India's Microlenders Prepare For A New Phase Of Growth

India's microlenders have come full circle.

A decade of growth in the early 2000s, which brought microlending into the commercial mainstream. Concerns about over lending, followed by tighter regulations starting 2011. And now, a decade later, a new liberalised framework.

The Reserve Bank of India's new rules for microfinance could open the door to another burst of growth for microlenders across the country, even though borrowers may have to face higher interest rates in turn. The rules, finalised by the RBI on March 14, will lift pricing caps placed on these lenders, change the definition of microloans, and set new benchmarks on who can be offered this credit and how much is appropriate.

The rules, according to India Ratings & Research Pvt., will help improve the viability of small- and mid-sized microfinance institutions. It may also allow microlenders to penetrate into newer geographies "as pricing can now be differentiated, and cover the higher operating costs for the same", analysts Amit Rane and Jindal Haria wrote in a March 15 note.

A key change brought in by the new rules is lifting pricing caps, which had been put in place to prevent lenders charging excessively high interest rates.

While the earlier rules said that lenders can only charge a margin of 10-12% over their cost of funds based on size, the new guidelines leave pricing up to individual lenders. Boards will have the oversight and the regulator will keep a watch to avoid "usurious" rates being charged.

How easy will it be to ensure lenders don't raise rates to unreasonable levels?

“70% of the industry was already free, still the rates were not usurious," said Alok Misra, chief executive officer and director of the Microfinance Institutions Network, pointing to the fact that the earlier caps were applicable to MFIs but not to banks. Misra added the pricing formula now has to be in the public domain. There are enough players in the market to ensure healthy competition, Misra said.

That's not to say the risk doesn't exist.

"The risk of borrowers being charged high rates is real. Responsible lending is a necessary requirement for microfinance," said Alok Prasad, former chief executive of MFIN. "While reasonableness of pricing is a key precept of public policy, the basis and principles for the scrutiny have not been indicated. Greater clarity on this would be desirable," Prasad said.

According to Misra, allowing microlenders to charge a reasonable profit margin is important. MFIs take the cost of funding and build in operational costs and a profit margin to settle the rate at which they lend.

“Some margin has to be there because it is a business and there has to be something for investors. If someone charges anything exorbitant then the regulator comes into the picture and actions can be taken,” said Misra.

What would be considered "usurious" lending? Any significant deviation from industry standards can be considered as usurious, Misra said.

Boards of individual MFIs will also maintain scrutiny, said Manoj Nambiar, managing director of Arohan Financial Services. "This reduces the chances of any excesses." Besides, all price information has to be shared with borrowers and published on the company's website, said Nambiar.

While rates will likely rise, not all lenders will feel the need to raise them immediately.

"About 35% of MFIs who have high operating cost may increase interest rates," said Udaya Kumar Hebbar, chief executive officer at CreditAccess Grameen Ltd.

Under the new rules, all collateral-free loans to households having annual household income not exceeding Rs 3 lakh can be classified as microloans. In addition, lenders must ensure that the monthly EMI or payment does not exceed 50% of the monthly household income.

Earlier, lenders could only lend to those with income up to Rs 1.25 lakh in rural areas and Rs 2 lakh in urban areas. There was also a cap on how much loan could be given and on indebtedness.

Misra explained that the new rules will allow MFIs to cover borrowers who were earlier considered to be earning too much for this set of lenders. These borrowers, however, were too small to be covered by banks and hence fell between the cracks.

"Approximately 10 crore more households will be covered now by MFIs, of which 75% will be from deep rural areas and 35% from semi-urban areas,” said Hebbar.

Some interpretational issues remain, said Prasad.

For instance, the definition of household income will pose challenges as it is not clear whether the income cap applies to gross income or the net surplus after meeting the expenses of the micro-enterprise/business, he explained. Also since the maximum loan amount has not been specified, it will have to be derived based on the requirement that the monthly payment should not be more than 50% of the household income, Prasad said.

The definition of what constitutes a household may also need some clarity.

A common framework for evaluation and income assessment must evolve, said India Ratings in its report. "If not implemented carefully from the credit risk perspective, the purpose of microfinance could be diluted and the group structure may not be cut out to withstand defaults on high indebtedness," the analysts said.

The more liberal rules, according to the industry, will allow for quicker expansion.

With the ability to cover for higher operational costs, microlenders may be able to target areas where they have so far been reluctant to venture.

As of September 2021, eastern and northeastern India accounts for 39% of the microlending portfolio, according to data from MFIN. Southern India accounts for 26%, while western, northern and central India contribute 15%, 12% and 8%, respectively.

The new regulation will usher in the next growth phase of the MFI industry, said Nambiar. "If one considers the first phase as before the Andhra Pradesh Microfinance Ordinance in 2010, then the second phase started with specific RBI regulations for MFI. Now, with deregulation and harmonisation of rules the third phase begins—MFI Version 3.0.”

This story has been updated to clarify a comment from MFIN's Alok Misra on what would qualify as usurious lending.