By William Lord

Microfinance in recent years has become something of a darling for many in the development community. The practice of providing financial services, most commonly in the form of credit, to those too poor to previously access them has won plaudits around the world. The sector has seen impressive growth, not least in India where some 30 million households have borrowed small loans or "microcredit". The increasing importance of microfinance institutions (MFIs) in the country has led to a new wave of state and national-level rules designed to regulate the services they provide.

The first major calls for regulation of the sector came from the state of Andhra Pradesh, where one-third of Indian microfinance customers live. In 2010, a spate of suicides by farmers unable to pay back microloans they had borrowed led to wider scrutiny of lenders. Concerns were raised by borrowers and politicians that the sector was charging overly-high interest rates on its loans and using aggressive lending and recovery practices. This led to a state-wide creation of new rules, including a ban on collection from borrowers' homes and a requirement of government approval. Most damaging for MFIs in the state was the call by some politicians for borrowers to not repay loans, leading to a near-collapse in business. Funding from banks, which Indian MFIs generally rely on funding for, dried up as a result.

In response to Andhra Pradesh's example and calls for national regulation of microfinance, the government introduced a bill to Parliament this year, that would give the Reserve Bank of India new regulatory powers. Its provisions include a requirement for every microfinance institution to register with the RBI and place caps on margins. The Central Bank has been given the power to bar microlenders from operating if they fail to comply with new rules or pay back debts. Measures to encourage industry participation, such as the creation of national and state councils, were also included.

In general, the response from many in the microfinance community has been positive. Many of the bill's provisions may go a long way to restoring credibility and finance to the bruised sector. For instance, the registration requirement could help counter the problem of former money lenders posing as legitimate microlenders, one of the main factors leading to the suicides in AP state. National level regulation is also preferable to a myriad of state level regimes, which some local politicians may be willing to utilise to crush a sector that weakens their grip on patronage through lending.

Thankfully, India has not gone the way of its neighbour Bangladesh, whose government imposed interest annual rate caps and forced the head of the country's biggest microlender, Muhammad Yunus of Grameen Bank, from his job. An area as sensitive as microfinance requires smart regulation. The task of creating a sensible regime that encourages both growth and good behaviour is not yet complete, but the Indian government has made some solid steps in the right direction.

All views and commentary are the author's own.

 Follow our Linkedin Group