Integrating Financial Markets Through MUDRA

Why the MUDRA Bank is necessary and what shape is it likely to take. 

Last week, Prime Minister Narendra Modi launched the Mudra (Micro Units Development and Refinance Agency) Bank amid much fanfare.  Mudra Bank, focused on small and micro enterprises, will facilitate credit by refinancing financial institutions for lending to micro businesses and entrepreneurs covering loans from Rs.50,000 to Rs.10 lakh. It will also act as a regulator for micro-finance institutions (MFIs).

The initiative has attracted quite a bit of criticism and skepticism, but these do not understand the scope and possible structure and even the context in which the Mudra Bank became a necessity. That context is the extreme difficulty that small and micro enterprises face in accessing credit. The government has itself admitted that only 4 per cent of the 57.7 million small business units have access to institutional finance. This is true and unfortunate.

Unincorporated enterprises comprising proprietorship and partnership firms  account for close to 50 per cent of India’s gross domestic product (GDP) and an almost similar share of value addition in the manufacturing sector.  They also constitute almost 70 per cent of enterprises in various segments of the service sector, which has a nearly two-third share in GDP and has been averaging an 8 per cent growth in the last decade. Trade, which is part of the service sector, itself is nearly 17 per cent of GDP, as much as manufacturing.

In spite of playing such an important role in the economy,  the credit available to unincorporated enterprises from formal banking channels is actually shrinking. Industry experts estimate that the demand for loans from the sector outstrips the supply by more than Rs 30 lakh crore.

Consider these numbers. Between March 1990 and 2012, the share of the household sector in national income [consisting of unincorporated or small and micro units]  came down from 58 per cent to 36 per cent. Ironically, it was during this  period that the role of the unincorporated enterprises in trade, transport, construction, restaurants, and other business services  grew at more than an 8 per cent compounded annual growth rate (CAGR). In contrast, the private corporate sector, whose share in national income, is between 12 per cent and 15 per cent takes away nearly 40 per cent of the credit provided by the banking sector.

Let us look at another set of figures – outstanding credit of scheduled commercial banks. In the up to Rs. 10 lakhs category, the share of credit outstanding has come down from 32% of total credit outstanding in March 2000 to 21% in 2011. Even if one increases the credit limit range to up to Rs 1 crore, the share has fallen from 45% to 32% over the same period.

This is not just lazy banking but also banking with significant structural distortions.

With the formal banking sector failing the unincorporated sector, the latter has little choice but to rely on the non-banking financial sector. This is an assorted group of entities which include unincorporated bodies or money lenders, chit funds and nidhis and kuris.

Consider yet another set of figures. At Rs 13.5 lakh crore, the share of trade in national income (at factor cost at current prices) was 18 per cent in 2011-12. Of this, the share of the non-corporate sector was nearly 76 per cent, or approximately Rs 10.1 lakh crore. If 75 percent needs to be financed (which could be an underestimation since we are looking at value addition and not sale), then the credit need of the trade sector is Rs 7.6 lakh crore. However, according to the Annual Report 2012 of the Reserve Bank of India, the financing of trade by the banking sector was Rs. 2 lakh crore  in 2011, which was 28 per cent of the credit availed by the sector. So, more than 70 per cent of the financial requirement of the non-corporate sector in trade is met by non-banking sources.

Someone could well wonder what the problem is because the non-corporate sector is getting finance from some source, after all. The counter to this is – but at what cost.

In the recent past, interest rates have been slowly moving south and most large companies are able to access funds from banks at less than 12 per cent a year interest. But my flower girl and my vegetable vendor have to borrow at half per cent per day, which works out to be more than 180 per cent per annum. My retail provision stores owner gets Rs 45,000 (for a loan amount of Rs 50,000) up front and pays Rs 500 per day for 100 days to repay Rs. 50,000. It turns out to be more than 10 per cent for three months. My barber borrows through a local chit process at around 4 per cent per month.

No Single Yield Curve

Estimating a yield curve for our economy is a very difficult task. On the one side we have rates in the range of 12 to 14 per cent for corporate, more so for listed companies (nearly 8,000) of which 200/300 are actively traded in the exchanges. The remaining Uninc, which borrows at 2 to 6 per cent per month, is totally different. The transmission mechanism of our monetary policy is weak due to this segmented market.

This brings out the need to have a comprehensive approach towards the non–bank sector in the credit market instead of looking at issues in a piecemeal fashion.

Generally the interest rate for unincorporated enterprises varies from 2 per cent to 6 per cent a month, depending upon the requirement and speed of getting credit.

So we have a situation of huge funds available with the formal banking sector, on the one hand, even as the non-corporate sector is forced to borrow at prohibitive interest rates from the non-banking sector.

What is really needed is a comprehensive approach towards the non-bank sector in the credit market instead of looking at issues in a piecemeal fashion. Currently, different entities under the broad rubric of non-banking companies are regulated by different agencies. Unincorporated bodies are regulated by state governments, chit funds by the registrar of chits of state governments and nidhis by the department of company affairs of the Union government. The stress is more on regulation rather than on development of an integrated financial market. This is where Mudra Bank can play a role by integrating the large number of individual money lenders and other micro/mini financial bodies into the main financial markets.

Remember, Mudra Bank is not a regular lending bank. It will formulate lending norms and responsible financing practices for micro-finance institutions so that the small businesses do not face hardship over indebtedness, while getting a fair environment for repayment. It will facilitate credit of up to Rs 10 lakh to small entrepreneurs, benefitting small manufacturing units, shopkeepers, fruits and vegetable sellers, hair saloon, beauty parlors, truck operators, hawkers, artisans in rural and urban areas – the very sectors that get a raw deal from the formal banking sector.  Providing access to institutional finance to such micro/small business units/enterprises will not only help in improving the quality of life of these entrepreneurs but also turn them into strong instruments of GDP growth and employment generation.  The initial products and schemes under this umbrella have already been created and the interventions have been named ‘Shishu’, ‘Kishor’ and ‘Tarun’ to signify the stage of growth/development and funding needs of the beneficiary micro unit/entrepreneur.

However, it is not yet clear if Mudra Bank will emerge as the sole regulator of the micro-finance sector, replacing the Reserve Bank of India, which regulates MFIs that are registered as non-banking finance companies (NBFCs). A decision on this will be taken when the bill on Mudra Bank will be drafted. Till the Mudra Bank gets statutory status through an Act, it will be a subsidiary of the Small Industries Development Bank of India and will be registered as an NBFC.

The Mudra Bank can be different from existing systems if it will be more relationship-based and not just rule-based. It should involve less paper work, enabling easy accessibility to finance. In addition, it should deal with cash flow-based lending rather than asset-based lending. After all, most of the target borrowers are in the service sectors and hence the need to focus more on income generated rather than fixed assets etc.

The lending institutions are expected to be less rigid in terms of risk adjusted capital/NPA provisioning etc and will encourage technology-based collection mechanisms for ease of transactions.

The Mudra Bank can become a vehicle for integrating the currently segmented and disparate financial markets. It needs to become a Small Business Finance and Development Authority (SBFDA), with the authority to register, develop and regulate small business finance institutions and be fashioned on the lines of the National Housing Bank. This SBFDA will be initially owned by the nationalized and private banks to the extent of 51 per cent with the central government holding the remaining 49 per cent stake. It must have the right to offer shares to foreign institutions through their funds floated for financing small businesses. The SBFDA will also float long-term bonds to augment funds from banks and foreign sources.

MUDRA may formulate guidelines for minimum capital for Small Business Finance Institutions (SBFIs) and also capital adequacy norms for all SBFIs, frame rules for new SBFIs that come up as well as for the migration and registration of all existing SBFIs under the new law.

What will be needed is a new definition of small business. Under the new regime, the term small business will include manufacturing, trading and services by sole proprietors, family concerns and partnerships, including limited partnerships and one-person companies within the meaning of the Companies Act. This definition is more appropriate than one based on assets/investments/turnover, which invariably lead to companies splitting after they reach a certain size. Small business finance will mean extending finance to small businesses by way of term loans, working capital, venture capital and other means.

There will be different kinds of SBFIs that will come under the umbrella of Mudra Bank as SBFDA. They can apply for registration with the SBFDA, within a certain period – say, 180 days – of the coming into force of the new law and be subject to the rules and regulations set by it.

– SBFIs: These are  institutions promoted for and engaged in providing small business finance. More than 60 per cent of their average loan and credit portfolio  will consist of small businesses. SBFIs will include all existing non-banking finance institutions including chit funds, unincorporated business and other traditional institutions which satisfy the criteria of small business finance.

– National Small Business Finance Institutions [NSBFIs]: Small business finance institutions with operations in more than one state and which are engaged in providing small business finance directly to SBFIs or act as wholesale funding institutions for other small business finance institutions.  Existing NBFCs which provide finance for small businesses may migrate to the new regime and get registered as NSBFIs as well,  with the proviso that small business finance must comprise 60 per cent of their loan and credit portfolio within a period of three years, failing which their registration will be cancelled.

– State Small Business Finance Institutions [SSBFIs]: are existing NBFCs which are engaged in providing finance to small businesses either directly or act as wholesale funding institutions for other small business finance institutions but operate within a particular state. They can migrate to the new regulatory regime and get registered as SSBFIs. They can also get registered as NSBFIs.

– Other Small Business Finance Institutions [OSBFIs]: These will comprise all SBFIs, other than NSBFIs and SSBFIs, which operation in parts of any state.

In addition to registering these SBFIs, the SBFDA can set norms (including deposit insurance conditions) for NSBFIs and  SSBFIs to access public funds by way of deposits and bonds without issuing advertisements or otherwise soliciting subscriptions.

To integrate existing lenders, there is need to undertake a massive survey-cum-rating exercise involving state-level NBFCs and further lower-level financing entities. This will bring orderliness and inclusiveness into the new financial architecture. The process of rating all these entities will enhance credibility and help in risk assessment. This will reduce  the cost of lending to some extent.

All in all, this refinancing/rating/regulating body will reduce cost of capital and integrate the currently segmented financial markets. The process of funding the unfunded, results in the existing last mile financier being made a part of the system. Let us hope the coming bill fulfills our expectations.