Demonetisation and MFIs: Withering of institutional neutrality

The development policy in India has always accorded priority on access to finance as a tool for building an inclusive India. The policy approach to achieve this objective has gone through major shifts: nationalization of banks, recognition of private sector banks post 1991 financial sector reforms, use of Banking Correspondents (BCs) since 2006 and the recent PMJDY targeting universal access to basic savings account. However, the common underlying theme of these diverse policy thrusts has been reliance on a bank-led model. The recent policy of setting up Small Finance Banks and Payments Banks can also be seen as a step towards that as it provided a graduation path to NBFC-MFIs and Pre-Paid Issuers. Microfinance Institutions (MFI) remained on the fringes of regulatory ambit for long and it took the 2010 crisis of Andhra Pradesh to bring them centre stage. Post crisis, implementation of the Malegam committee recommendations by the RBI, introduction of a new category of NBFC-MFI, recognition to industry associations as Self Regulatory Organisations (SRO) and more active regulation by the RBI brought forth hope that policy recognizes the contribution of MFIs in financial inclusion as an integral part of the inclusion architecture. The report of the Mor Committee (2014) set up by the RBI seemed to cement this idea by advocating for an institutional neutral policy. It observed “Any design must ensure that the treatment of each participant in the financial system is strictly neutral and entirely determined by the role it is expected to perform and not its specific institutional character”. This sounded as a whiff of fresh air in decades old bank-led policy despite strong empirical evidence on limitations of the formal sector banks in catering to the poor.

However, the demonetization decision taken on 8th November, 2016 and subsequent clarifications have dealt a blow to the philosophy of “institution neutrality” and are having a deleterious impact on MFIs and their clients. The policy guidelines following the demonetization drive did not allow NBFC-MFIs, which are regulated by the RBI to accept discontinued currency notes. Similar was the fate of cooperative banks catering to the agriculture sector. The microfinance model is built on the principle of weekly/fortnightly repayments of small loans to keep the repayments within the capacity of low income borrowers. Regular repayments, joint liability and expectation of another loan on repayment of earlier loan keep the cycle going. The decision to exclude MFIs from the ambit of being able to accept discontinued notes broke the cycle. Poor microfinance clients could not repay their loans despite having the money and default rates in the sector rose to as high as 70% in the first fortnight. In normal times, the microfinance players have 99% recovery and that has been the key to their success in expansion.

Not only did the recovery rates fall, the inability of MFIs to disburse loans due to cash shortage has further exacerbated the crisis. Clients on coming to know that they might not get a next loan started shying from repayment even if they had valid legal tender. Sometimes a positive move ends up serving wrong cause and this is what happened with the RBI’s instructions to all entities regulated by it on 21 November, 2016. Realising the problems being faced by the small borrowers in repaying loans post demonetization, RBI allowed additional 60 days for recognition of substandard asset. A move purely related to asset classification was read as loan waiver by many and the notion was reinforced by erroneous reporting in newspapers. Local level political elements were quick to jump to the scene and vitiate an already precarious situation. Despite proactive work by Microfinance Institutions Network (MFIN), the industry body of NBFC-MFIs, several districts in Karnataka, Madhya Pradesh, Uttar Pradesh and Uttarakhand are beset with delinquency and mass default problem. Demonetisation is being used as a ruse for encouraging defaults by local elements. It is noteworthy that these four states account for nearly one third of NBFC-MFIs loan portfolio, the total exposure in these states being around Rs.20,000 crore. After one month of demonetization, as new currency flows in the system, while the All India recovery position of NBFC-MFIs is inching towards 80%, in these states it is said to be around 60%. The critical point is that regular and frequent repayments of small amounts hold the system together in microfinance and missing of a few cycles of repayment has the potential of repayment amount going beyond the capacity of client leading to default cascades. Probably recognizing this, ICRA has put 3 MFIs on a negative watch list implying that these institutions face the risk of severe impairment of credit quality.

A vicious cycle starting from exclusion of NBFC-MFIs has now extended to local level political interference and defaults. It is ironical that despite being a well rather over regulated sector, NBFC-MFI frontline staff are being asked questions about the legitimacy of their legal form. This is logical as clients see banks and BCs accepting old notes. What is at stake is Rs.60,000 crore industry catering to nearly 35 million poor clients ignored by the formal banking sector. Even after policy thrust on financial inclusion, MFIs continue to be the main player in BOP segment and that is at risk today. The fact that much of MFIs funding comes through wholesale debt from banks and the MFIs portfolio accounts for a major part of achievement under Pradhan Mantri Mudra Yojana (PMMY) underlies that this disruption will not only deprive the poor from their access to loans but also put at risk public money. It has also led experts to question as to whether institutional neutrality is a mere catch phrase?

The abdication of neutrality under demonetization has caused much anxiety as also created moral hazard for the client who does not distinguish between a bank, BC or NBFC-MFI. One approach in current situation could be to wait for things to normalize, which can prove risky as no one knows when the situation can snowball. The other prudent approach will be to accept the reality and take remedial measures and this has to start from the regulator. The regulator can issue a press note clarifying that there is no loan waiver, possibly offer an explanation for not including NBFC-MFIs and also may be allow them to collect old notes till 3o December, 2016. The issue of laundering can be checked by checking the demand due from clients with repayments. It needs to be recognized that painstaking efforts of last 25 years to build a sector focused on poor and marginalized is not allowed to wither. May be like 2010, it is another crisis, which will bring MFIs mainstream.