Microfinance in India: Legal & Regulatory Framework

Agenda

• To explore various legal forms under which microfinance services are provided in India

• Regulatory issues and implications of different legal forms

Legal structure determines

• Clarity of ownership• Initial capital requirement and capital adequacy• Ability to mobilise deposits• Ability to raise equity• Ability to raise grants• Ability to raise funds from banks• Regulatory authority• Tax implications

Classification of MFI

Type of MFI Legal Form

Not for Profit Entities Society, Trust and Section 25 Companies

For Profit Entities NBFC, Local Area Bank, RRBs, Other Commercial Banks,

Mutual Benefit Entities Cooperatives, MACs, Producer Companies, Cooperative Banks

SHGs and Federations

• SHG is an unregistered entity of between10-20 individuals, having own rules and regulations, office bearers and books of accounts.

• SHGs are recognized by the NABARD and Government for specific purposes.

• SHGs use savings of their members as well as funds from banks and MFIs for providing credit to their members.

• SHGs network in clusters and form into Federations which are usually registered as Societies or Co-operative Societies

Societies

• Societies can be registered under the Societies Registration Act, 1860 or under respective state acts.

• A society can be registered by any seven persons associated for any literary, scientific or charitable purposes by subscribing their names to a memorandum of association and filing with the registrar.

• Registration does not require any minimum initial capital contribution

• Difficulty to determine ownership makes banks uncomfortable in lending large sums

• Cannot raise equity so scalability is an issue• Cannot accept public deposit• Exempt from Income Tax if registered under Section 12A of

the Income Tax Act.• Need registration under FCRA to be able to accept foreign

grants

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• Public Trusts can be established under the respective state regulations. Private trusts can be established under Indian Trusts Act 1882.

• Difficult to attract commercial equity and loans

• There is no minimum capital requirements

• Cannot accept public deposits

• Exempt from Income Tax if registered under Section 12A of the Income Tax Act.

• Need registration under FCRA to be able to accept foreign grants

Trusts

Section-25 Companies• Section 25 Companies are promoted for the purpose of promotion of

commerce, arts, religion, charity or any other useful purpose with the intention to apply its profits, if any, or other income in promoting only its objects

• They are prohibited from payment of dividends to shareholders Difficult to mobilize equity Can accept grants if got FCRA approval

• Exempted from paying income tax

• RBI has exempted NBFCs licensed under section-25 of the Indian Companies Act from registration, maintenance of liquid assets and transfer of profit to Reserve Funds, provided– They are engaged in micro-financing activities (Rs50,000 for small businesses

and Rs125,000 for housing)– they do not mobilize public deposits

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Co-operative Societies

• Cooperative Societies can be registered under – Co-operative Societies Act, 1912, or – Relevant state Co-operative Societies acts, or– Relevant state Mutually Aided Co-operative Societies Act, or– Multi-state Co-operative Societies Act, 1995

• Primarily regulated by Registrar of Co-operative Societies

• ‘One person one vote’; Can accept deposits from its members and can lend to their members; cannot mobilize equity

• Membership restricted to individuals, other co-operatives and government (including government corporations)

• Banks are reluctant to lend to co-operative societies because of non-equity based ownership and their tendency to get political

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Co-operative Banks• Registered under central/state/multi-state co-operative

acts.

Regulated by Registrar of Co-operatives for registration, management and audit

Regulated under the Banking Regulation Act, 1949 for licensing, area of operations and interest rates

• Origins in cooperative credit societies which were organised to provide credit to meet consumption needs of their members, and relied on principles of thrift and self

• Urban cooperative banks were traditionally mandated to lend only for non-agricultural purposes and were located in urban and peri-urban areas

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Co-operative Banks 2

• Allowed to mobilise deposits from members but difficult to raise equity

• Tendency to get political, susceptible to political influence State governments have close control over central co-

operative banks and state cooperative banks. Not well-managed, several irregularities in primary co-

operative banks; RBI not keen to take corrective action

• RBI is reluctant to give new licenses owing to failure of a large number of co-operative banks in different parts of the country;

Regional Rural Banks (RRBs)

• Established by the Central Government through a notification in the official gazette notification

• Minimum capital requirement is Rs 25 lakhs

• The share capital of the RRBs is required to be held by the Central Government, State Government and Sponsor Bank in the ratio 50:15:35

• From the financial year 2006-07 RRBs have been brought under Income Tax net

• RBI has also stipulated that RRBs need to maintain disclose Capital Adequacy Ratio (CAR) starting March 2008.

Local Area Banks (LABs)• RBI allowed the establishment of Local Area Bank in 1996 with a view to

providing institutional mechanisms for promoting rural savings as well as for the provision of credit for viable economic activities in the local areas

• LABs to observe priority sector lending targets at 40% of net bank credit

• Lending primarily to agriculture and allied activities, SSI, agro-industrial activities, trading activities and the non-farm sector with a view to ensuring the provision of timely and adequate credit to the local clientele in the area of operation.

• LABs are registered as public limited companies under the Indian Companies Act 1956

• Are allowed to operate in a maximum of three geographically contiguous districts

Local Area Banks (LABs)

• Minimum capital requirement for a LAB is Rs 5 crores

• Promoters of the bank may comprise individuals, corporate entities, trusts and societies => Can mobilise deposits from public

• Prudential norms related to banks are applicable

• At present only four LABs are functioning and no new licenses are being issued

Non-Banking Financial Companies (NBFCs)

• Companies registered under Indian Companies Act 1956 can apply to RBI to carry on the business of an NBFC (except Section 25 companies)

• NBFCs are for-profit entities and are taxable

• NBFCs are required to have net owned funds of Rs20 millions Ownership can be defined precisely and they can raise equity, FDI Mobilisation of public deposits allowed but under strict guidelines by RBI

• Banks are comfortable lending to NBFCs which are well-capitalized and well-performing

• NBFCs are subject to prudential regulations regarding income recognition, asset classification and provisioning, prudential exposure limits and accounting/disclosure requirements provided they are mobilising public deposits

Systemically Important NBFCs

• All non-deposit taking NBFCs having asset size of Rs1bn (Rs100 crores) or more as per last audited balance sheet will be considered as systemically important NBFCs.

• Non-deposit taking and systemically important NBFCs will be subject to capital adequacy regulations, single/group exposure norms and disclosure pertaining to derivative transactions

• Capital Adequacy Ratio (CAR) requirement is 15% from April 2009 for systemically important NBFCs

Organizations under BC/BF guidelines of RBI

Business Facilitators

• Business facilitators can be used by the banks for various pre-disbursement and post-disbursement activities pertaining to lending.

• Does not include disbursement and collection activities

• No approval is required from the RBI for using Business Facilitators

NGOs Insurance agentsFarmers' Clubs Well-functioning panchayatsCo-operativeSocieties Village Knowledge CentersPost-offices KVIC/KVIB centersIT Enabled outlets of corporates Agri Clinics

Organizations under BC/BF guidelines of RBI

Business Correspondents

• BCs can undertake disbursement of loans as well as collection of principal. They can also accept deposits on behalf of the banks.

• Banks can compensate BCs but BCs cannot charge anything from the consumers

• Transactions need to be accounted for and reflected in bank’s books by end of day or next working day

Societies/Trusts Non-deposit taking NBFCsCooperative Societies Post officesSection 25 Companies

Transformation

• MFIs registered as societies, trusts and Section-25 companies want to transform to a for-profit NBFC as– For profit structure allows them to raise commercial equity– Banks are more comfortable lending to the NBFCs

• MFI promoters find it difficult to mobilize Rs20mn of minimum capital required for an NBFCs

• Many MFI promoters have ‘acquired’ old NBFCs having lesser minimum capital required but have to pay significant premium to the existing owners. There are also legacy issues.

Access to commercial equity and Bank funds helps MFIs scale-up faster

Scale vs depth

Mission drift