Microfinance In India: The Bad Loan Crisis And The Regulatory Conundrum

BY Kshitij Kashyap and Yash Vineesh Bhatia FOURTH- Year
STUDENT AT DSNLU, Visakhapatnam

INTRODUCTION

Microfinance offers financial services to low-income people generally overlooked by conventional banking systems, facilitating small businesses and propelling the growth of the economy. India is a country where nearly every second household relies on microcredit, therefore, it is often the only bridge between aspiration and destitution. While the sector empowers millions, it is increasingly burdened by bad loans, also known as Non-Performing Assets (‘NPA’).

In India, microfinance is regulated by the Reserve Bank of India (‘RBI’). Although the Indian microfinance sector has shown promising growth, it has had its share of challenges. During COVID-19, Micro Finance Institutions (‘MFIs’) experienced an unprecedented rise in NPAs, followed by a sharp recovery. The recovery appears promising, but a closer look reveals deeper structural vulnerabilities in the sector, owing to its fragmented regulatory framework.

 This piece analyses the statutory framework of India’s microfinance sector, reviewing past and present legislations, and exploring potential reforms for the future, allaying the existing challenges. While doing so, it does not touch upon The Recovery of Debt and Bankruptcy Act, 1993 (‘Act’) since Non-Banking Financial Companies (‘NBFCs’) do not fall within the ambit of a “bank”, “banking company” or a “financial institution” as defined by the Act in Sections 2(d), 2(e) and 2(h) respectively.

LOST IN LEGISLATION: WHY THE MICROFINANCE BILL FAILED

In 2012, the Government of India introduced The Micro Finance Institutions (Development & Regulation) Bill (‘Bill’), intending to organise microfinance under one umbrella. However, in 2014, the Bill was rejected by the Standing Committee on Finance (‘Yashwant Sinha Committee’), chaired by Mr. Yashwant Sinha. Glaring loopholes were identified, with a lack of groundwork and a progressive outlook.

In its report, the Yashwant Sinha Committee advocated for an independent regulator instead of the RBI. It highlighted that the Bill missed out on client protection issues like multiple lending, over-indebtedness and coercive recollection. Additionally, it did not define important terms such as “poor households”, “Financial Inclusion” or “Microfinance”. Such ambiguity could potentially have created hurdles in judicial interpretation of the Bill since several fundamental questions were left unanswered. 

A SHIELD WITH HOLES: SARFAESIs INCOMPLETE PROTECTION FOR MFIs

The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (‘SARFAESI’) Act, 2002, is a core legal statute when it comes to credit recovery in India. It allows banks and other financial institutions to seize and auction property to recover debt. Its primary objective involves allowing banks to recover their NPAs without needing to approach the courts, making the process time and cost-efficient.

While SARFAESI empowered banks and financial institutions, originally, NBFCs and MFIs were excluded from its purview. This was changed in the 2016 amendment, which extended its provisions to include NBFCs with an asset size of ₹500 crore and above. This threshold was further reduced via a notification of the government of India dated 24 February, 2020, which incorporated smaller NBFCs with an asset size of ₹100 crore and above within the ambit of this Act. However, its impact is extremely limited when it comes to MFIs as they do not meet the financial requirements

.

THE IBC GAP: WHERE SMALL NBFCs FALL THROUGH THE CRACKS

The Insolvency and Bankruptcy Code, 2016 (‘IBC’), is another statute aimed at rehabilitating and restructuring stressed assets in India. Like the SARFESI Act, this too originally excluded NBFCs from its purview. The IBC recovers debt through Corporate Insolvency Resolution Process (‘CIRP’), wherein the debtor’s assets are restructured to recover the debt. In 2019, the applicability of  IBC was extended to NBFCs with an asset size of ₹500 crore and above.

The IBC, however, has certain pitfalls, which have kept it away from the finish line when it comes to debt recovery. Some of these pitfalls were enumerated in the thirty-second report of the Standing Committee on Finance 2020-2021 (‘Jayant Sinha Committee’), chaired by Mr. Jayant Sinha. The Jayant Sinha Committee observed that low recovery rates and delays in the resolution process point towards a deviation from the objectives of this Code. Further, under the existing paradigm, Micro, Small and Medium Enterprises (‘MSMEs’), which somewhat rely on microfinance, are considered as operational creditors, whose claims are addressed after secured creditors.

BRIDGING THE GAP: REGULATORY PROBLEMS AND THE WAY FORWARD

Fundamentally, three problems are to be dealt with. The first one is a regulatory overlap between the SARFAESI Act and the IBC. While the SARFAESI Act caters to NBFCs with an asset size of ₹100 crore and above, the IBC caters to those with an asset size of ₹500 crore and above. Secondly, there is a major regulatory gap despite there being two statutes addressing debt recovery by NBFCs. The two statutes taken collectively, fix the minimum threshold for debt recovery at ₹100 crore. Despite this, they continue to miss out on the NBFCs falling below the threshold of ₹100 crore. Lastly, the problem of the recovery of unsecured loans, which constitute a majority of the loans in the microfinance sector and are the popular option among low to middle income groups, also needs redressal since unsecured loans have largely been overlooked by debt recovery mechanisms.

For the recovery of secured loans

Singapore’s Simplified Insolvency Programme (‘SIP’), may provide a cogent solution to these regulatory problems. First introduced in 2021 as a temporary measure, it was designed to assist Micro and Small Companies (‘MSCs’) facing financial difficulties during COVID-19. This operates via two channels; Simplified Debt Restructuring Programme (‘SDRP’) and Simplified Winding Up Programme (‘SWUP’). SDRP deals with viable businesses, facilitating debt restructuring and recovery process, while on the other hand, SWUP deals with non-viable businesses, such as businesses nearing bankruptcy, by providing a structured process for winding up. The SIP shortened the time required for winding up and debt restructuring. Winding-up a company typically takes three to four years, which was significantly reduced by the SWUP to an average of nine months. Similarly, the SDRP expedited debt restructuring, with one case completed in under six months, pointing towards an exceptionally swift resolution.

In 2024, this was extended to non-MSCs, making it permanent. The application process was made simpler compared to its 2021 version. Additionally, if a company initiates SDRP and the debt restructuring plan is not approved, the process may automatically transition into alternative liquidation mechanisms, facilitating the efficient dissolution of non-viable entities. This marked a departure from the erstwhile SDRP framework, wherein a company was required to exit the process after 30 days or upon the lapse of an extension period. This, essentially, is an amalgamation of the approaches adopted by the SARFAESI Act and the IBC.

Replicating this model in India, with minor tweaks, through a reimagined version of the 2012 Bill, now comprehensive and inclusive, may finally provide the backbone this sector needs. Like the SIP, this Bill should divide the debt recovery process into two channels; one for restructuring, like the IBC, and the other for asset liquidation, like SARFAESI. A more debtor-centric approach should be taken, wherein, based on the viability of the debt, it will either be sent for restructuring or asset liquidation. If the restructuring plan is not approved, after giving the debtor a fair hearing, it shall be allowed to transition into direct asset liquidation and vice versa. The classification based on asset size of the NBFCs should be done away with, since in Singapore, the SIP was implemented for both MSCs and non-MSCs. These changes could make the debt recovery process in India much simpler and could fix the regulatory overlap and gap between SARFAESI and the IBC.

For the recovery of unsecured loans

For the recovery of unsecured loans, the Grameen Bank of Bangladesh, the pioneer of microfinancing, can serve as an inspiration. It offers collateral free loans with an impressive recovery rate of over 95%. Its success is attributed to its flexible practices, such as allowing the borrowers to negotiate the terms of repayment, and group lending, wherein two members of a five-person group are given a loan initially. If repaid on time, the initial loans are followed four to six weeks later by loan to other two members. After another four to six weeks, the loan is given to the last person, subject to repayment by the previous borrowers. This pattern is known as 2:2:1 staggering. This significantly reduced the costs of screening and monitoring the loans and the costs of enforcing debt repayments. Group lending practically uses peer pressure as a method to monitor and enforce the repayment of loans. Tapping basic human behaviour has proven effective in loan recovery by the Grameen Bank. The statute should similarly mandate unsecured microcredit lenders to adopt such practices, improving recovery rates while cutting operational costs.

CONCLUSION

Microfinance has driven financial inclusion in India but faces regulatory hurdles and weak recovery systems. Existing systems offer limited protection for unsecured lending. A unified legal framework, inspired by the models like Grameen Bank and Singapore’s SIP can fill these gaps and ensure sustainable growth for the sector.