Lack of a proper regulatory framework, including lack of proper supervision had played an important role in the disorderly growth of the NBFC MFIs

A recent news item stated that, “In its report ‘Trend and Progress of Banking in India 2010-2011’, The Reserve Bank of India (RBI) states that if State Governments start enacting their own legislations to regulate microfinance institutions (MFIs) including the ones regulated by the Reserve Bank, there will be plurality of regulation leaving scope for regulatory arbitrage. The responsibility for regulating NBFCs has been given to the Reserve Bank, thus, empowering it to regulate the NBFC- MFIs. If other States also come out with legislation similar to the Andhra Pradesh Government, it will raise concerns not only about multiple regulations but also about client protection, as borrowers would then be subject to different regulations. If there are separate regulations governing NBFC-MFIs in individual states, the task of regulation by the Reserve Bank of MFIs operating in more than one State will become even more difficult. This may also impact the business of MFIs, which are operational in more than one State, it says.” (RBI against State Govt regulating microfinance institutions,)

While that is a fair point, without question, it is clear that the lack of a proper regulatory framework (including lack of proper supervision) has played an important role in the disorderly growth of the NBFC MFIs and the challenges arising therein. I shall look at this in detail here and outline the implications Indian micro-finance including the above assertion that state governments have no jurisdiction to regulate micro-finance, even in terms of protection of clients.

In any regulatory framework, there are three major aspects:
1.    To provide legitimacy and a proper regulatory framework to MFIs (Legitimacy For Micro-Finance Institutions and Players) and others involved in delivery of financial services to low income people
2.    To ensure that MFIs indeed satisfy the broader objectives for which they have come into being (in the first place) and also that they operate and function in a sound and legal manner, in accordance with norms and standards required of such (pro-poor financial) institutions (Regulation and Supervision of Micro-Finance Institutions and Players), and
3.    To protect clients from MFI bad practices as well as protect MFIs that operate legally and correctly from usury laws (Protection of Micro-Finance Clients and Institutions)

These are huge diverse tasks spanning financial sector regulation as well as client protection. And given that RBI desires to perform all these roles (directly or through delegation), it seems fair to ask the following questions:  a) how are these tasks to be structured at the RBI (assuming that they would be done by RBI in the first place)?; b) Does the RBI have sufficient capacity to effectively and efficiently manage the various tasks including supervision and client protection both of which require a significant local presence across the country?; c) In case the RBI delegates these tasks, what about the alternative institution and its capabilities with regard to these tasks including supervision?; and d) several other aspects

The rationale behind asking the above questions is that a regulatory system is more efficient if the responsibilities are assigned to the institutions/bodies that have the powers, resources, skills, and knowledge to perform their roles most effectively. If one uses this framework of analysis, the assets of various institutions who are candidates for regulation/supervision of micro-finance in India should be compared as they pertain to the required regulatory and supervisory activities. This is a very critical exercise and must be done objectively and with utmost integrity. A related key question here is whether the said institutions/bodies can obtain, sufficient skills, resources, and capacity to undertake the regulatory/supervisory responsibilities effectively. If sufficient capacity does not exist or cannot be developed, building a regulatory structure that relies on such inst6itutions/bodies will not yield the desired result. This needs to be remembered with utmost caution.

That said, other factors should also be considered in choosing the institution/body to function as the regulatory/supervisory authority and they include the following:

•  Legal jurisdictions: Which institution has the legal jurisdiction to make rules and to supervise the micro-finance industry players involved – especially, given their diverse and varied legal forms?
•  Power, authority and local presence: Which body has the power and authority to investigate, discipline, and impose effective sanctions on the micro-finance industry players involved? For example, some institutions may have the power only to collect evidence from and to discipline member firms and their employees but lack the actual (local ground level) infrastructure to do so  
• Conflicts of interest: Do significant conflicts of interest arise/exist? Conflicts of interest always exist in regulatory systems, but vary depending on the type of regulation and institution involved. There are obvious trade-offs and these need to be evaluated as well
• Existing regulatory mechanism as a platform: Is there an existing regulatory structure that can serve as a foundation for the proposed new micro-finance regulatory system? Has it been effective in the past and can it be used as a platform for the future?
• Industry specific knowledge, skills, experience and data: Who possesses the knowledge, expertise, and skills required to regulate and supervise micro-finance? Which institution has access to the information and data needed for the task of regulation and supervision?
• Regulatory tools: Which body has the necessary regulatory tools (including information technology tools) for the complex task of micro-finance regulation/supervision?
•  Resources including finance: Last, but not the least, which institution has the funding and resources to do an effective job and deliver in terms of regulating and supervising micro-finance in an enabling manner?

I really hope the various stakeholders approach the issue of finalizing the exclusive micro-finance regulator/supervisor using an objective and professional process, giving due consideration to issues such as those identified above.

Without question, the above questions and issues are very relevant and cannot be ignored and need to be analysed thoroughly. The idea here is not to find fault but rather to highlight practical issues that would need to be considered first before passing on the entire responsibility of micro-finance regulation to RBI, as outlined in the proposed micro-finance bill.

And for that, we also need to look at regulatory and supervisory lessons/issues from the present micro-finance crisis (using the example of RBI’s supervision of NBFCs and banks) and raise the important question of whether or not, the RBI and its concerned departments indeed have the wherewithal to perform all of the functions given above – especially given the 2010 crisis that involved banks and NBFC MFIs. This requires an objective analysis of RBI’s past regulatory role and supervision record and is taken up in the succeeding articles…