The ever increasing rate of failure of urban co-operative banks in recent years has made prudential regulation and supervision of micro-finance institutions crucial, to protect the financial system as a whole, particularly the small depositor. This will also improve the performance of the existing MFIs and ensure that only well-organised and committed institutions come in.
While MFIs are an easy and dependable source of financial services to poor households, not many of these institutions have a great performance record. With not too well-trained or experienced staff, MFIs are not competently managed. Many countries are putting in place regulatory and supervisory mechanisms.
The Union Government, which is in the process of enacting a comprehensive law on micro-finance regulations, must enable MFIs mobilise deposits from members and general public so as to provide financial services to landless labourers, tenant farmers, share croppers, oral lessees, and those farming in dryland, drought-prone, desert, hilly and tribal areas. It must also put in place a system of monitoring compliance by the MFIs, and for a periodic review.
As the loans granted are usually unsecured, such lending must be capped at 100 per cent of an MFI's equity base. Almost all loans tend to be short-term, of three months, with a weekly repayment schedule. But more often that not repayment does not happen to schedule and loan losses are common. Thus, 100 per cent provisioning for all unsecured loans must be insisted at the time of disbursal itself. While the loans are supposed to be "Group Guaranteed", this is quite ineffective as MFIs rarely enforce the guarantees. There is no evidence that `group guaranteed' micro-loans have better repayment record than non-guaranteed individual loans.
MFIs' portfolio tends to be extremely volatile and can deteriorate any time because of an unsecured loan going bad or even default of a secured loan but where the collateral does not sufficiently cover the principal, interest and the collection cost. This happens as the borrowers have no collateral at risk, and they do not feel constrained to repay. Delinquency is often contagious. When one borrower sees that another is not repaying, and getting away with it too, he could be tempted to follow suit. Such delinquency can be debilitating for MFIs as they may not have access to other ready sources of finance. Indeed, that is one reason why MFIs also charge stiff interest rates.
High capital adequacy requirements tend to lower the return on equity in micro-lending, reducing its attractiveness as a business. Applying capital adequacy norms to financial cooperatives also raises issues of definition of capital. All members of a cooperative are required to invest a minimum amount as "share capital". But unlike an equity investment, in an MFI a member's share capital can usually be withdrawn whenever the member decides to leave the cooperative. From the point of institutional safety this is not a very satisfactory arrangement. The impermanence of the capital, and the possibility that a member can withdraw his share any time — perhaps when the institution needs it most — could land the MFI in trouble. The new norms must take care of this aspect but without compromising the safety aspects.