Microfinance needs regulation

By Aneel Karnani, Stanford Social Innovation Review, Winter 2011 Volume 9, Number 1

Since it was first pioneered in the mid-1970s microfinance has established a reputation as an effective tool for poverty alleviation. It is not considered a panacea for poverty some naysayers even report that microfinance does not lift large numbers of people out of poverty, but its empowering approach has attracted worldwide attention of governments, development professionals, philanthropists and investors.  Offering the poor microloans so they can start up or grow a micro-business and thus climb out of poverty is a highly compelling alternative to having the poor continually reliant on the vagaries of handouts.

As reported by Karnani the microfinance industry has recently come under criticism sparked by allegations of exploitative practices against vulnerable, ill-informed and ill-educated borrowers, increasing participation by profit-seeking microfinance institutions (MFIs) capitalised by investors seeking financial as well as social returns and perceptions of minimal competition.  Whether the criticism is fair or not, it has stirred debate on the need to regulate microcredit to protect poor borrowers.

Karnani argues that regulation focused on three issues – lack of transparency, high interest rates, and abusive loan recovery practices – will go a long way to protecting borrowers at risk of market exploitation. Government is identified as the primary force in regulating microfinance, with Karnani seeing industry self-regulation or reliance on socially responsible practices of industry stakeholders merely as supplemental to legal regulation. He in fact expresses a heavy degree of cynicism that either MFIs, their shareholders or wholesale lenders to MFIs could be trusted to act in the best interest of borrowers.

The question of regulation for the microfinance industry has been played out in real time in India over the past nine months.  The announcement in October 2010 of a politically motivated ordinance, now a law, in response to allegations that MFIs were over-lending to the same best online casino clients, charging usurious interest rates, and using coercive collection methods brought the microfinance industry in the Indian state of Andhra Pradesh to a near standstill.  In January 2011, the Malegam Committee of the Reserve Bank of India (RBI) which was tasked with studying the microfinance industry released a series of restrictive regulatory recommendations for MFIs.  On May 3 the RBI released its Monetary Policy Statement for 2011-2012 which accepted the broad framework of these recommendations as encapsulated in a released Circular on Bank Loans to MFIs. The regulations include a profit margin cap for MFIs of 12%, an interest rate cap of 26% and limitations on loan amounts and borrower indebtedness.

It remains to be seen how these new regulations will impact upon the microfinance industry in India, for while those advocating for regulation are claiming victory little consideration is being given to potential negative impact that may flow from regulation stifling investment in the microfinance industry thus impeding its growth and ability to increase access to financial services for the poor.

Balancing the good and bad impact of regulation will be the challenge faced by governments across developing countries as they give consideration to regulation of the microfinance industry.

To read the full article see: csi.gsb.stanford.edu/microfinance-needs-regulation

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