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

We are Microfinance Management and Investment Advisory 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.

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

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

Microfinance defined Provision of financial services to low income clients LoansSavingsInsuranceRemittance

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

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

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

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

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

Trusts Public Trusts can be established under the respective state regulations. Private trusts can be established under Indian Trusts Act 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

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)

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

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

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

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 50:15:35 From the financial year RRBs have been brought under Income Tax net RBI has also stipulated that RRBs need to maintain disclose CAR starting March 2008.

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

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

Private banks Private banks have to obtain license from RBI under the Banking Regulation Act 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

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

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.

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

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% - US$0.5 mn to be brought upfront –FDI between 51% and 75% - US$5mn to be brought upfront –FDI between 75% and 100%- US$50mn 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

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

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

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 bank’s books by end of day or next working day

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

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.

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

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

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.

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

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, Microfinance: Reserve Bank’s 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/ /204, DNBS.PD/ CC.No. 86/ / December Financial Inclusion by Extension of Banking Services - Use of Business Facilitators and Correspondents. RBI/ /288. DBOD.No.BL.BC. 58/ / January 2006 Application of Capital Adequacy Norms to RRBs, RBI/ /218 RPCD.CO.RRB.No. BC.44 / / December Guidelines for Setting-up Local Area Banks in the private Sector. Press Release / August 1996 FAQ on NBFCs. 5 February Amendments to NBFC regulations, Ref.DNBS.(PD).CC.No. 12 /02.01/ , 13 January 2000.

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