Revision in Interest rates of Micro Finance Institutions- Who will get benefit?

The Reserve Bank of India (RBI) vide a notification on 7 February 2014 has made modification to the non-banking finance companies (NBFCs)- micro finance institutions (MFIs) directions with regard to pricing of credit whereby the earlier interest rate cap (As per the Malegam Committee recommendations, the interest rate cap on loans given by MFIs has been fixed at 26%) imposed on NBFC-MFIs was reviewed and modified.
 

The notification reviews and modifies the interest rates to be charged by NBFC-MFIs to its borrowers and will be calculated to be lower of the following:

a.     The cost of funds plus margin; or

b.     The average base rate of the five largest commercial banks by assets multiplied by 2.75

Further, RBI shall at the end of each quarter advice on the average of the base rates of the five largest commercial banks and shall determine the interest rates for the ensuing quarter.  The modification is to take effect from 1 April 2014.
 

The modification notification leads us to several tricky questions and the benefit this modification will pass to the borrowers.
 

What would be the impact on the lending interest rates?
 

If we had to consider the five largest banks by assets, State Bank of India, Bank of Baroda, Bank of India, Punjab National Bank and ICICI Bank, (assuming total assets, in absence of explicit mention in the notification), and find the 2.75x of the average base rate, it would come to 27.89% as on date. On the other hand, under the extant directions all NBFC-MFIs are required to maintain an aggregate margin cap of not more than 12% and the present average borrowing rate for NBFC-MFIs would be around 14-15% for smaller NBFC-MFIs and 12.5% for larger NBFC-MFIs.
 

Going by the RBI notification, the lower of the two interest rates would be as follows:

a.     For larger NBFC-MFIs, the two interest rates will be 24.5% and 27.89%, and the lower of the two would be 24.5%.

b.     For smaller NBFC-MFIs, the two interest rates will be 26.5% and 27.89% and the lower of the two would be 26.5%.

Looking at the current scenario, the modification will not have any impact on the on-going lending rates for NBFC-MFIs irrespective of the size.
 

However, with effect from 1April 2014 as per the RBI master circular , the margin caps may not exceed 10% for large MFIs (loans portfolios exceeding Rs100 crore) and 12% for others. For larger NBFC-MFIs this would still not have any impact as the lending rates for larger NBFC-MFIs for who the lending interest rates would 22.5% with a maximum 4% variation to 26.5% still lower than the average base rate multiplier.
 

However, going by the above analogy, smaller NBFC-MFIs will have an advantage in the current position as the margins may be relaxed a little. For the borrowers, this may not be good news on the interest rates charged to borrowers as the interest rates can be as high as 30.5%.
 

The chart below explains the multiple scenarios that may exist if the base rate was to vary:

 

Currently, it seems that this amendment will not have an impact of the lending rates as the borrowing costs plus margin is anyway lower than the average base rate multiplier. Only if the base rate average was to be around 8% or lower in case of systematically important companies or 9% and lower in case of other NBFC-MFIs would this modification pass the benefit of the lower interest rates to the borrowers from larger NBFC-MFIs. However if the base rate was to drop down it is highly unlikely that theborrowing costs for the NBFC-MFIs will not fall down. Also what is critical to note is that the pricing becomes unreasonably high with the higher base rates. So in effect this amendment is not achieving much in terms of passing benefit to the borrowers on practical grounds.
 

In essence, the average BLR-based pegging does actually nothing on a policy issue, borrowers paying 2.75 times the rate at which credit worthy borrowers pay seems like travesty of social justice or financial inclusion. The problem here is that the yield spread is not expressed as a parallel spread over BLR it is exponential since is X times. For instance, if base rates in the system become 12%, will MFI borrowers pay 33%?

There is no rationale in the multiple; it should have been nothing but a spread, which is parallel spread over BLR, even if it was to be pegged with BLR.
 

Will the amendment be effective for the existing loan portfolios?
 

The amendment is to come into effect from 1^st April, 2014. While there is no explicit mention on the same, but it does not seem this amendment would have an impact on the existing portfolio. However any fresh lending by the NBFC-MFIs will have to comply by these amendments.
 

Where the interest rates are to be revised, will they be revised monthly, quarterly or annually?
 

Considering the fact that the NBFC-MFIs directions state that the average interest rate on loans during a financial year must not exceed the average borrowing cost during that financial year plus the margin, the pricing of the credit directions must be complied with on annual basis.
 

Further the average interest paid on borrowings and charged by MFIs are to be calculated on the average monthly balances of outstanding borrowings and loan portfolios respectively, and the 2.75x of average base rates will be announced quarterly, so MFIs will be able to vary the interest rates quarterly, where required. However practically, the auditors do a review of the compliance on a semi-annual basis for smaller NBFC-MFIs and quarterly basis for systematically important companies.
 

While the NBFC-MFIs may have to review the interest rates and borrowing costs on a quarterly basis, but practically it may not be possible to review the interest rates charged and revise the instalments. For NBFC-MFIs it may be a challenging task to explain the borrowers on any revision in the interest rates and bring that to effect. So the practical implementation of the modification is something, which will be put to test. Also in the tug of war of maintaining interest rates, the repayment history of the borrower, the credit worthiness of the borrower will become secondary considerations for charging interest rates.