The Reserve Bank of India (RBI) proposed its intention to review the regulatory framework for Non-Banking Financial Company – Micro Finance Institutions (NBFC-MFIs) and harmonise the regulatory frameworks for various regulated lenders in the microfinance space. This was made as part of the Bi-monthly Monetary Policy Statement, 2020-21, announced on February 5, 2021. As acknowledged by the RBI in this statement, there is a case for having in place a framework that is uniformly applicable to all regulated lenders in the microfinance space, i.e., scheduled commercial banks, small finance banks, NBFC-MFIs, other NBFCs, and NGO-MFIs. We believe that this proposal is a much-needed step in the right direction.
In this context, the issue of creditworthiness assessments in microfinance needs to be paid greater attention to. Having studied the issue of over-indebtedness in microfinance, we have, in the past, raised our concerns around the effectiveness of RBI’s regulatory approach to these assessments in limiting the risks of excessive lending and borrower over-indebtedness. In this post, we revisit these issues and provide a set of suggestions to address them. The latter, we believe, are well-aligned with the RBI’s interests in protecting the financial well-being of microfinance borrowers.
Need for credit bureau integration and use of comprehensive credit information reports
The RBI Master Direction, dated September 1, 2016, requires NBFC-MFIs to use data with Credit Information Companies (CICs) to inform their lending decisions. Current lending practices of NBFC-MFIs indicate that they use data from MFI-only bureaus, resulting in an incomplete capture of the borrowers’ credit profile. Costs of obtaining comprehensive reports, which include all formal debt, has often been cited by MFIs as a reason for using MFI-only bureaus. Evidence from extensive primary research conducted by Dvara Research in the Krishnagiri district of Tamil Nadu in 2016 showed that on average, 42% of the sampled households’ total institutional debt was excluded due to the usage of MFI-only bureaus. The research also indicates that using only this bureau resulted in 33% of the clients being wrongly classified as being eligible for a new loan, when in fact, they were over-indebted based on the limits prescribed by the RBI.
If avoiding over-indebtedness is the objective, there is an urgent need to ensure comprehensive credit information reports are available to all microfinance lenders at a reasonable price. Additionally, the use of such comprehensive reports must be made mandatory to assess the repayment capacity of borrowers.
Household-level underwriting rather than at the borrower level
Credit availed by a member of a household is in most cases added to the overall cash flows of the household, while repayments most commonly come from pooled cash flows of the household. Consider, for example, the case of a small farmer who has agriculture as her single source of income and receives cash inflows only twice a year. She may seek a microfinance loan to fill the income gaps and satisfy her consumption needs during the intervening period. In a scenario such as this, it is likely that other members of the household contribute to cash flows through ancillary activities like dairy from a head of cattle or a kitchen garden. However, in the absence of these alternative sources of income, the microfinance loan would place the household under tremendous stress and force them to borrow informally in order to make the equated monthly instalments on these loans. Therefore, it is pivotal that the lender be required to ascertain the household’s capacity to repay and not just that of the borrower’s. However, NBFC-MFIs, as a practice, carry out borrower level underwriting as part of creditworthiness assessments and focus on ensuring that the total indebtedness at an individual borrower level (presently at Rs. 1.25 lakh) as prescribed by the RBI is not breached. The MFI-only bureau records, too, do not lend themselves useful to such comprehensive assessments as current reporting formats do not capture household-level debt.
Hence, in addition to ensuring that credit information reporting formats used by lenders capture household-level financial information, it should be made mandatory for all microfinance lenders to use such comprehensive information, i.e., household-level income, expense, and debt, to assess the repayment capacity of borrowers.
Move towards cash flow-based underwriting
indebtedness, and the number of NBFC-MFIs that can lend to the same borrower (presently at two) have raised concerns around NBFC-MFIs “lending to the limit” as a practice and relying excessively on credit bureau records instead of assessing the borrowers’ repayment capacity in meaningful ways. The prescriptive nature of these limits also suggests that as long as NBFC-MFIs adhere to them, there is no liability on them for failing to protect their borrowers from over-indebtedness.
An effective way to address this issue would be to require all microfinance lenders to adopt cash flow-based underwriting rather than just verifying the aggregate annual income, expense, and debt data of the household. Such an underwriting process would require lenders to capture details of occupational profiles, income flows, expense flows, and debt flows of the entire household, either directly or through the use of proxies and questions and combining these with information from credit bureau records. An assessment based on these cash flows should be carried out for each period demarcated by an expected repayment instalment for the microfinance loan in question, i.e., weekly or monthly. Additionally, such assessments can also be modelled to account for seasonality or expected patterns in the cash flows.
Lay down principles for creditworthiness assessments
The RBI Master Direction, dated September 6, 2016, requires NBFC-MFIs to adopt Fair Practices Code (FPC). The FPC requires them to carry out due diligence to ensure repayment capacity of the borrowers. The Master Direction also requires NBFC-MFIs to become a member of at least one Self-Regulatory Organisation recognised by the RBI and comply with the Code of Conduct prescribed by them. A prudent and responsible lender would put in place processes to ensure compliance with these requirements. However, as outlined in the previous points, there is no real incentive for NBFC-MFIs to put in place such processes given the prescriptive nature of the current regulations.
The RBI should begin reconsidering the effectiveness of these regulations. Instead, it must mandate all microfinance lenders to establish processes to carry out creditworthiness assessments which can help them determine the true repayment capacity of borrowers. Such a process would also incorporate household level and cash flow-based underwriting discussed in earlier points. In doing so, the RBI can consider laying down the fundamental principles that should underpin creditworthiness assessments. These principles can act as a practical guide to all microfinance lenders and cover in detail what they should or should not do in carrying out such assessments. With this, the RBI would be joining other jurisdictions which have gone a step further in articulating these principles in considerable detail, covering questions such as how to analyse financial position, collaterals, and credit risk, business model and strategy, credit scoring, and financial commitments of the borrowers (for instance, see ‘Guidelines on loan origination and monitoring’ of the European Banking Authority). The RBI, on its part, can also consider laying down these principles for different borrower segments. For example, by broad occupation profiles of microfinance borrowers.
However, a mandate such as this would require microfinance lenders to have in place sufficient frontline capacity, technical skills, and IT infrastructure. The RBI must therefore consider implementing this in phases. These assessments can eventually replace lending caps and other restrictions on consumer choice in the current regulatory framework.
Finally, the effectiveness of the current regulations has also been reduced because most of the regulations discussed till now apply only to NBFC-MFIs. Specifically, on the need to assess the repayment capacity of the borrower, regulatory language is either absent or not uniformly applied to all microfinance lenders such as banks and other NBFCs (by lenders, we mean both those who originate these loans and those who hold them on their books). For example, the FPC applicable to non-NBFC-MFIs do not have any language around the need to conduct due diligence of their borrowers before lending (irrespective of whether they are microfinance or other loans). Therefore, the current regulations and our recommendations must be considered for uniform application across all lenders who originate and/or hold microfinance loans to ensure that they effectively protect the interests of microfinance borrowers.
 See ‘Assam Crisis Brings to Fore Protracted Regulatory Issues in Tackling Borrower Debt Stress’ by Amulya Neelam, February 2021, Dvara Research. Available at: https://dvararesearch.com/2021/02/03/assam-crisis-brings-to-fore-protracted-regulatory-issues-in-tackling-borrower-debt-stress/#_ftn1
 See ‘When Is Microcredit Unsuitable?: Guidelines using primary evidence from low-income households in India’ by Vaishnavi Pratap & Rachit Khaitan, December 2016, Dvara Research. Available at: https://dvararesearch.com/wp-content/uploads/2017/01/When-is-Microcredit-Unsuitable-Guidelines-for-Lending.pdf
 The RBI, vide circular dated August 2, 2017, had directed CICs to issue comprehensive credit information reports replacing the practice of offering limited versions of these reports based on credit information available in specific modules (commercial, consumer or MFI). CICs were also found to be charging much higher rates for such specific reports. Continued reliance on MFI-only bureau indicates that integration of credit bureau records remains incomplete.
 The RBI Master Direction dated September 6, 2016, requires NBFC-MFIs to fulfil the Qualifying Asset criteria by ensuring that it lends to a borrower with a household annual income not exceeding Rs. 1.25 lakh (rural) or Rs. 2 lakh (in other cases). This, to an extent, indicates the RBI’s preference for household-level underwriting.
 See ‘Let’s stop kicking the can down the road: Highlighting important and unaddressed gaps in microcredit regulations’ by Nishanth Kumar & Deepti George, October 24, 2019, Dvara Research. Available at: https://dvararesearch.com/2019/10/24/lets-stop-kicking-the-can-down-the-road-highlighting-important-and-unaddressed-gaps-in-microcredit-regulations/
 For a detailed description of business processes that microfinance lenders can adopt see ‘A Practical Note on Operationalising Suitability in Microcredit’ by Deepti George, February 2019, Dvara Research. Available at: https://dvararesearch.com/wp-content/uploads/2019/02/Operationalising-Suitability-in-Microcredit.pdf
 See ‘Guidelines on loan origination and monitoring’, May 2020, European Banking Authority. Available at: https://www.eba.europa.eu/sites/default/documents/files/document_library/Publications/Guidelines/2020/Guidelines%20on%20loan%20origination%20