-22-2652 8141 Telefax +91-11-2652 8612 Email mcid@nabard.org Email Marie.Haberberger@gtz.de Homepage www.nabard.org Homepage www.gtz.de

Challenges and potential for Indian banks to implement Business Facilitator and Business Correspondent models A status report by Ajay Tankha October 2006 3

Table of Contents List of Abbreviations...5 1. Introduction...6 2. Objectives...8 3. Eligible Entities, Activities and Terms of Engagement...9 4. Business Facilitators: Emerging Role and Scope of Operations...12 4.1. SHG bank linkage... 12 4.2. Doorstep banking and small deposit schemes... 12 4.3. Post offices and postal agents... 13 4.4. Recovery agents... 14 5. Business Correspondent Models...15 5.1. ICICI Bank-MFI Partnership Model... 16 5.2. RBI's Business Correspondent Model... 16 6. Open Questions...18 6.1. Interest rates and servicing fees of the Business Correspondent... 18 6.2. Status of the Bank-MFI (Partnership) Model... 18 6.3. Why can NBFCs not act as Business Correspondents?... 18 7. Operational Concerns...20 8. Other issues...21 9. Concluding Remarks...22 References...23 Annex...25 Acknowledgements This status report has benefited greatly from the information and insights provided by a small group of bankers and microfinance experts who have shared their valuable time and knowledge on the subject. A list of persons contacted and organisations visited in this connection is presented in Annex 1. My sincere thanks go to all of them. 4

List of Abbreviations e.g. AAB ABN-AMRO BDO BC BCM BF BFM CSO CBO CCAP FINO FLDG HDFC ICICI IT JLG KVIB KVIC KYC KBSLAB MFI MFP NABARD NMIB NGO NBFC NPA PLR PNB RBI SARFAESI SHG SBI SGSY SKS UTI UP Abbreviation of Latin 'exempli gratia': for example ABN-AMRO Bank Algemene Bank Nederland Amsterdam Rotterdam Block Development Officer Business Correspondent Business Correspondent Model Business Facilitator Business Facilitator Model Civil Society Organisation Community Based Organisation Consultative Group to Assist the Poor Financial Information and Network Operation First Loss Default Guarantee Housing Development and Finance Corporation Industrial Credit and Investment Corporation of India Information Technology Joint Liability Group Khadi and Village Industries Board Khadi and Village Industries Commission Know Your Customer Krishna Bhima Samruddhi Local Area Bank Microfinance Institution Microfinance Provider National Bank for Agriculture and Rural Development National Microfinance Information Bureau Non-Governmental Organisation Non-Banking Finance Company Non-Performing Assets Prime Lending Rate Punjab National Bank Reserve Bank of India Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Self Help Group State Bank of India Swarnjayanti Gram Swarozgar Yojana Swayam Krishi Sangam Unit Trust of India Uttar Pradesh 5

1. Introduction One of the objectives of the GTZ-NABARD Rural Finance Program is the provision of affordable, qualitative and sustainable financial services to SHGs through the rural formal banking sector. At present there are three predominant delivery models of such services. In model one the bankers form and finance the groups. Under the model two, the self help promoting institution (SHPI) forms and nurtures the groups and the bank directly finances the groups. In the third model, the SHPI also acts as financial intermediary between the groups it has formed and the financing bank. Thus the SHPI acts as a micro finance institution. During the past several years, the Government of India has taken an active interest in the growth of the microcredit movement. Since 1999, the budget speeches of Finance Ministers have contained references to the growth in the numbers of self-help groups (SHGs) and their linkage with the banks. In the budget speech of 2005 for the first time an initiative for promoting Microfinance Institutions (MFIs) was announced. The Finance Minister stated therein that Government intends to promote MFIs in a big way. The way forward, I believe, is to identify MFIs, classify and rate such institutions and empower them to intermediate between the lending agencies and the beneficiaries. Commercial banks may appoint banking correspondents to provide transaction services on their behalf. 1 The Finance Minister s announcement took the microfinance community somewhat by surprise. While welcoming the interest of government in MFIs that had thus far been largely operating in a policy vacuum, it was struck by his identification of the banking correspondent model for promotion. While banks had been engaging agents to perform various services in support of their banking operations, the direct involvement of such agents in the conduct of banking business for the microfinance sector had not been seriously examined or proposed by either the public sector banks or the MFIs. ICICI Bank, the leading Indian private bank, however, had, recently pioneered new financial structures and arrangements with partner MFIs with a view to expand the flow of financial services to their clients. It was thus accepted that by introducing the banking correspondent model the government intended to formalize this partnership model which had also been adopted by a couple of other private sector banks. Following the Finance Minister s announcement, RBI constituted an Internal Group, with Mr. H. R. Khan as Chairman, to examine issues related to rural credit and microfinance. Its terms of reference were as follows: i) examine the issue of allowing banks to adopt the agency model, by using the infrastructure of civil society organisations, rural kiosks and village knowledge centers to provide credit support to rural and farm sectors and to suggest operating guidelines therefore; ii) examine the feasibility and modalities for appointment of "banking correspondents" to function as intermediaries between lending banks and beneficiaries; iii) identify steps to be taken to promote micro finance institution (MFIs) and propose a system for their classification and rating; and iv) examine the extent of regulation, if need be, of MFIs. The report of the RBI Internal Group 2 set out a range of interventions and relationships under two models viz. business facilitator and business correspondent which covered the engagement by banks of various types of entities towards aligning banking business with the objectives of greater financial inclusion and outreach of the Indian banking sector as set out in the Annual Policy Statement of RBI for 2005-06. 3 The guidelines on outsourcing of financial services by banks through partnering business facilitators or correspondents by the Reserve Bank of India (Draft Guidelines: 6th December 2005; Notification: 25th January 2006) thus state that It has been decided in public interest to enable 1 As quoted in Reserve Bank of India (RBI) (2005), Report of the Internal Group to Examine Issues Relating to Finance and Microfinance (Khan Report), also referred to as Khan Report, which is discussed further below. 2 RBI (2005), op. cit. 3 From Reddy, Y. V. (2005), Micro-Finance: Reserve Bank s Approach, address at the Micro-Finance Conference organized by the Indian School of Business 6

banks to use the services of Non-Governmental Organisations/Self Help Groups (NGOs/SHGs), Micro Finance Institutions (MFIs) and other Civil Society Organisations (CSOs) as intermediaries in providing financial and banking services through the use of Business Facilitator and Correspondent models. 7

2. Objectives This is intended as a status report on the activities of banks in implementing the use of Business Facilitators (BFs) and Business Correspondents (BCs) as described in the RBI circular on Financial Inclusion by Extension of Banking Services dated 25 January 2006 4. The following questions are of interest for this status report which may be of use to bankers and other stakeholders intending to get involved in the use of these entities. What are the features of BF and BC models? What banks have implemented the BF or BC model? What are the challenges and potentials of the BF/BC models? In order to get practical insights into the challenges and potentials of the banks in implementing the BF/BC models, it was intended to cover i) two banks which have implemented the BF/BC model already; and ii) at least two banks which have not implemented the BF/BC model yet, but may be intending to do so. However, this plan had to be dropped since enquiries from eight leading public sector banks 5 revealed that none of them had implemented these models, though a few were at the planning stage of introducing BFs in part of their operations. These public sector banks were mainly looking to increase outreach through their existing branch networks 6 rather than seek out BC intermediaries for undertaking a range of financial functions. In fact, only one private bank (ICICI Bank) has introduced BCs as part of its business strategy and plans for the future. Other private and public sector banks have adopted a wait-and-watch policy until clarifications are received from the Reserve Bank of India on certain aspects of the Bank-BC relationship. Important issues that have come up since the announcement of the guidelines for the BF/BC model are discussed in this paper. They are based upon meetings with and feedback received from bankers, including their discussions with RBI, and with other stakeholders in the microfinance sector. These have been supplemented by a review of recent newspaper reports on the subject and through internet resources. 4 Notification RBI/2005-06/288; DBOD.No.BL.BC.58/22.01.001/2005-2006 dated 25 th January 2006 5 Bank of India, Canara Bank, Corporation Bank, Indian Bank, Oriental Bank of Commerce, Punjab National Bank, State Bank of India and Syndicate Bank. 6 For example, the initiatives of Union Bank of India and Syndicate Bank described in section 4. 8

3. Eligible Entities, Activities and Terms of Engagement Table 1 gives a summary of the guidelines contained in RBI circular dated 25 January 2006 in respect of the eligible entities, their scope of activities and other terms and conditions to be met by banks in engaging the services of BFs and BCs in furtherance of the objective of increasing their outreach for microfinance. Eligible entities and scope of activities: There is a clear basis for the demarcation between the activities of BFs and BCs. The role of BFs is limited to the provision of facilitation services to clients on behalf of banks. The activities of the BCs, in addition, cover those undertaken in the normal course of banking business. These include disbursal of loans, collection of savings and insurance premia and other payments as also recoveries of loan principal and interest. This allows banks freedom to outsource their operations to realize cost economies and to increase client outreach. 7 The distinction between the two entities is such that BCs can undertake financial and banking functions while the role of BFs covers only non-financial functions. The list of eligible entities in the case of BFs is larger and includes intermediaries such as NGO/Farmers Clubs, cooperatives and Community Based Organisations (CBOs), panchayats, village knowledge centers, insurance and postal agents, agri-clinics and IT-enabled outlets, etc. BCs, however, are expected to be only drawn from the established forms of NGOs/MFIs set up under Societies/Trusts Acts, societies set up under Mutually Aided Cooperative Societies Acts of States, non-profit section 25 companies and post offices. While registered Non-Banking Finance Companies (NBFCs) not accepting deposits were also initially included in the list, banks have been advised to defer the use of NBFCs (other than section 25 companies) as BCs through a subsequent RBI circular dated 22 March 2006 8. This development has been a factor in reducing the enthusiasm for the BC model among private sector banks and leading MFIs. Restrictions: While in the case of BFs no permission is required from the RBI, the situation is not clear regarding whether RBI permission is to be sought before engaging BCs even though banks are permitted to devise schemes for using BCs within the provisions of the 25 January 2006 circular. 9 The activities of BCs are to be conducted at places other than the bank premises. The Khan Report, however, had proposed that RBI permission be required on a scheme to scheme basis. Payments: Banks are allowed to pay reasonable commission/fees to the BFs and BCs but these agents are specifically prohibited from charging any fee to the customers on behalf of the bank. This stipulation has an important bearing on the feasibility of the BC model and is discussed in detail in section 4. Other terms and conditions: Agreements and contracts with the customer are to specify that the bank is responsible for the acts of omission and commission of the BFs and BCs. Attention is drawn in the circular to the risk to banks through the engagement of BFs and BCs and the need to manage the risk, among others, through limits on cash-handling by the BCs and through technology-based solutions. Another requirement is that transactions are accounted for and reflected in the bank s books by end of day or next working day. This has implications for the minimum scale of operations and the necessity 7 In terms of RBI s draft guidelines for outsourcing of financial services by banks issued on 6 December 2005 banks would not require prior approval of RBI for outsourcing services except when the service provider is located outside India or when the outsourcing is related to doorstep banking. Banks cannot outsource core management functions like corporate planning, organization, management and control and decision-making functions like determining compliance with KYC norms for opening deposit accounts, according sanction of loans and management of investment portfolio. 8 Apart from the Khan Report and RBI s January 2006 notification, a working group set up by the RBI under Ms. Usha Thorat to examine the issues regarding financing of NBFCs had recommended, among others, using them as BCs (Venkitaramanan, 2005). Possible reasons for the removal of NBFCs (other than section 25 companies) from the list of entities eligible to act as BCs are discussed in section 5. 9 RBI permission would at least appear to be necessary in the case of BCs for doorstep banking in terms of its circular DBOD.No.BL.BC.86/22.01.001/2004-05 dated 30 April 2005. 9

of technology-based innovations, particularly for operations in remote areas. Other issues covered in the circular relate to the grievance redressal mechanism for services rendered by the BFs and BCs and the need for flexibility in compliance with Know-Your-Customer (KYC) norms while extending financial services to the underprivileged and unbanked population. Table 1: Criteria of the Business Facilitator and Business Correspondent Model 10 CRITERIA BUSINESS FACILITATOR MODEL (BFM) BUSINESS CORRESPONDENT MODEL (BCM) Eligible Entities NGOs / MFIs set up under Societies / Trust Acts, Societies registered under Mutually Aided Cooperative Societies Acts or the Cooperative Societies Acts of States, Section 25 companies Registered NBFCs not accepting public deposits 11, and Post offices Scope of Activities Restrictions Intermediaries such as NGOs / Farmers Club, Cooperatives, Community Based Organisations (CBOs), IT enabled rural outlets of corporate entities, Post offices, Insurance agents, and Well functioning Panchayats, Village Knowledge Centres, Agri Clinics / Agri Business Centres, Krishi Vigyan Kendras and KVIC / KVIB units Identification of borrowers and fitment of activities Collection and preliminary processing of loan applications including verification or primary information/data Creating awareness about savings and other products and education and advice on managing money and debt counseling Processing and submission of applications to banks Promotion and nurturing Self Help Groups / Joint Liability Groups / Credit Groups / others, and Follow-up for recovery As these services are not intended to involve the conduct of banking business by BFs, no approval is required from RBI for using the above intermediaries for facilitation of services indicated above. Banks may conduct thorough due diligence on such entities keeping in view the indicative parameters given in Annex 3.2 of the Report of the Internal Group appointed by RBI to examine issues relating to Rural Credit and Micro-Finance (July 2005). In engaging such intermediaries as BCs, banks should ensure that they are well established, enjoying good reputation and having the confidence of the local people. Banks may give wide publicity in the locality about the intermediary engaged by them as BC and take measures to avoid being misrepresented. In addition to the activities of BFM, BCM includes: Disbursal of small value credit Recovery of principal / collection of interest Collection of small value deposits Sale of micro insurance / mutual fund products / pension products / other third party products, and Receipt and delivery of small value remittances / other payment instruments The activities to be undertaken by the BCs would be within the normal course of the bank s banking business, but conducted through the entities indicated above at places other than the bank premises. In furtherance of the objective of increasing the outreach of the banks for microfinance, in public interest, the RBI permits banks to formulate a scheme for using the entities indicated above as BCs. Banks should ensure that the scheme formulated and implemented is in strict compliance with the objectives and parameters laid down in the circular. 10 According to RBI guidelines RBI/2005-06/288 dated 25 January 2006 11 Banks have been advised since to defer selection/use of NBFCs as BCs vide RBI guideline RBI/2005-06/331 dated 22 March 2006. However, banks can engage NBFCs licensed under Section 25 of the Companies Act, 1956 as BCs. 10

Payment Other Terms and Conditions Redressal of grievances Compliance with KYC BUSINESS FACILITATOR MODEL (BFM) / BUSINESS CORRESPONDENT MODEL (BCM) Banks may pay reasonable commission / fee to the BFs / BCs, the rate and quantum of which may be reviewed periodically. 12 The agreement with the BFs / BCs should specifically prohibit them from charging any fee to the customers directly rendered by them on behalf of the bank. As the engagement of intermediaries as BF / BC involves significant reputational, legal and operational risks, due consideration should be given by banks to those risks. They should also endeavor to adopt technology-based solutions for managing the risk, besides increasing the outreach in a cost effective manner. 13 The arrangements with the BFs / BCs shall specify: Suitable limits on cash holding by intermediaries as also limits on individual customer payments and receipts, The requirements that the transactions are accounted for and reflected in the bank s books by end of day or next working day, and All agreements / contracts with the customer shall clearly specify that the bank is responsible to the customer for acts of omission and commission of the BF / BC. Banks should constitute Grievance Redressal Machinery within the bank for redressing complaints about services rendered by BFs and BCs and give wide publicity about it through electronic and print media. The name and contact number of designated Grievance Redressal Officer of the bank should be made known and widely publicised. The designated officer should ensure that genuine grievances of customers are redressed promptly. The grievance redressal procedure of the bank and the time frame fixed for responding to the complaints should be placed on the bank s website. If a complaint does not get satisfactory response from the banks within 60 days from the date of his lodging the complaint, he will have the option to approach the Office of the Banking Ombudsman concerned for redressal of his grievance/s. Compliance with KYC norms will continue to be the responsibility of banks. Since the objective is to extent savings and loan facilities to the underprivileged and unbanked population, banks may adopt a flexible approach within the parameters of guidelines issued on KYC from time to time. The KYC guidelines issued vide our circulars dated November 29, 2004 and August 23, 2005 provide sufficient flexibility to banks. In addition to introduction from any person on whom KYC has been done, banks can also rely on certificates of identification issued by the intermediary being used as Banking Correspondent, Block Development Officer (BDO), head of Village Panchayat, Post Master of the post office concerned or any public functionary, known to the bank. 12 The circular indicates that RBI Master circular DBOD.Dir.5/13.07.00/2005-06 dated July 1, 2005 may be treated as modified to that extent. 13 In formulating their schemes, banks are advised to be guided by the recommendations made in the Khan Group Report as also the draft outsourcing guidelines released by RBI on December 6, 2005 11

4. Business Facilitators: Emerging Role and Scope of Operations The role of BFs in the extension of banking business is restricted to promotion of awareness of products, processing of loan applications, promotion and nurturing of Self-Help Groups (SHGs) / Joint Liability Groups (JLGs) and follow-up of loans towards ensuring recovery. Some of the areas in which BFs are being engaged by banks are discussed below. 4.1. SHG bank linkage A major area in which banks have come forward to engage the services of NGOs and other agents is in linking them to well-functioning SHGs. Typically, a fee is paid to the NGO/agent for facilitating the opening of a savings account of an SHG and for credit linkage. This is in addition to grant assistance that NGOs can access for SHG promotion from the Microfinance Development and Equity Fund of NABARD now Rs. 3,000 per SHG and available for activities over a period of three years. Punjab National Bank (PNB) and State Bank of India (SBI) are paying Rs. 1,000 and Rs. 750 respectively as incentive to NGOs for linking SHGs to the bank. This excludes SGSY groups. Payments are made in installments upon achieving different stages/landmarks. Thus in the case of SBI Rs. 375 per SHG is paid to the NGO at the time of opening of the savings bank account of the SHG and the balance of Rs. 375 three months after credit linkage. In the case of PNB, payments of Rs. 300, Rs. 300 and Rs. 400 respectively are made at the time of savings linkage, four months after savings linkage and after credit linkage to the bank. Further incentives are provided by SBI to their bank branches with a sum of Rs. 5,000 per SHG savings-linked to the bank is credited to the concerned branch 14. There is, however, no provision to suggest that these sums are utilized for a campaign of SHG promotion or to build up the existing SHG portfolio. SBI, in particular, is pressing hard for formation of SHGs and has a special officer earmarked for SHG development at each Zonal/Regional Office. In certain districts of UP, a central processing cell has been formed to assist bank branches in the screening and processing of loan applications on behalf of SHGs. This can also be seen as a form of outsourcing of branch functions, but to an agency from within the bank. Banks appear to be realizing the need for using BFs in promoting SHGs as clients. Indeed, SHG promotion is part of the corporate strategy of public sector banks and carries the mandate of the Board of Directors. However, some rural bank managers do not consider SHGs as a sound business proposition. Nor do they always see the need for this form of social investment directed at developing long-term clients. In fact, they generally feel that the bank s SHG programme is being pursued primarily in order to fulfill corporate social responsibility. Since, in many areas, SHGs account for only about 2-5% of the portfolio of a bank branch at present they are also not perceived as an important and stable client group of the banks. 4.2. Doorstep banking and small deposit schemes Over the years most public sector banks have implemented various schemes designed to extend financial services to the rural poor. The use of BFs, or agents, by banks for this purpose is not new. As stated in the Khan report, the pygmy deposit scheme which involved daily/weekly collection of tiny deposits at the depositors'doorstep by engaging local people as agents, was operated in the past by a few banks. This had been banned in 1983 due to various malpractices. While doorstep banking has probably been carried out unofficially 15 over the past several years, it was allowed again by RBI in April 2005 16. Banks can now offer banking services to government departments and institutions at their premises. For individuals, permission of the bank board and 14 Thus the Chowk, Shahjahanpur (U.P.) branch of SBI received a transfer of Rs. 50 lakhs for opening over 1,000 savings bank accounts of SHGs through its profit centre management accounting system. 15 Harper (2005) reports that while RBI regulations forbade anyone except bank employees from collecting savings on a bank s behalf, Syndicate Bank s agents were paid to do so on a commission basis. However, they signed specially worded letters that allowed them to be treated as employees by the RBI for deposit collection. 16 Vide Circular DBOD.No.BL.BC.86/22.01.001/2004-05 dated 30 April 2005. 12

RBI is necessary. 17 Risk management of such schemes remains an issue with the need to institute necessary checks and balances and the use of IT applications to minimize risk. Some public sector banks are coming forward to revive their old doorstep banking initiatives. SBI has realized that rural business (agricultural and non-agricultural) has been its strength and is again building on it, despite having been diverted to consumer credit in the 1990s. SBI is serious about expanding its rural operations focusing on SHGs, not MFIs, in microfinance. The focus is likely to be on insurance and small deposits as it feels it has not done enough on liability products despite its vast network of 6,500 branches. A pilot scheme on small savings/doorstep banking has been launched in Aurangabad district of Maharashtra. Union Bank of India is planning to offer doorstep banking through BFs recruited from among local people or farmers clubs in rural areas. This is part of a programme by the bank to go into rural business in an aggressive way. Syndicate Bank, which pioneered doorstep banking in 1928, has recently launched a new small deposit scheme Pigmy+ 2006 with provisions for doorstep collection. Further, the bank plans to implement the BF model on a pilot basis in regional rural banks sponsored by it in selected regions. Strictly speaking, the RBI circular on BFs and BCs does not envisage the usage of individual agents in deposit collection that has been the feature of pygmy deposit scheme of the past. It would appear that the new enthusiasm for doorstep banking stems from the RBI circular of 30 April 2005 rather than the BF/BC model. Nevertheless, banks are now able to use agents of various kinds as BFs and BCs, rather than their own staff, towards making initiatives such as doorstep banking more cost-effective. 4.3. Post offices and postal agents The postal department has a unique position in providing savings facilities and low-priced insurance products. The National Savings Institute (formerly National Savings Organisation) operates through 154,000 Post Offices and around 10,000 branches of nationalised banks, spread throughout the country, which act as its distribution channel. It uses 500,000 postal agents, including 150,000 women, who provide doorstep services to the people. 18 Despite the decline in interest rates from 12 % to 8 % per annum during the last few years there is still an increase in its deposit mobilization. Postal products carry a high level of trust of the public since the Union government acts as a guarantor. Savings mobilisation costs are 1% and postal deposits are lent without risk to State governments at 9.5% per annum. The Khan report mentions the experiment under the aegis of NABARD in a few districts of Tamil Nadu to use the services of post offices for facilitating SHG bank linkages. It suggests that, based on the results, post offices/postal employees may be considered for both BF and BC relationships. Postal agents can become an important part of the extension of financial services by banks in future. Union Bank of India s plans include, apart from the village knowledge centres it has launched, the use of the postal channel for doorstep banking. Of course, the department of posts is itself a player and potential competitor to the banking system in the provision of financial services, particularly liability products. Its life insurance product carries a comparatively low premium for a given cover and its savings products bear an attractive return. It has a strong presence in remittance services in the form of money transfer facilities, in which it assumes a universal obligation not possible for other service providers. Indeed, it could also be enabled, as in the case of Banco Postal, Brazil 19, to use a small part of its large deposit mobilization to provide loan services. 17 http://www.the hindubusinessline.com/2005/05/08/stories/2005050801720300.htm 18 From a contribution by the Head, National Savings Institute to the CGAP savings e-conference, December 2005. 19 See Khan Report (2005). 13

4.4. Recovery agents The outsourcing of recovery of overdue loans by banks has become quite common. These recovery agents have been appointed under the existing Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests (SARFAESI) Act 2002. Many banks, including SBI and Bank of India, are using NGOs and former bank staff as recovery agents to collect bad debts (overdue as well as written-off loans) to bring down the level of their nonperforming assets - with up to 10% commission on collections for hard-core NPAs over 5 years old. This is showing results and can be a lucrative business for the agent as well. SHGs too have been similarly given the responsibility by banks of the collection of repayments from delinquent borrowers in their villages. 20 Thus, BFs have already been engaged by banks to assist in recovery of loans even prior to the BF/BC circular. Overall, there do not appear to be any contentious issues about the role of BFs. These facilitation agents can be appointed without RBI s permission. In fact, some important areas of involvement of BFs, as discussed above, had already been made possible by earlier RBI decisions. 20 For example, bankers report that Punjab National Bank and State Bank of India are using retired bank staff as well as NGOs for this purpose in Budaun district of UP. 14

5. Business Correspondent Models While BFs have a comparatively limited facilitation role as agents of banks, the BC can undertake a range of financial functions not permitted for the BF. There are several outstanding issues that need to be addressed before the BC model can be fully operational and adopted on a large scale. The BC model essentially applies to the bank-mfi relationship (covering the several legal forms adopted by the latter). Since SHGs are unregistered entities they cannot act as BCs, though registered federations and associations of SHGs would qualify. SHGs could, however, be clients of banks through the medium of the correspondent MFIs. As per the Khan Report, in the recent times, several new generation banks who came into existence with a heavy reliance on technology but with a very limited branch network, have taken innovative steps, such as, bulk lending to microfinance institutions (MFIs), using them as pass through agencies, to tap the rural credit market. In the Indian context ICICI Bank has taken the lead in developing the partnership model, followed by UTI Bank and HDFC Bank. The BC model appeared to have been designed to set out the norms and to formalize the relationship between banks and their agents (or BCs) in increasing the outreach of financial services for the poor. It is instructive to compare the basic ICICI Bank-MFI partnership model and RBI s BC model. (However, forms of credit enhancement under variants of the Bank-MFI partnership will be excluded from the discussion.) Figure 1 illustrates the financial flows and relationships under the Bank-MFI partnership model 21, as implemented currently by ICICI Bank, and RBI s proposed BC model. These are also contrasted with the relationships and prevailing interest rates under the MFI SHG-Bank linkage model as implemented through MFI intermediaries. Figure 1: MFI SHG-Bank Linkage Model, ICICI Partnership Model and RBI s Business Correspondent Model MFI SHG-Bank Linkage Model Loan contract at interest rate = 12-18% Loan disbursement Loan disbursement Bank Interest & Principal MFI Interest & Principal SHG Loan contract at interest rate = 9-12% ICICI Partnership Model loan contract at interest rate (9-10%) + service fee MFI (9-20%) = 18-30% service fee ICICI Loan disbursement Interest & Principal MFI Loan disbursement Interest & Principal Client (SHG/JLG/Grameen, individuals, etc.) Partnership agreement with FLDG RBI Business Correspondent Model service fee loan contract at Prime Lending Rate (PLR) = 11-13% Bank Loan disbursement Interest & Principal BC Loan disbursement Interest & Principal Client (SHG/JLG/Grameen, individuals, etc.) correspondent agreement 21 Adapted from Duflo (2005) and Ivatury (2005) 15

5.1. ICICI Bank-MFI Partnership Model Under the partnership model the bank enters into a loan contract with the client and provides the loan funds while the MFI handles all the other operational tasks related to the origination, disbursement, supervision and recovery of the loan. The loan amount flows through the agent/partner MFI. The bank has a fixed interest demand from the client (usually a joint liability group (JLG) or self-help group (SHG)) of around 9% to 10% per annum while the MFI collects its servicing fees directly from the client, through a mark up of 9 to 20% over and above the bank s demand, to cover its own transaction costs. The loan cost to the client (or effective annual rate of interest paid) could be between 20 and 30%, or even higher. To share the credit risk, the bank requires the MFI to deposit with it 8 to 15% of total funds utilized as first loss default guarantee (FLDG). Alternatively, the bank extends an overdraft facility to the MFI at a high rate of interest that is drawn upon by the bank in the event of default by the MFI 22. The flow of credit to clients through MFIs under this model has increased substantially over the last few years. 23 This arrangement is said to combine the comparative strengths of each agency since the bank has the liquidity and the MFI the social mobilization skills and appropriate credit methodology. Ivatury (2005), however, poses the question Is the MFI a bank or a distribution channel? 24 Indeed, in the partnership model the MFI acts as a retail service agent on behalf of the bank, which owns the portfolio, rather than as a genuine financial intermediary. A similar relationship is envisaged in the RBI s BC model but with some significant differences related to the question of the agent s fees. In the diagram above, the pass through character of the agent s function (under the MFI partnership model and the BC model) is illustrated by the broken section of the line illustrating the financial flows on account of the bank loan in the two models. The differences in the sourcing of the fees of the partner-mfi and the BC are also evident; as also the absence of the FLDG in the case of the BC model. 5.2. RBI's Business Correspondent Model In the RBI s BC Model, the service fees of the BC/MFI/other agent are to be paid by the bank as the BCs are specifically debarred from charging any fees from clients. Further, though the bank is free to set the rate of interest on loans to the JLGs/SHGs/individuals that are its clients, the bank is constrained to charge no more than the Prime Lending Rate (PLR) for loans up to Rs. two lakhs a limit which would cover almost all its potential microfinance clients under this model. PLRs are currently in the region of 11-13% or so for most banks (as high as 13.25% for ICICI Bank since 12 June 2006). As a result in the BC model the bank has to meet the cost of its agent from its own intermediation margin, while at the same time being subject to an interest rate cap in the form of the PLR. Assuming cost of deposit mobilization of about 5% to 8% per annum, this would hardly leave an intermediation margin of about 5% to be shared between the bank and the MFI. Given the prevailing structure and levels of costs of lending to poor clients in rural areas this would appear to be a tall order. This is the major reason for uncertainty regarding the BC model that has prevailed 22 By way of illustration, in a case study of ICICI Bank and its retail service agent, Spandana, a CGAP note reports the cost to the borrower on the one-year term loan is a flat 15% (about 30% effective p.a.), the same rate that Spandana charges when it is the lender of record. Of this charge, 9.25% is interest income and fees for ICICI Bank, and the remainder (about 20.75%) is a service charge collected by Spandana. To share the credit risk, ICICI Bank requires Spandana to make a fixed deposit with the bank in the amount of 12% of the total committed amount. As an alternative, Spandana may take an overdraft from the bank for this amount and pay a 1% upfront fee. If losses occur, ICICI Bank will draw from this overdraft, charging Spandana 19% interest on the amount drawn. (CGAPa, n.d.) These, however, may not be currently prevalent rates. 23 Accoring to Ghate (2006), ICICI Bank supported 100 MFIs by the end of March 2006 with a total exposure of Rs. 2350 crores to microfinance, which also included SHG lending and jewel loans. He estimates the outstandings under the partnership model to be 60% of this figure, or Rs. 1410 crores. 24 Mathison (2005) suggests that the term (MFI) generally refers to independent microfinance institutions, and tends to be exclusive of alternative models for delivering microfinance that are emerging. Retail service agents of commercial banks, as in the partnership model, or business correspondents given the nature of their functions may better be referred to as Microfinance Providers (MFPs). 16

during the past six months or so. It also follows that the BC cannot be provided the reasonable margin available to the partner MFI as servicing fees under the partnership model. Also, in the BC model there is no provision for first loss default guarantees to be imposed on the BC by the bank. However, the Khan Report which is the reference point for details of possible arrangements does mention the possibility of a delinquency liability like the FLDG - being imposed by the banks on the BCs as part of the checks and controls that are required for risk management. 17

6. Open Questions 6.1. Interest rates and servicing fees of the Business Correspondent The RBI BC model bears close similarity to the bank-mfi partnership already developed by some private banks. The stipulation debarring BCs from collecting fees from clients can be considered to be sound in that the MFI/other entity involved as BC is no more than an agent acting on behalf of the bank and should be remunerated by it and not by the client. However, this stipulation has created an anomaly in relation to the existing partnership model in the matter of who pays the BC/MFI. Further, given the PLR constraint banks do not have the necessary margins to work with to remunerate the BC. 25 While the bank and the MFI agent could share loan interest and fees of up to 30% in the partnership model, under the RBI BC model this is limited to around 11-13%. The banks clearly have a limitation on the chargeable fee to clients from which it is difficult for them to meet the costs of the BC. The matter has been referred by concerned banks to the RBI and its decision is awaited. The thrust of the discussion with RBI is regarding the cost of credit delivery under the BC model - in order to arrive at a basis for remunerating the BC. RBI agreed to study the costs of using MFIs for this purpose. It is expected the matter will be resolved soon. The lifting of the PLR constraint would be one way - which has been suggested by bankers in the past - or the setting of a limit expressed in the form of a PLR plus rate, e.g. 5% above PLR. Alternately, the BC could be allowed to charge a small fee to the clients. Otherwise, banks may have to impose some form of service fees over and above the PLR-based interest rate in order to meet the cost of the BC. At the same time the high loan charges paid by microfinance clients under the partnership model have also come in for criticism, as has happened recently in certain districts of Andhra Pradesh. The requirement of the FLDG to be provided by MFIs is also a factor responsible for raising their credit delivery costs under this model. Nevertheless, it is possible that the intention of the RBI is to ensure a check on the effective interest rate paid by the client under the BC model. Indeed, the Khan report observes that there is a need for caution to see that the cost of credit is not usurious. 6.2. Status of the Bank-MFI (Partnership) Model The RBI circular dated 25 January 2006 would appear to debar arrangements along the lines of the ICICI Bank partnership model for the future. However, this continues to be a grey area such that opinion is divided on whether or not banks can continue with the terms of the original partnership model such that the bank s partner MFIs (effectively BCs) independently receive fees from clients. Though the bank s contract with the client under the partnership model does not violate the new regulations the composite three-way arrangement (with the MFI as a party) certainly would. As discussed above, RBI is understood to be reviewing the matter of the remuneration of BCs. For the present private sector banks already operating the bank-mfi partnership continue to do so. Understandably there is disquiet among such banks which see the stipulations as unrealistic and would wish to see the partnership model regularized by the lifting of the PLR cap on loans below Rs. 2 lakhs as well as the restraint on banks from charging loan processing fees on loans below Rs. 25,000. At the same time some bankers feel that if there continues to be uncertainty about the legality of the arrangements banks should opt out of implementing the partnership model in its present form. Another private bank, ABN-AMRO Bank, which has thus far only provided term loans to MFIs, prefers to wait for a clearer picture to emerge before implementing the BC model. 6.3. Why can NBFCs not act as Business Correspondents? One of the debated issues on the BC model is the subsequent debarring of NBFCs (except the not-for-profit section 25 companies) from acting as BCs through RBI s circular dated 22 March 2006. Leading NBFCs engaged in microfinance have been early adopters of the partnership model with ICICI Bank and other banks. Other private sector banks were also looking forward to 25 Ghate (2006) too notes this regulatory anomaly. 18

associating with these NBFCs under the BC model. Hence the new circular has led to a loss of enthusiasm for this form of partnership since banks would prefer to do business with established NBFCs acting as BCs. Indeed, both the Khan report and the Usha Thorat Working Group on NBFCs had visualized them as operating as BCs. The matter is under review by the Department of Banking Operations and Development of the RBI. Some bankers and MFIs are optimistic that a decision permitting NBFCs once again to act as BCs could be forthcoming. It is understood that the RBI has three concerns that are coming in the way of a ready acceptance of NBFCs as BCs of banks. These are (i) foreign banks may take advantage of this route to bypass the need for obtaining branch licenses towards extending their operations; (ii) the commercial interest of the partnership of large banks and NBFCs may place their poor illiterate clients in a weak bargaining position as compared to alternative institutional forms such as community based organizations or cooperatives that are people-centered and democratic; (iii) the possibility of commercial and large consumer finance companies also registered as non-deposit-taking NBFCs entering the sector in alliance with banks as BCs. 26 26 Thus with NBFCs being allowed to participate, it would be possible for, say, the big Citigroup companies and GE Capital, also non-deposit-taking NBFCs, to act as BCs for a bank. 19

7. Operational Concerns Some of the major operational concerns in the implementation of the BC model as reported by bankers are as under: i) There are difficulties related to posting transactions at the bank by the end of the day or within 24 hours as required in terms of the RBI circular. This is not possible without the use of IT devices like simputers and smart cards and unless large investments are made and business is undertaken on a large scale by the bank. Further, there are limitations in communications, power supply and other infrastructure which do not make it feasible to meet this requirement while working in far-flung rural areas. ii) There is lack of clarity about aspects of savings collection through BCs such as the meaning of small value deposits referred to in the circular as also whether savings bank accounts can be opened or not, e.g., how large are small value deposits? RBI will be responding on some of these questions. Indeed, there are mixed views on the feasibility of using BCs for the delivery of savings and other liability products (see box 1). iii) The role of the regulator in the BC model has to be clarified. For example, RBI approval is necessary for doorstep banking. However, it is not clear if it is necessary for MFIs/agents acting as BCs. iv) Banks can engage only one BC/BF in a particular geographical area and BCs can operate only on behalf of one bank. Particularly, in view of the lifting of the service area regulations it is not clear how to define geographical area for the contractual relationship between the BC/BF and the bank. The RBI has been in touch with banks to resolve these issues. It is understood that one of the private sector banks, ABN-AMRO bank, which is keen to expand its operations in microfinance, feels constrained to implement the BC model on account of the above concerns. ABN-AMRO has not operated the bank-mfi partnership model thus far. Instead it provides term loans of one to five years duration at 8 to 11% p.a to 24 MFIs in eight states. Its clients include Basix, Bandhan, Biswa, KAS Foundation, Cashpor, SKS and KBSLAB. According to bank sources, there is also no excitement among the MFIs about the BF/BC circular because of outstanding issues related to the delivery of credit services through the BC model. Box 1: Business Correspondents in delivery of liability products ICICI Bank has launched pilot projects in Andhra Pradesh and Orissa that have adopted the BC model for delivering liability products micro-savings, a variety of insurance products and micro-pensions - to poor families in rural areas. BCs are to collect savings deposits and offer insurance products to customers in these under-banked areas. The bank expects to increase the number of BCs significantly by the end of this year. A less optimistic view regarding the use of BCs in the delivery of liability products, particularly small deposit collection, has been provided by ABN-AMRO Bank (AAB). AAB officials feel that raising small deposits through BCs/MFIs is not financially feasible since cost estimates prepared by SKS (a leading MFI and client of AAB) suggest that it would cost Rs. 2.50 for Rs. 20 of small deposits collected every month from microfinance clients. They claim that, as a result, MFIs are also not keen to participate as BCs in such savings collection on behalf of banks. 20

8. Other issues Since BCs are acting on behalf of the bank, their long-term sustainability and credibility becomes critical and has to be established through a wide range of enabling measures, checks and controls. Given below is a summary of other issues likely to come up in the course of implementing the BC model, particularly in respect of the ability of MFIs and other types of BCs to play the role expected of them in the successful implementation of the model. 27. Capability of BCs and long-term sustainability of the model Sustained capacity-building of BCs required Need for sustained strong field presence of the BC Quality of service by BC can impact bank s image Customer confidentiality Adequacy of internal controls Over-aggressive build-up of portfolio by bank One MFI having relationship with various banks Finally, if the BC model is to be adopted and expanded, the Management Information System (MIS) requirements will necessarily be great as banks and MFIs reach across to overlapping geographical areas and clients. Besides, there is the need for a sound MIS to operate smart card technology and related IT applications. Financing agencies may also like to share information on their client base to insulate themselves against predatory competition on the one hand, and stop dissipation of efforts on the other by reaching out to clients already serviced by others 28. At the same time MFIs are not comfortable sharing their data with the banks. In this connection Financial Information and Network Operations (FINO) - a technology backbone company - has been launched in July 2006 by ICICI Bank. This will provide a core banking solutions platform (which can be used by other banks and can be accessed by MFIs) for end-toend delivery of the entire suite of financial services. However, there are still some questions about the eventual cost of the services to be provided by FINO. While FINO could well fill the need for a centralized data base other banks may still be reluctant to share or utilize it. The idea of a credit bureau for sharing information, while critical and important, has still not been implemented in India, even though the Khan report favoured the setting up of a National Microfinance Information Bureau (NMIB) to be managed by NABARD. This will also need to be pursued in the near future. 27 From Vikraman (2005) 28 Khan report (2005) 21