Legal structures for Microfinance

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Legal structures for Microfinance
Deepak Alok, co-founder and partner, M2i
Consulting
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We are

• Microfinance Management and Investment Advisory
  http//www.m2iconsulting.com
• http//www.m2itrainings.com
• Founded in March,2006
• We seek to
• catalyze the growth of microfinance by bringing
  in more professionalism
• facilitate integration of microfinance with the
  economic mainstream.

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Our work

• Mentorship of MFIs
• Diagnostic Assessments
• Loan Portfolio Audit
• Capital Structuring and valuation services
• Business planning
• Implementation of Microfinance programme
• Trainings

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Agenda

• To explore various legal forms under which
  microfinance can be provided
• To understand issue which are faced at the time
  of transformation from a not-for profit structure
  to a for-profit structure

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Microfinance defined
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Importance of legal structure

• Legal structure determines
• Clarity of ownership
• Initial capital requirement
• Ability of the MFI to mobilize deposits
• Ability to raise equity
• Ability to raise grants
• Ability to raise funds from banks and FIs
• Regulatory requirements
• Tax implications

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Legal Structures

• SHGs and federations
• Societies and Trusts
• Co-operative societies
• Co-operative Banks
• Regional Rural Banks
• Local Area Banks
• Public and private sector banks
• Companies incorporated under Section 25 of the
  Companies Act
• Companies registered with the RBI as NBFCs
• Eligible organizations under BC/BF guidelines of
  RBI

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SHGs and Federations

• An SHG is an unregistered entity of between10-20
  individuals, having own rules and regulations,
  office bearers and books of accounts.
• SHGs are recognised by the RBI 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 in to
  Federations which are usually registered as
  Societies or Co-operative Societies

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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

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Societies

• 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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Trusts

• 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

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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
• Can access equity as well as deposits from their
  members and can lend to their members
• Membership generally restricted to individuals,
  other co-operatives and government (including
  government corporations)

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Co-operative Societies

• Mobilization of equity is restricted as
  co-operative societies can raise equity only from
  their members. The principle of one person one
  vote acts as disincentive to equity
  mobilization from the members
• 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

• Could be
• Primary co-operative bank (urban co-operative
  banks)
• State co-operative bank
• Central co-operative bank
• 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
  by the Reserve Bank of India for licensing, area
  of operations and interest rates
• Can undertake most of the banking activities

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Co-operative Banks

• Difficulty in raising equity and tendency to get
  political.
• Respective state governments have close control
  over central co-operative banks and state
  cooperative banks. Many of these are not
  well-managed.
• Series of irregularities have been noted by RBI
  in many primary co-operative banks and it has
  taken action against several existing banks.
• RBI is reluctant to give new licenses owing to
  failure of a large number of co-operative banks
  in different parts of the country

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Regional Rural Banks (RRBs)

• Established by the Central Government through a
  notification in the official gazette
• Minimum capital requirement is Rs2.5 million
• The share capital of the RRBs is required to be
  held by the Central Government, State Government
  and Sponsor Bank in the ratio 501535
• From the financial year 2006-07 RRBs have been
  brought under Income Tax net
• RBI has also stipulated that RRBs need to
  maintain disclose CAR starting March 2008.

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Local Area Banks (LABs)

• RBI allowed the establishment of Local Area Bank
  in 1996
• LABs are registered as public limited companies
  under the Indian Companies Act 1956
• Minimum capital requirement for a LAB is Rs50
  million
• Are allowed to operate in three geographically
  contiguous districts
• Can mobilise deposits from public

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Local Area Banks (LABs)

• Prudential norms related to banks are applicable
  but rules relating to liquidity and interest
  rates applicable to RRBs are applicable
• At present only four LABs are functioning and no
  new licenses are being issued
• Resumption of licensing of LABs with stricter
  capital requirements being considered

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Private banks

• Private banks have to obtain license from RBI
  under the Banking Regulation Act -1949
• A minimum capitalization of Rs3bn (Rs300 crores)
  is required for private sector banks, including
  wholly owned subsidiaries of foreign banks
• Can do normal banking activities

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Section-25 Companies

• Section 25 Companies are promoted for the purpose
  of promotion of commerce, arts, religion, charity
  or any other useful purpose
• They are prohibited from payment of dividends
• 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
• Section-25 NBFCs find it difficult to mobilize
  equity owing to restrictions on payment of
  dividends

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Section-25 Companies

• Can mobilise foreign grants if registered under
  FCRA
• Exempt from Income Tax if registered under
  Section 12A of the Income Tax Act.

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Non-Banking Financial Companies (NBFCs)

• Companies registered under Indian Companies Act
  1956 can apply to RBI to carry on the business of
  an NBFC
• NBFCs are required to have net owned funds of
  Rs20 millions
• Ownership can be defined precisely and they can
  raise equity
• Mobilisation of public deposits, though allowed,
  is almost impossible given strict guidelines of
  the RBI
• Banks are comfortable lending to NBFCs which are
  well-capitalised and well-performing

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Non-Banking Financial Companies (NBFCs)

• NBFCs are for-profit entities and are taxable
• FDI through automatic route is allowed subject
  the following limits
• FDI up to 51 - US0.5 mn to be brought upfront
• FDI between 51 and 75 - US5mn to be brought
  upfront
• FDI between 75 and 100- US50mn out of which
  7.5 million to be brought up-front
• NBFCs are subject to prudential regulations
  regarding income recognition, asset
  classification and provisioning, prudential
  exposure limits and accounting/disclosure
  requirements provided
• they are mobilizing public deposits, or
• they are systemically important

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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 now
  12 and will be increased to 15 from April 2009
  for systemically important NBFCs

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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

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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 banks books by end of day or next
  working day

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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

Access to commercial equity and Bank funds helps
them scale-up faster
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Issues in Transformation

• Capital
• MFI promoters find it difficult to mobilise
  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.

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Issues in Transformation

• Transfer of assets and liabilities
• Option 1 Assets from the old entity can be
  purchased by the new entity
• Option 2 All new disbursement to be made by the
  new entity and the loan portfolio of the old
  entity is allowed to come down gradually
• Option 3 New entity gives loans to the clients
  who can pre-pay loans in the old entity

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Microfinance Bill

• Registered MFOs will be required to submit
  reports to the regulator
• MFOs will also be subject to inspection by the
  regulator in case of complaints of harmful
  practices

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Microfinance Bill

• Bill to promote and regulate the microfinance
  sector. NABARD to be made the regulatory
  authority
• Microfinance is defined to include loans,
  savings, insurance and pension services. Loans
  cannot exceed more than Rs50,000 (Rs150,000 for
  housing purposes)
• The bill defines an MFO as any organisation that
  provides micro-finance services and include
  societies, trusts and cooperative societies.
• All MFOs that accept deposit from eligible
  clients need to be registered with NABARD.
  Minimum experience of three years and minimum net
  owned fund of Rs five lakhs has been fixed as
  condition for registration.

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To conclude

• Different legal structures reflect diversity
  within the country and represent various stages
  of evolution of the financial sector
• Each legal structure has a purpose, has its pros
  and cons and is more effective in a particular
  situation

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References

• Microfinance Sector Legal and Regulatory
  Framework, Trilegal, Asian Development Bank,
  Discussion Paper, Microfinance, November 2004
• Emerging Scenario for Microfinance Regulation in
  India, some observations from the field, GTZ,
  2004.
• Microfinance Reserve Banks Approach. Speech of
  Mr YV Reddy in Indian School of Business
• RBI Circulars/Press Releases/Notifications
• Financial Regulation of Systemically Important
  NBFCs and Banks Relationship with them for
  NBFCs, RBI/2006-07/204, DNBS.PD/ CC.No. 86/
  03.02.089 /2006-07. 12 December 2006.
• Financial Inclusion by Extension of Banking
  Services - Use of Business Facilitators and
  Correspondents. RBI/2005-06/288. DBOD.No.BL.BC.
  58/22.01.001/2005-2006.
• 25 January 2006
• Application of Capital Adequacy Norms to RRBs,
  RBI/2007- 2008/218RPCD.CO.RRB.No. BC.44
  /05.03.095/2007-08.. 28 December 2007.
• Guidelines for Setting-up Local Area Banks in the
  private Sector. Press Release 1996-
• 97/103. 24 August 1996
• FAQ on NBFCs. 5 February 2007.
• Amendments to NBFC regulations,
  Ref.DNBS.(PD).CC.No. 12 /02.01/99-2000, 13
  January 2000.

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Thank you

• Visit us at
• www.m2iconsulting.com
• www.m2itrainings.com
• Send an email to
• contact_at_m2iconsulting.com
• deepak.alok_at_m2iconsulting.com