Monday, September 21, 2015

Microfinance Institutions

Microfinance Institutions (MFIs) dominated the second set of differentiated and small finance banks announced by Reserve Bank of India (RBI) on Wednesday. Eight of the ten companies that received the in-principle nod from the central bank are MFIs.
Surprisingly, some of the big names among the 72 applicants for small finance bank permits were dropped from the final list. These include India’s only listed microlender, SKS Microfinance, Dewan Housing, IIFL Holdings and former chief financial officer of Infosys, V Balakrishnan.Of the other two that received approvals, one is a Rajasthan-based non-banking finance company (NBFC) and the other is a local area bank.
Here's the full list
Why it matters
Considering the dominance of MFIs in the final list, the RBI clearly wants microlenders to take up a bigger role in taking banking to the rural poor, who aren't yet covered by the existing full-service banks. By having small banks, India now will have a network of small, focused lenders, specifically targeting the low-income segment. This is something on the lines of community banks in US.
By definition, small finance banks can undertake almost all operations of a normal commercial bank, albeit on a smaller scale. The RBI clearly restricts these banks to operate in low-income segment, by stipulating that 75 per cent of the total credit extended by these banks should be given to borrowers who qualify to be in the priority sector as defined by the central bank.
Also, the maximum loan size and investment limit exposure to a single and group obligor would be restricted to 10 per cent and 15 per cent of its capital funds, respectively. Further, in order to ensure that the bank extends loans primarily to small borrowers, at least 50 per cent of its loan portfolio should constitute loans and advances of upto Rs 25 lakh.
Thus the new set of banks will be forced to operate among low-income segments and not chase big borrowers. Logically, they have to work out viable models to stay in the competition. This can give a major boost to financial inclusion and credit-expansion to unbanked areas given that in this case financial inclusion wouldn’t be a charity forced by regulation like the existing commercial banks. In this case it would be the mainstay of the business. That’s good news for the Indian poor.
In August, the RBI had given another 11 licences to payments banks, which will undertake basic banking functions, except lending. The whole process is part of advancing country’s financial system to a differentiated banking regime, where each set of banks focusses on certain specific segments in which they understand the business and have expertise. The RBI has made it clear that it intends to make bank licencing on-tap (on a continuous basis) in the future which could mean we might see more banks operating in specialised areas.
The idea of floating several small private banks were mooted by Raghuram Rajan long before he took over the governor of Indian central bank. At the time the high-level financial sector reforms committee headed by him proposed a ‘A hundred small steps’ to reform India’s financial sector. By paving the way for payments and small banks, Rajan has taken the country’s banking industry to its biggest stage of reform since the nationalization of banks that began in 1969.
How this helps MFIs and people
As Firstpost noted earlier, the entry of MFIs in the small finance bank segment is a revolutionary step since these entities are well-familiar with the nuances of banking with the poor borrowers. MFIs were so far not allowed to accept deposits and engaged in extending credit after sourcing money from commercial banks.
Now, by getting access to banking, these entities can tap public deposits, which will significantly lower their cost of borrowing and enable them bring down their rate of interest on loans from the current 24-26 per cent to a level decided by the market competition, possibly lower double digit figures.
In fact, this is a golden opportunity to microlenders to reinvent themselves after facing a major crisis in 2010 in the aftermath of a controversial law promulgated by the erstwhile Andhra Pradesh state government. These companies went through a correction phase in the following years.
The crisis had forced MFIs to change the way they conduct business. Some stability returned to the sector after the RBI came out with guidelines to govern such companies. In the aftermath of the crisis, many smaller micro-lenders had to shut shop, while even some of the big NBFC-MFIs based in Andhra Pradesh had to carry out massive loan recasts to stay afloat. Since then, these entities haven’t fully recovered from the impact of the crisis.
Becoming small banks will help them significantly lower their borrowing costs, and engage in businesses focused on small and medium enterprises and the lower end of the retail customer base.
Once these firms enter the banking industry, logically, the bigger commercial banks will face intensified competition in the cheaper deposit and small-value loan market. State-run banks, which used to have dominance in rural areas of the country with their reach, will find competition tougher if the new set of banks hit the market with competitive rates of interest to poach customers. Public banks will have to work harder.
The bottomline of the RBI decision is this: The entry of small and payments banks mark the biggest banking revolution India has witnessed after the nationalization of banks. This will create positive disruptions in the country’s banking sector, intensifying competition, thus making banking more affordable for the common man.

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