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The Mor Committee – Giving credit where credit is due (Part-II) Priority Sector Lending (PSL) and Credit Pricing

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Priority Sector Lending (PSL) and Credit Pricing

The Mor Committee on “Comprehensive Financial Services for Small Businesses and Low Income Households has also made a number of suggestions related to the priority sector lending (PSL). The Committee recommends raising the overall PSL requirement to 50% of adjusted net bank credit (ANBC) or credit equivalent amount of off-balance sheet exposure, whichever is higher. This is likely to be unwelcome amongst banks, which often struggle to achieve the current 40% requirement. However, the Committee offers some “sweetners” in terms of weights for different sectors and proposals for a much more market-led approach to credit/risk pricing.

In 2013, a significant number of banks did not meet their PSL targets – including 16 public sector banks that did not meet the their PSL targets. (See 16 PSU banks missed priority sector lending target). While a large number of banks are indeed meeting PSL targets on an overall aggregate basis, many fall particularly short on the PSL targets for categories like Direct Agriculture which includes loans to farmers, SHGs and producer companies, cooperative which are at the centre of the government’s focus on directed lending. The banks will continue to treat this as a burdensome portfolio unless PSL segments are made attractive by allowing the market-based pricing, where financial services providers price products based on inherent risk, cost to serve and competition. Therefore, the Committee’s suggestion is to do away with the hand-outs in the form of cheaper interest rates in priority sector lending. It recommends transferring subsidy directly through direct benefit transfer much like any other social benefits.

The Committee has also raised the debate of “access” versus “affordability” of financial services. In fact, MicroSave believes the issue here may be more than plain “access”. It is also about the “suitability” of the access. In modern India, economic sub-sectors are much more diversified than the ones envisaged under the current PSL segmentation, and need far more customisation in terms of financial and risk management products. This will not happen unless the banks follow a more granular approach to developing and offering products. If a free pricing regime is allowed, the banks are likely to be more innovative in offering “suitable” products since this will have a bearing on the profitability and risks on their books.

The Committee also makes a number of recommendations related to the NBFC-MFIs and the special conditions to be followed by them. These touch on the interest rate and margin cap conditions noting that these have led to no reduction in the interest rates for borrowers. This seems to be because of the current limit on the maximum number of lenders serving a borrower, which reduces the impact of competitive forces to bring the prices down. The Committee’s recommendations suggest some progressive steps like treating total indebtedness of borrowers in terms of their ability to service debt and not just their absolute total debt. Moreover, the Committee suggests looking at loans from all types of institutions rather than only from NBFC-MFIs. Another good recommendation is the requirement that all the lenders report to the Credit Bureau. This will make the regulation on maximum number of borrowers redundant.

We do not have any empirical evidence as to whether the limits on interest rates and margins have had any impact on MFIs’ ability to reach out to “more risky” segments and/or to the segments that are costlier to serve. But it is reasonably safe to assume that these limits do indeed reduce MFIs’ willingness or ability to serve remote and vulnerable communities. Essentially, the logic of liberalising PSL interest rates applies in the case of NBFC-MFIs also. While this is a difficult policy stance, the Committee could have offered a clearer opinion on this, even if there were no recommendations for the immediate term.

There are other interesting and welcome recommendations around doing away with the biased policy stance on consumption versus income generating loans. That poor need credit to smooth cash flows is a well-researched and widely accepted fact. Moreover, with smaller loans it is very difficult if not impossible, to ensure loan utilisation check for the MFIs. This is one regulation that is hard for MFIs to follow and even harder for RBI to ensure compliance, with no benefits for the client or for the MFIs. (See Are Loan Utilisation Checks Really Necessary?)

“Many Indian microfinance institutions (MFIs) introduced the individual lending (IL) methodology as a natural progression from the group lending methodology. The lure of “big ticket” loans and higher profitability is attracting growth oriented MFIs to aggressively push for IL without considering the inherent risks. IL has its own idiosyncratic needs like cash flow based lending; analysing business needs and risks; bringing flexibility in product features; building staff capacities and processes that must be followed for successful implementation”.

–   Sandeep Panikkal, Venkata N.A. and T.V.S. Ravi Kumar in Risks and Challenges in Micro and Small Enterprises Lending

The recommendation to raise the borrowing limit to Rs.100,000 per person is obviously welcome; as is the recommendation to phase out the restriction on making large loans (above the current limit of Rs.50,000). Larger loans are required by more mature clients in later loan cycles, who (in some cases at least) may have been growing their businesses. Many clients who are able to expand their businesses would still like to avail higher loans from the MFIs as they do not have access to formal financial institutions to serve them as efficiently as the MFIs. Such clients lie on the lower band of the “missing middle” – the huge under-served segments of micro and small enterprises. However, perhaps an overall limit on average loan size (on overall portfolio basis and not on client basis) will still be needed to make sure the MFIs do not move away from serving the poorer segments. That said, an overall higher average loan size will enable the MFIs to balance their portfolio between large loan and small loans. With an overall average loan size limit the MFIs can continue to focus on poorer people while still having the flexibility to serve “not so poor” with higher loan sizes. (See Are You Poor Enough? Client Selection by MicroFinance Institutions).

The Mor Committee has made the case for an even more affirmative approach to ensuring credit for marginalised sectors by recommending hiking PSL targets to 50%. More importantly, the Committee has also recommended steps that enable the banks to achieve this. The liberalisation steps, most important of which is allowing free pricing regime, can change the way banks look at the priority sector. It is very likely that the banks will start to look at the PSL segments as potentially attractive segments and adopt more market-led solutions to achieving these targets. This will be a significant improvement over the current ‘push’ policy of the government, which works neither for the banks and nor for the priority sector segments. Keeping its liberal stance on pricing of financial services and in general following a market-led approach the suggestions of the Committee to increase the borrowing limit for microfinance borrowers is well taken. A liberal stance, but the one requiring absolute transparency on pricing by the MFIs, will allow these institutions to deepen their offerings and contribute to achieving ‘real’ inclusion. This perhaps could be the next transformational step for small businesses and low income households.

Dairy Value Chain Financing Opportunities

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This podcast focuses on Dairy value chain and shares why it’s not only attractive to financing institutions but is highly endorsed to improve rural economy and aid food security. Speaking to MSC on the benefits and features of dairy value chain models, Value Chain expert, Mukul Singh, talks about the participants/aggregators involved in a typical value chain and how do they function.

This podcast also outlines the structures and the economics of a typical dairy value chain from the perspective of a producer and what does it mean for financial institutions. Talking on the financing models, Mukul explains two main financing models – Cash entrapment model and Direct financing model.

The Mor Committee has delivered its report – What will the report deliver? (Part-II)

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The Mor Committee on “Comprehensive Financial Services for Small Businesses and Low Income Households” submitted its report in record time. Following the high level review in the previous blog, this one raises some specific comments on certain suggestions by the committee.

Use of Aadhaar to open accounts

The idea of the Unique Identification Authority of India (UIDAI) instructing banks to open accounts (waiving a direct application from the customer) is not well conceived. It assumes that every UIDAI registrant wants to open a bank account. A customer has to formally to apply for an account (a contract needs to be signed between the bank and the customer). This could be done without visiting a bank branch – such as authenticating with biometrics that he wants an account to be opened and authorizing UIDAI to provide the information to a chosen bank. Without an effort on the part of the customer, the legal requirements for providing a banking service are not fulfilled. In a related issue, waiving the requirement for the current address of customers will weaken the position of banks, with the current focus on anti-money laundering (AML) measures world over.

Payments Banks

While the idea of payment banks is a constructive one, the logic of low entry capital is not clear. The permission to invest in three month securities is also not clear as one does not expect payment banks to hold on to remittances and payments for a long period of time.

USSD charges

The suggestion (in Para 3.11) that the telecom companies should cap their charges for the use of USSD seems to have been influenced by the potential for over-charging for these services seen in other parts of the world. But financial sector entities should be able to negotiate better rates for use of USSD from time to time. The philosophy of reasonable charges is well taken, but a specific cap on these charges is not.

State Finance Regulatory Commissions

State Finance Regulatory Commissions The suggestion of setting up State Finance Regulatory Commissions (SRFCs) is intriguing. Some states have not shown adequate maturity in regulating finance related activities. Despite the proposed membership which represents most relevant institutions, there should be formal guidance from, and linkage to, the Reserve Bank of India (RBI), and not by state government.

Convergence of regulatory norms 

The convergence suggested between banks and non bank financial companies (NBFCs) in the matter of regulatory norms is welcome in principle. However the committee has recommended for continuation of the difference in current reserve ration (CRR) and denial of deposit insurance to NBFCs; these recommendations are not tenable. Banks have both asset and liability side risks – as such there is no case for lower CRR for them when compared with NBFCs, which have mostly have an asset side risk. Deposit insurance is aimed at protecting interests of small savers. By denying the same to NBFCs, the committee is breaching its design principle of institutional neutrality.

Limits

In a number of places the committee has used absolute limits (in Paras 3.11, 4.24, etc.)  such as small borrower loan limit of Rs.100,000, Rs.50,000 transaction limit per customer for new payment banks, security deposit of Rs.500,000 per business correspondent (BC) agent, etc. Any such limits should not be hardwired, but set at normative levels – as a percentage of some base business parameter. Otherwise within a short time the limit will be out of date and there would be a clamour for change.

Priority Sector Lending and outreach

While banks are asked to invest in technology, branch infrastructure, establish customer service points through BCs and increase priority sector lending (PSL) to 50% in Para 4.40, how banks will remain viable is not satisfactorily dealt with. Perhaps the pricing freedom on loans is meant to help banks remain profitable. The committee has not considered the past (and current) evidence that public sector banks do not use their pricing freedom in PSL – in agriculture and small loans in particular. Further the suggestion to have a point of presence in every square kilometer – such as small kirana store or mobile recharge seller – ignoring the presence of rural post offices and Primary Agricultural Credit Societies – is bound to result in unhealthy competition in some locations and make every competing institution unviable. Even while setting up new institutions, the existing ones, which have better knowledge of the local area should be strengthened.

“Suitability”

The section on suitability of products (starting with Para 6.1) is a welcome one. But asking RBI to issue regulations is not a satisfactory arrangement as the enforcement might suffer from a weak legal basis. As in some other countries a separate legislation on vendors’ liability – for providing suitable products and services and ensuring that these do not harm the customers – should be brought in. Such legislation will be able to prescribe the penalties for non-compliance (and means of enforcement) and remedies available to customers.

The Mor Committee’s report is full of outstanding ideas that build on the existing financial infrastructure, while challenging some of the established norms in India. If the RBI implements the committee’s recommendations, while addressing the challenges outlined in this blog, we have the very real potential of seeing significantly improved financial inclusion statistics by 2020.

The Mor Committee – Giving credit where credit is due (Part I) The role of Non Bank Financial Companies (NBFCs)

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The Role of Committee Financial Companies (NBFCs)

The Mor Committee on “Comprehensive Financial Services for Small Businesses and Low-Income Households”  has recommended some very bold, as well as several transformational steps, to reconfigure the delivery of credit to the ‘un-served’ and ‘under-served’ in India. In this blog, we analyze some of the recommendations in the section on credit that the Reserve Bank of India (RBI) could adopt and implement without disrupting the overall financing institutional structure (which may take time).

The Committee recommends allowing non-bank financial companies – non-deposit-taking (NBFC-ND) to act as business correspondents (BCs) for banks. The NBFC-NDs include, of course, NBFC-microfinance institutions (NBFC-MFI). Some NBFC-MFIs are already offering BC services having set up entities that are allowed to act as BCs. Allowing NBFC-MFIs as BCs will remove the additional complexity of having to set up and manage new entities, and will provide more opportunities and incentives for MFIs to provide a fuller range of bank and non-bank products. This clarity will also remove many of the barriers that have prevented MFIs taking up this role in the past. (See Are Banks and Microfinance Institutions Natural Partners in Financial Inclusion?)

“The BC channel has enormous potential in the long-run, and there are obvious synergies between large banks and grass-roots MFIs. However, while banks’ interest is dominated entirely by the need to fulfil customer acquisition mandates, their activities will remain focused almost exclusively on channel development. MFIs can only urge banks to refocus attention on the product proposition, but they cannot themselves make it happen. … The entire sector is still searching for a blueprint, and MFIs have valuable inputs to bring to that”.

–          Ignacio Mas et al. in Are Banks and Microfinance Institutions Natural Partners in Financial Inclusion?

Around 12,000 NBFCs-ND, spread all over the country, have the potential to add many more spokes to the distribution nodes of the country’s over 109,811[1] bank branches. NBFCs are the only entities (other than banks) effectively providing financial services in underserved areas. Many NBFCs have managed to win the trust of the consumers, something that hardly any BC institution has been able to accomplish in the 7 years since the inception of the model – not least 0f all because of the high levels of churn amongst agents (see Behind the Big Numbers: Improving the Reach and Quality of Agent Networks in India). In particular, the NBFC-MFI category has a large presence in rural areas. In 2013, 41 MFIs that reported to Microfinance Institutions Network (MFIN) reached out to a total of 25.16 million clients through a network of 9,224 branches (See MFIN Micrometer). Thus with NBFCs-ND included in the BC space, the model would not only broaden but also deepen the provision of financial services in the under-served areas. And, of course, offering BC services provides NBFC-MFIs with many strategic opportunities and operational advantages (See Microfinance in India – Is Business Correspondent the Way Forward?).

“MFIs are potentially an excellent channel and product development partner for banks, as long as they have the capacity and resources to dedicate to it. MFIs can help all stakeholders to leverage their existing engagement with the customers. In this way, MFIs’ core competence of customer engagement and management can be more fully exploited”.

–          Ignacio Mas et al ibid

There seems to be no cogent reason why NBFCs were precluded from acting as BCs earlier. As the report states, the risk of commingling of accounts can be managed by daily settlement, something that should not be too difficult to ensure using technology. Other mechanisms such as cash-account collateral and transaction limits, which the banks apply to the BCs anyway, will also be applied in the case of NBFCs. In return, banks would get access to the brick and mortar infrastructure of the NBFCs; relatively well-qualified staff; relatively better financial and operational risk management culture than the current BCs; deep knowledge of the low-income market segment; and familiarity with the use of technology.

The report does not delve into whether the NBFC BCs should also offer credit products on behalf of banks. Instead, it leaves this issue to be sorted out by individual banks as part of their business strategy. It is not difficult to imagine that banks may have products that have some complementarities because of the inherent nature of the balance sheet structure of two types of entity. Nonetheless, all said and done, the NBFCs will pose competition to the banks in terms of many other products, especially low-value, and short-term consumer loans (where they clearly have an edge already). This is an issue that needs some more thought given the earlier experience of direct selling agents (DSA) model of banks. We need to learn from the operational risks faced by the banks that used DSAs for credit origination. Many banks had to finally abandon the DSA model in favor of in-house staff for better underwriting standards, conservative loan to value and therefore better portfolio quality of credit products.

The Reserve Bank of India needs to allow banks to choose from a wider menu of distribution channels to realise the dream of financial inclusion. NBFCs, including the NBFC-MFIs, present an obvious choice and a highly credible BC option for their inherent strengths in terms of their physical presence in under-served and geographically challenging areas. The NBFCs, as quasi-banking outfits, are better equipped to retail financial products and therefore have a distinct advantage to operate as BCs. The NBFCs are also better prepared to handle the operational risks of BC business compared to other BC managers.  The Mor Committee’s recommendations on this deserve not just attention but also implementation.

[1] As on October 05, 2013. Includes administrative offices.

G2P Payment Delivery in India

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India has become one of the front runners in undertaking G2P payments. Introduction of Aadhaar enabled biometric payment system demonstrated the active role played by the Government in delivery of these payments. In this video, Amir Hamza, highlights the current G2P payment structures, the pitfalls with the system and improvements envisaged that could make the payment model work effectively

The ambitious Mor committee report – Challenging Indian norms

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The Reserve Bank of India (RBI) Committee on “Comprehensive Financial Services for Small Businesses & Low Income Households” headed by Dr. Nachiket Mor has released a report that challenges us all. It is a magnum opus of 265 pages that is surprisingly readable and builds on, and significantly extends, the 2008 Rajan Committee report to the Planning Commission entitled “A Hundred Small Steps: Report of the Committee on Financial Sector Reforms”.

The Mor Committee report is, in the Indian context at least, both visionary and, for many at least, little short of revolutionary in its approach. Small wonder then perhaps that the Economic Times notes, “bankers feel most proposals are either impractical or ambitious”. Are bankers really not just conservative, but also devoid of ambition when it comes to financial inclusion? The evidence suggests so – see for example “Branchless Banking Update: Should We Bank on Phones or the Post?”

“This Report … makes a conscious effort to redress this balance and issues of risks and costs have been kept at the very center in the discussions of each of the strategies for providing better access to financial services to small businesses and low-income households.”

The Committee’s recommendations are firmly market-led approach rather than the top-down, directives that have failed to deliver financial inclusion over the last two decades. The report recognizes that banks have business imperatives that shape their behavior much more strongly than even the most stringent diktat from the RBI or Ministry of Finance. This was most recently highlighted in 2012 when the Ministry of Finance sought to impose a cluster-led approach to driving business correspondence (see MicroSave Policy Brief #7 “Is the Business Correspondent Model in Policy Paralysis?” for a discussion of this episode).

The Committee recommends the removal of many of the provisions that have so hampered bank lending to the poor and made the business correspondent (agent) model so unattractive to banks. So, for example, the Committee recommends the removal of the requirement for banks to price farm loans below Rs. 3,00,000 at 7%, noting,  “[from the] perspective of Stability that entails sustainable pricing, banks must be allowed to freely price these loans based on their risk models”. Similarly, the Committee recognizes that banks need to charge low value accounts for their transactions. If they cannot charge, banks will either make a loss on those accounts and/or actively seek to avoid opening/making transactions on those accounts – as we have seen so clearly in the years since the Khan Committee’s report “Financial Inclusion by Extension of Banking Services – Use of Business Facilitators and Correspondents” in 2006. This has been well documented by many including, for example, “No Thrills – Dormancy in No Frills Accounts”.  Furthermore, MicroSave research clearly shows that poor people are indeed ready and willing to pay for high quality, convenient financial services – see for example “The Answer is “Yes”—Cost and Willingness to Pay in India”. All this is common sense to the outside world, but for many in India, this may require a revolution in their thinking.

“An important issue behind the reluctance of banks has been the requirement to bundle a number of free transactions along with a basic bank account … it would be important for policy to move away from the notion of forced bundling (which is equivalent to hidden subsidies) to a strategy in which the customer needs to pay for every transaction but has a choice of competitive channels through which she can access her account at an affordable cost.”

The Committee report also makes the argument for a diverse approach to deliver financial inclusion, noting that there have been a series of one size fits all approaches (cooperatives, regional rural banks, SHGs etc.) that have been promoted as cure-all silver bullets. Each has played a role in expanding financial access (we should remember that in comparison to much of the developing world, India’s financial inclusion statistics are enviable), but none have truly delivered. Given the diversity of India, it is perhaps surprising that this point has not been made before – or at least that the need to encourage a wide range of actors and partnerships has not been more clearly articulated in, and supported by, policy. Partnerships leveraging new and innovative technologies such as mobile money and the Aadhaar unique identification system provide tremendous opportunities, see for example “Can Mobile Network Operators Lead the Way for Banking the Excluded? (1 of 2)” and “Can The Unique Identification Authority of India be a Saviour of Financial Inclusion?”

“The danger of developing too specific or prescriptive of an approach towards comprehensive financial services is that it will become very quickly outdated and the design will begin to act as an impediment to change instead of being an enabler. … the best way to proceed would be to articulate broad principles that do not vary with financial or technological innovation but instead have a timeless character.”

However, Professor Sriram of the Centre for Public Policy at Indian Institute of Management, Bangalore and Member, Advisory Council on Financial Inclusion and Payment Systems, UIDAI, in The Mint, suggests that the Mor Committee has put all its eggs in the Aadhaarbasket. This is clearly not the case in the context of credit, where the Committee recognizes the role of NBFCs, microfinance institutions, and self-help groups. However, in the context of savings and (to some extent) risk management or insurance services, it is reasonable to assert that in the current market environment a business case can only be credible if it built on Aadhaar enabled technology. Aadhaar has the potential to remove the extraordinarily high cost of account opening and offers low-cost authentication. So the idea of creating a Universal Electronic Bank Account for all as an integral part of the Aadhaar process is an excellent one. (Of course, encouraging the use of this account will be challenging but by no means, impossible see “The Mor Committee Report – The Demand Side Conundrum”). But it is also reassuring to see the Committee recognize the limitations of Aadhaar in places with low connectivity and suggesting PIN-based authentication as an alternative as well. But it should be noted that the Mor Committee is not wedded to Aadhaar. The idea is not to make Aadhaar mandatory, but rather that it is currently the readiest and enabling platform available and can be leveraged … if tomorrow a better platform emerges, then banks should also consider that.

“The Committee recommends that authentication for the purpose of transactions happen in either of three ways:

a. Fingerprint in combination with the Aadhaar number or the bank account number (Token-less authentication)

b. One-time Password (OTP) in combination with the Aadhaar number or the bank account number (Token-less authentication)

c. PIN in combination with the Aadhaar number or the bank account number (Token authentication)

The Mor Committee has been criticised in the MicroSave LinkedIn Group for focusing on what needs to be done to achieve financial inclusion rather than the details of exactly how it should be done. And Professor Sriram also notes, “The report provides lip service to the last mile and concentrates on financial sector architecture”.  But the Committee offers a sound approach to this challenge. After all, it is impossible to detail out the ways to deliver the last mile and each type of financial service provider is likely to have its own approach to doing so.

So long as there is a credible business case, it is fair to assume that the extraordinary Indian entrepreneurial spirit will find a way to deliver convenient and accessible financial services. Indeed, it is much more likely to do so when the business case is clear than when cajoled to do so by the RBI or Ministry of Finance. Now, of course, the excesses of the Indian entrepreneurial spirit were on alarmingly graphic display in the 1980s when many Non-Bank Financial Companies (NBFCs) went bankrupt – an episode seared on the consciousness of all Indian regulators. So while letting a thousand flowers bloom, the regulator will have to keep a close eye on the nursery.