During the recent 4th bi-monthly monetary policy statement on October 4th 2019, the Governor of the Reserve Bank of India made an announcement to revise the indebtedness limits for borrowers of NBFC-MFIs. According to this revision, NBFC-MFIs would be able to lend to borrowers with a total NBFC-MFI debt of Rs. 1.25 lakh or less. Such assets originated by NBFC-MFIs could be classified as a “qualifying asset” as long as other conditions such as limits on the annual income of the household, loan amount, loan tenure and repayment schedule among others are met.
These limits on household indebtedness were introduced, along with other lending conditions, following the recommendations by the Sub-Committee of the Central Board of Directors of Reserve Bank of India to Study Issues and Concerns in the MFI Sector (more popularly known as the Malegam committee) in 2011. In response to the Andhra Pradesh microfinance crisis, the sub-committee recommended taking a more prescriptive approach to regulating NBFC-MFIs. The use of lending caps, restrictions on borrower selection and mandatory credit reporting to credit bureaus were introduced with the intention of limiting the risks of excessive lending and borrower over-indebtedness. The regulatory framework had also ensured that these entities were directly under the purview of the RBI, releasing them from the domain of state government money lender regulations.
While the prescriptive nature of these regulations has helped by setting in place core systems, processes and an overall structure towards better compliance, there is a growing concern over the capability of the current regime to effectively protect borrowers from over-indebtedness. This post discusses three issues that the RBI must prioritize as it seeks to revise MFI regulations.
1. Raising the debt-to-income limits may increase the risk of over-indebtedness
Consider a borrower having two loans from two different MFIs for a total of Rs. 1,25,000 each, to be paid over 24 equated monthly installments with an annual income of the borrower (and the household) is Rs 1,00,000 (or Rs 1,25,000 under the proposed revision). Under these conditions, the prescribed limits allow for the average monthly installment (EMI) for a household (with only one borrower) to be about 0.8 times the average monthly income of the household (and 0.64 if we assume the household income is reflexive to the revision). This ratio is called the Debt to Income ratio which describes the amount of the household’s monthly income that goes to servicing debt – the higher this ratio, the lower the capacity of a household to manage their repayments using their income. If we assume that there are two eligible borrowers in this household and both members avail the microfinance debt up to the limit, the total EMI shoots to 1.6 times the average monthly income of the household.
As seen in Table 1, each revision to these limits has allowed for borrowers with higher and higher debt to income ratios to become eligible for microfinance debt. This clearly suggests that the current guidelines allow for a scenario where households have debt obligations that would be hard to manage based on the current levels of income.
Table 1: Revisions to MFI lending criteria to rural households
|Year||Total Indebtedness Limit||Annual Income Limit||Total Loan Amount limit||Household Debt-to-Income
If we were to consider the same ratio with disposable income, i.e., the monthly debt-related outflows to disposable income ratio (after essential consumption expenditure is taken care of), the picture would become even more stark.
2. Incomplete credit reports, lack of income assessments and Bureau Integration are of immediate concern
The above estimations, however, remain a largely theoretical exercise as the current regulatory framework does not mandate lending institutions to report the annual household income to the credit bureau. In fact, the current format of credit reporting captures no information at a household level. While we have seen incremental developments in reporting of credit information by even the smaller microfinance institutions, there is a significant challenge: the credit profile of microfinance borrowers is incomplete. Extensive primary research in the district of Krishnagiri in 2016 shows that less than half of a household’s institutional debt is captured in the credit bureau. The lending by commercial banks, small banks and non-MFI NBFCs to these customers was not entirely captured. Upon constructing a complete credit report capturing debt from all institutional sources, it was found that 33% of households were misclassified as being eligible borrowers when in fact they were over-indebted based on the limits prescribed.
3. Serious concerns of “lending -to-limit” behaviour
The motivation behind having a maximum household income limit as a part of the borrower eligibility criteria is to ensure that microfinance lending is targeting low-income households and promoting inclusion objectives. While this is laudable, there needs to be more attention directed to assessing the disposable income of the household and the complete debt picture of all borrowings at the household level. The prescriptive nature of these limits suggests that as long as lenders adhere to them, there is no liability on lenders to protect against borrower over-indebtedness. Several research studies show that for a variety of reasons ranging from peer-pressure in joint-liability groups to the systemic lending and collection practices, the financial stress faced by borrower households does not materialize into delinquency. A prudent and responsible lender would have put in place additional processes to assess the capacity of an “eligible” borrower and her household to repay. However, there is no real incentive for MFIs to put in place such a process as current compliance mandates require firms to only verify these microfinance debt limits and to document household incomes as being lower than the prescribed annual limits.
While the RBI’s fair practice codes for NBFCs (includes the section for NBFC-MFIs) requires the assessment of borrower’s capacity to repay, there have not been any effective measures taken to protect borrowers from becoming over-indebted. Commercial banks, small banks and non-MFI NBFCs do not have any requirement to avoid over-indebtedness at the customer/ household level. They are also allowed to lend ‘beyond the limit’ to microfinance customers.
On the other hand, in less than 5 years, the RBI has increased borrower indebtedness limits with the objective of boosting “MFI lending to the bottom of the economic pyramid”. With each revision, however, these prescriptions seem to be losing the focus on the risks core to low-income households. It is about time that the RBI begins to address the down-side risks of increasing MFI lending instead of kicking the can down the road. The RBI should begin by reconsidering the effectiveness of using prescriptions for indebtedness limits at the household level. Instead, the RBI should consider fixing the credit information infrastructure and mandate lenders to establish processes to assess the actual debt servicing capability of households.
A comprehensive description of business processes that MFIs can incorporate into their operations to reduce instances of borrower over-indebtedness can be found here.
 These assumptions on loan tenure, total indebtedness and annual income come directly from the limits set under regulations. For any loan in excess of Rs. 15000, the minimum loan tenure prescribed is 24 months. The maximum annual household income for a rural borrower to be eligible for an MFI loan is Rs. 1,00,000. We assume the outer bounds of these restrictions to provide conservative estimates. The average interest is assumed to be 26% on all MFI debt.
 The loan amount limit is different for the first time borrower, which was originally at Rs. 35,000 in 2011 and later increased to Rs. 50,000 in 2015.
 The only revision announced in the bi-monthly monetary policy announcement was the increase in indebtedness limit. We assume the other limits remain the same as before.
 The BCSBI Code of Banks’ Commitment to Customers states “8.12 Lending: a) We will have a Board approved the policy on Loans and Advances. b) We will base our lending decision on a careful and prudent assessment of your financial position and capacity to repay”. The Master Circular – Fair Practices Code applicable to other NBFCs has no language around credit affordability requirements. Available at: https://rbi.org.in/Scripts/BS_ViewMasCirculardetails.aspx?id=9823