The AP microfinance crisis has raised significant questions on the design of the financial system that best ensures inclusion. The crisis has revealed deep discomfort with the regulation of Non-Deposit taking Institutions (NDI). Some observers have equated NDIs to moneylenders. In this draft paper, Nachiket and Bindu analyse the various design choices we have and as a thought experiment, test them for likely impact in terms of solvency and liquidity.
They recommend that while the eventual end-state for the Indian financial system would be to have many more Deposit taking Institutions (DIs) offering a full suite of financial services to their clients, the aggressive use of NDIs may be a good interim step that permits for adequate experimentation without sacrificing depositor protection as an objective. In this process the poor quality and the ill intentioned players would be weeded out and then those that survive may be permitted to become full-fledged DIs through formal licensing.
To read the full paper click here. Share your thoughts in the comments section below.
8 Responses
Very informative paper I must say, though I have a doubt regarding the “weeding out” process. Since the liquidity of NDIs will be ensured by their ability to conform to the expectations of the DI’s, the DI’s have to enact supervisory roles. Will the cost of this supervision by the DI’s and the compliance by the NDI’s be transferred to the end-user in the form of higher interest rates? How does one evaluate different trade-off points between financial inclusion and systemic stability?(if there is a trade-off).
Very informative paper I must say, though I have a doubt regarding the “weeding out” process. Since the liquidity of NDIs will be ensured by their ability to conform to the expectations of the DI’s, the DI’s have to enact supervisory roles. Will the cost of this supervision by the DI’s and the compliance by the NDI’s be transferred to the end-user in the form of higher interest rates? How does one evaluate different trade-off points between financial inclusion and systemic stability?(if there is a trade-off).
Thanks for your comments Sunny. You are right that there is a cost to supervision by DIs but the presumption is that this would be much smaller than if DIs were to originate directly. Rangarajan Committeee estimates that the transaction cost to a Bank to make a loan less than Rs. 25,000 is around 30%. On the other question, our belief is that there must be no trade-offs between financial inclusion and stability. Systemic stability has to be a hard constraint for any inclusion plan. This leads us to choose some designs over the others. So for example, while we might believe that small local entities offering savings services is good for financial inclusion from an access perspective, this also puts deposits at risk given that these entities might not have the scale/capital to weather shocks. This in turn would lead us to alternate designs like Business Correspondents that offer savings access through local points but where the liability for depositor protection is with regulated commercial banks.
Thanks for your comments Sunny. You are right that there is a cost to supervision by DIs but the presumption is that this would be much smaller than if DIs were to originate directly. Rangarajan Committeee estimates that the transaction cost to a Bank to make a loan less than Rs. 25,000 is around 30%. On the other question, our belief is that there must be no trade-offs between financial inclusion and stability. Systemic stability has to be a hard constraint for any inclusion plan. This leads us to choose some designs over the others. So for example, while we might believe that small local entities offering savings services is good for financial inclusion from an access perspective, this also puts deposits at risk given that these entities might not have the scale/capital to weather shocks. This in turn would lead us to alternate designs like Business Correspondents that offer savings access through local points but where the liability for depositor protection is with regulated commercial banks.
What is to be regulated? Should we recognize microfinance as a separate asset class or micro finance be part of the financial services sector. Again whether there should be prudential regulations if it treated as a separate asset class or should the focus be on non-prudential measures like transparency in operations, disclosures with regard to interest rates, fair practices code, self-regulation, stress on corporate governance etc.
If the concern is interest rates – it is to be recognized that interest rates depend upon competition, access to low cost of funds, financial market development, cost of infrastructure and institutional efficiency etc. Just as the Government has set up the Rs.800 crore Fund to reach out to the financially excluded population ( in addition to the Rs.1000 crore Financial Inclusion Fund (FIF) and Financial Inclusion Technology Fund (FITF) set up with NABARD, the Government could also set up a Micro Finance Fund to lower the interest rate. May be the Government could dip into the unclaimed deposits kitty lying with the banks. But then the moot point is whether to refine the existing practices or Regulate.
As per newspaper reports the Economic Advisory to the Prime Minister has pitched for a Regulatory mechanism for the microfinance sector. The panel has also called upon MFIs to reform their business practices. Formal regulatory system will have to be put in place…. The significant expansion (of financial inclusion) can occur from the banking sector but at the same there is also the role for MFIs. The MFIs are already linked to the banking system…. But if this link is to be strengthened, and if this link is to become really significant one, the MFIs need to modify some of their lending practices. Greater linkage between banks and SHGs and expansion of the business correspondent model were likely to bring a surge in the Micro Finance sector. There is a need for multiple systems of operation in the microfinance field. The bank SHG linkage programme has an important role to play with the addition of the business correspondents model.
As there is still no clarity in this regard, the article seems to be arguing for a transitional regime which would regulate smaller institutions. But then these institutions should be adequately regulated. We cannot hope that these institutions will be well run self-regulated entities. Light touch regulation may not help much. The article itself gives an example of Indian Bank. When well regulated entities have failed then?
Poverty eradication and not profit from the poor should be the approach.
Sir, the whole distinction between DI and NDI is partly to say that the systemic costs of failure of the latter is negligible, relative to the Indian Bank experience.
What is to be regulated? Should we recognize microfinance as a separate asset class or micro finance be part of the financial services sector. Again whether there should be prudential regulations if it treated as a separate asset class or should the focus be on non-prudential measures like transparency in operations, disclosures with regard to interest rates, fair practices code, self-regulation, stress on corporate governance etc.
If the concern is interest rates – it is to be recognized that interest rates depend upon competition, access to low cost of funds, financial market development, cost of infrastructure and institutional efficiency etc. Just as the Government has set up the Rs.800 crore Fund to reach out to the financially excluded population ( in addition to the Rs.1000 crore Financial Inclusion Fund (FIF) and Financial Inclusion Technology Fund (FITF) set up with NABARD, the Government could also set up a Micro Finance Fund to lower the interest rate. May be the Government could dip into the unclaimed deposits kitty lying with the banks. But then the moot point is whether to refine the existing practices or Regulate.
As per newspaper reports the Economic Advisory to the Prime Minister has pitched for a Regulatory mechanism for the microfinance sector. The panel has also called upon MFIs to reform their business practices. Formal regulatory system will have to be put in place…. The significant expansion (of financial inclusion) can occur from the banking sector but at the same there is also the role for MFIs. The MFIs are already linked to the banking system…. But if this link is to be strengthened, and if this link is to become really significant one, the MFIs need to modify some of their lending practices. Greater linkage between banks and SHGs and expansion of the business correspondent model were likely to bring a surge in the Micro Finance sector. There is a need for multiple systems of operation in the microfinance field. The bank SHG linkage programme has an important role to play with the addition of the business correspondents model.
As there is still no clarity in this regard, the article seems to be arguing for a transitional regime which would regulate smaller institutions. But then these institutions should be adequately regulated. We cannot hope that these institutions will be well run self-regulated entities. Light touch regulation may not help much. The article itself gives an example of Indian Bank. When well regulated entities have failed then?
Poverty eradication and not profit from the poor should be the approach.
Sir, the whole distinction between DI and NDI is partly to say that the systemic costs of failure of the latter is negligible, relative to the Indian Bank experience.