The Corporate & Commercial Law Society Blog, HNLU

Tag: loans

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

    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.

  • Evaluating the Impact of the RBI’s Draft Prudential Framework on Project Financing

    Evaluating the Impact of the RBI’s Draft Prudential Framework on Project Financing

    BY ARYAN SHARMA, THIRD-YEAR STUDENT AT MAHARASHTRA NATIONAL LAW UNIVERSITY, MUMBAI

    INTRODUCTION

    Project financing serves as a cornerstone for infrastructure development, by facilitating the construction of essential assets such as roads, power plants, and urban facilities. In May 2024, the Reserve Bank of India released the draft ‘Prudential Framework for Income Recognition, Asset Classification, and Provisioning pertaining to Advances—Projects Under Implementation, Directions 2024’. The draft was aimed at strengthening the regulatory environment that governs project finance. This circular created quite a stir in the financial sector.

    This article aims to examine the implications of these regulatory changes for lenders, borrowers, and the broader infrastructure sector. It explores whether the RBI’s cautious approach strikes the right balance between financial prudence and India’s ambitious infrastructure goals, and it analyzes potential market reactions and policy adjustments that may emerge in response to these new norms.

    UNDERSTANDING PROJECT FINANCE

    A discourse on the implications of the draft prudential norms requires an insight into project financing. Project finance refers to the method of financing infrastructure and other long-gestating capital-intensive projects like power plants, ports, and roads involving huge financial outlays. The typical project involves a high-risk profile, long gestation periods, and uncertain cash flows, all of which characterize the infrastructure sector.

    Unlike a regular loan sanction, which would depend on the character, capital, and capacity of the borrower, the loan structure of project financing predominantly depends on the project’s cash flow for repayment. The project’s assets, rights, and interests form part of the collateral. Additionally, the lender assesses the project sponsors and their experience in handling and commissioning the project. Project funding could be through a consortium of several lending institutions or include loan syndication. It could have any sort of funding proposition. A project has three distinct phases: design, construction, and operation.

    Banks and lending institutions primarily become involved during the construction and operational phases, where money is lent, and out standings appear in the books of accounts. After this, the extant prudential framework of income recognition, asset classification, and provisioning comes into effect.

    The draft prudential framework recently released by the RBI pertains to loans and advances for projects. The regulator has proposed stricter regulations for project financing, which makes it more expensive for lenders to provide loans for infrastructure and industrial projects like roads, ports, and power. The main question is: what has changed and why?

    WHY HAVE THESE CHANGES BEEN PROPOSED?

    During the infrastructure lending boom of 2008 to 2015, banks whitewashed their books of bad loans and defaults, which forced RBI to launch an asset quality review. This led to the unearthing of thousands of crores of hidden bad loans, causing investors to lose money. NPAs in banks shot up to an all-time high of ₹6.11 lakh crores, and the government had to invest more than ₹3 lakh crores in capital to bring banks back into shape.

    Furthermore, facts show that most project loans have been categorized as standard assets, even though there were some projects delayed beyond the planned schedule and were not yielding cash flows. This gave rise to the necessity for more stringent lending standards with extra provisions, which were directed towards avoidance of accounting shocks that might adversely affect the balance sheets of such entities. These actions are cautious from a risk management point of view, based on the regulator’s experience in the last credit cycle. Experience, after all, is a good teacher.

    WHAT ARE THESE NEW REGULATIONS?

    Under the new norms, there will be a broad provisioning of 5% of the funded outstanding on all existing and new exposures at a portfolio level. The new norms also demand a 1% provision even post-completion of the project, well over double the current requirement.

    The central bank has created a provisioning timeline of: “2% by March 31, 2025 (spread over four quarters of 2024-25); 3.50% by March 31, 2026 (spread over four quarters of 2025-26); 5.00% by March 31, 2027 (spread over four quarters of 2026-27)”

    Further, the allowable deferment periods for date of commencement of commercial operations (“DCCO”) are: “Up to 1 year for exogenous risks (including CRE projects); Up to 2 years for infrastructure projects with endogenous risks; Up to 1 year for non-infrastructure projects with endogenous risks; Up to 1 year for litigation cases”.

    Perhaps the RBI’s proposal to impose a 5% provision requirement on project loans has been triggered by the Expected Credit Loss (“ECL”) norms, which require banks to make provisions based on past default experiences.

    The ECL approach provides for the recognition of losses on loans as soon as they are anticipated, even if the borrower has not defaulted. These are prudential standards in accordance with international best practices. Every time the ECL norms are notified, banks will be required to reserve provisions for defaults accordingly.

    HOW WILL THIS IMPACT LENDERS?

    These new norms will significantly increase the provisioning requirements for banks and NBFCs, particularly those involved in large-scale infrastructure lending. Since the 5% provisioning mandate applies uniformly across all infrastructure projects, regardless of their inherent risk profiles, it may create a deterrent effect for lower-risk projects. Lenders could become more cautious in financing even relatively safer infrastructure ventures, as the increased provisioning costs may reduce the overall attractiveness of such exposures. This one-size-fits-all approach could inadvertently constrain credit flow to viable projects.

    The higher provisioning during the construction phase will directly impact the profitability of lenders, as a substantial portion of their capital will be locked in provisions rather than being available for lending.

    For lenders heavily engaged in project financing, such as PFC, REC, and IIFCL, this could mean a reduction in their lending appetite, thereby slowing down infrastructure development in the country.

    IMPACT ON BORROWERS AND PROJECT DEVELOPERS

    Project developers, especially in sectors like power, roads, ports, and renewable energy, will face tighter credit conditions. The cost of borrowing is likely to increase as banks and NBFCs factor in the higher provisioning costs into their lending rates. This could lead to:

    • Higher interest rates on project loans
    • More stringent lending criteria, making it harder for some projects to secure funding
    • Potential project delays, as financing becomes more expensive and risk-averse

    While these measures may enhance financial stability and prevent a repeat of the bad loan crisis of the past decade, they could also create bottlenecks in infrastructure development.

    POSSIBLE MARKET REACTIONS AND POLICY ADJUSTMENTS

    The sharp decline in banking and financial sector stocks following the release of this draft indicates that the market anticipates lower profitability and slower loan growth in the sector. Industry feedback is likely to request risk-weighted provisioning (lower rates for low-risk projects), extended implementation timelines, and carve-outs for strategic sectors like renewables. Developers may also seek clearer DCCO extension guidelines for projects delayed by regulatory hurdles.

    Objections from banks, NBFCs, and infrastructure developers may include requests for tiered provisioning rates based on project risk (e.g., sectors with historically low defaults). There may also be appeals to adjust quarterly provisioning targets to ease short-term liquidity pressures. Additionally, there could be demands for exemptions in renewable energy or other priority sectors to align with national development goals.

    However, the RBI may recalibrate its stance after engaging with industry stakeholders. Potential adjustments could include phased implementation of the 5% norm, reduced rates for priority infrastructure projects, or dynamic provisioning linked to project milestones. Maintaining financial stability remains paramount, but such refinements could ease credit flow to viable projects and mitigate short-term market shocks.

    Given India’s ambitious infrastructure goals under initiatives like Gati Shakti and the National Infrastructure Pipeline, a balance must be struck between financial prudence and the need to maintain momentum in project execution.

    CONCLUSION

    The RBI’s draft prudential framework is definitely a step in the right direction to strengthen financial stability and prevent systemic risks in project financing. However, it also raises concerns about credit availability, borrowing costs, and infrastructure development. It is true that the primary focus remains on the increased provisioning requirements, but the norms also raise broader concerns about their potential impact on credit availability and infrastructure growth, which may have cascading effects. By necessitating higher capital buffers, the norms risk reducing credit availability and increasing borrowing costs, which are unintended consequences that could slow infrastructure development despite their prudential benefits. If implemented as proposed, these norms will fundamentally alter the project financing landscape, making lending more conservative and expensive.    

    Albeit the proposed norms will likely make lending more conservative and expensive, they also offer important benefits, such as improved risk management, better asset quality for lenders, and long-term sustainability of infrastructure financing. The framework could potentially reduce NPAs in the banking system.

    Looking ahead, if implemented as proposed, we may see a short-term slowdown in infrastructure lending followed by more sustainable, risk-adjusted growth. A phased implementation approach could help mitigate transitional challenges, which would allow lenders and developers time to adapt. The framework could be complemented with sector-specific risk weights and credit enhancement mechanisms for priority infrastructure projects.

    The final framework, once confirmed, will be crucial in determining the future trajectory of infrastructure lending in India. Whether the market’s initial reaction is justified or premature remains to be seen, but one thing is clear, i.e., the era of easy project finance is over, and a more cautious, risk-averse approach is here to stay.