This week, the Reserve Bank of India (India’s central banking regulator) proposed significant new microfinance regulations which would impact the majority of microfinance lending in India.

There are many new regulation recommendations which they hope to have adopted as early as April 1, 2011.  Here are a few highlights:

• Create a new non-banking financial company category called NBFC-MFI with new regulations
• Max microloan size of RS 25,000 (~US$500)
• Minimum 12 months duration for loans under RS 15,000 (~US$300) and 24 months for loans above that
• Each borrower chooses whether they make weekly, bi-weekly or monthly repayments
• Only one joint liability group (or self-help group) per borrower and max of 2 loans per borrower
• Interest rate cap of 10-12% margin over cost of capital
• Minimum 90% of assets must be for microloans and at least 75% of these loans must be for business purposes
• Limitation on loan-related revenue to interest, loan insurance (must be optional) and max 1% loan origination fee
• NBFC-MFI must have minimum capitalization of RS 15 crore (~US$3m) up from RS 2 crore (US$500k)
• Minimum capital adequacy of 15% up from 12% and with stricter definitions of capital basis
• Consideration of appointing local bank officials or political appointees as arbitrators in loan repayment issues

The RBI is attempting to create a national regulatory framework which supersedes specific India state-based legislation like we have seen in Andra Pradesh.  Overall, I think national banking regulation with an independent regulator is positive for the poor in India.

It is going to be interesting to see what the reaction to this proposal is from the microfinance industry.  Typically, this type of legislation is generally embraced by the large, established players because it creates more certainty and they have the resources and sophistication to leverage this to grow their market share at the expense of the smaller players.  Since in microfinance scale often benefits operational efficiencies, it is easier for the larger players to manage their profit optimization under regulations with price caps.

So, I would expect that if this is implemented it would have the following results:

• Slower growth in access to microfinance. The report notes that microfinance and self-help group market penetration is < 1% in all regions of India except the south where is is 3.4%.  Most MFIs will have to slow down growth as interest rate margin cap discourages forward investing.  Fewer new MFIs will start because of the higher initial costs and higher operating subsidy required before getting to large scale.  The interest margin cap will also dramatically slow growth in areas which are currently the most underserved — i.e. higher poverty and lower density areas of India where cost of operations are higher and revenue per client is lower (due to lower loan sizes).
• Significant industry consolidation. The big, at-scale players will gobble up many of the smaller players or the smaller players may just fold.  This is not necessarily good for borrowers as it reduces competition and some of the higher value add approaches of these smaller players.
• Less financial product innovation. The strict requirements are going to stall the development of better quality (from borrower perspective) financial products outside of the one-size-fits-all business microloan product.  This includes more business-cycle friendly working capital loans, housing loans, various insurance products, savings-type products, etc.  And % of revenue restrictions will prevent MFIs from distributing 3rd party products as well.
• More populist politicalization of financial products for poor. This concept of appointing a local ombudsman (for loan repayment arbitration) from the local business or political elite has predictable results — corruption, political posturing and ultimately higher costs for MFIs (which can’t be passed along to borrowers).

Do you agree with my observations and/or conclusions?  Please add additional insights and thoughts in comments.

UPDATE: Here are additional responses to RBI recommendations:

• M-CRIL, largest MFI rating agency responds [PDF]
• India’s Economic Times article on small MFIs won’t survive

Related Articles:

• Disinformation on Microfinance Hurts the Poor
• India microcredit crisis analysis
• India microcredit situation by the numbers
• SKS Microfinance IPO report