A Legal Analysis Of Microfinance Institutions And Financial Inclusion In India
Author: LawSphereX
Category: Banking & Finance
Published:
Updated:
A LEGAL
ANALYSIS
OF MICROFINANCE INSTITUTIONS AND FINANCIAL INCLUSION IN INDIA
Priti Pragyan Pradhan, BBA LLB, Alliance University, Bengaluru
ABSTRACT
Microfinance Institutions and Banks play a Crucial role in in promoting and ensuring financial inclusion and reducing poverty by providing access to financial services to the underserved population of the country. However, despite their importance the regulatory framework and existing legal framework governing them are not sufficient and adequate to ensure transparency, accountability and consumer protection. The paper explores the penetration of MFIs and how they are ensuring financial regulations evaluating the current legal frameworks that govern them by assessing their effectiveness and provides suggestion for better governance and potential improvements. The suggestions highlight the gaps of the legal framework and the recommends how to address those issues for a better transparent, accountable and sustainable system of financial services.
Keywords: Microfinance Institutions, Banks, Legal framework, financial inclusion, underserved population
Introduction
Financial Inclusion has been a very important aspect for the economic growth and development of the developing countries like India as it ensures the access to financial services for low-income people community and underserved population of the country. Micro Finance Institutions and Banks play a major role in proving small scale credit, savings, insurance and various other financial services different than the traditional banks t the sector of people lacking access to the traditional banking services. Micro Finance sector in India has shown rigorous growth by alleviating poverty, economic empowerment and entrepreneurship especially in the marginalized communities in India.
There has been a significant growth in users of the Microfinance services in India and the penetration of Micro finance Institutions and banks in Various regions of the nation to serve the underserved and maintain economic balance as well as growth. Despite the contributions of Microfinance Institutions and banks they operate under a regulatory framework that has faced challenges in ensuring consumer protection, transparency and equitable access to financial services. There have been issues related to high interest rates, lack streamlined registration procedures, limited awareness of consumer, lack of dispute resolution mechanism it is crucial to evaluate the existing legal framework that are responsible for governing these institutions and how far they are accessible to the consumers.
Microfinance Institutions and Financial Inclusion Microfinance Institutions are the sectors that are sources of the financial services for small business, entrepreneurs and other people who are remote to the access of the banking and related services. It is a service that focuses on the low-income clients particularly women it tends to include smaller monetary amounts than the traditional financial services provided acting as a tool for financial inclusion, by raising income level and standard of living. The services provided by the Microfinance institutions include loans, saving, insurance and remittances. The Reserve Bank of India Act1 provides the definition of microfinance institution as collateral free loans to household income of up to Rs. 3lakh annually. 2 Few components of Microfinance
1 The Reserve Bank of India, 1934, Act 21 of 1934.
2 Neha, Bhupender & Pathsk (2017) “ A Conceptual Study of Microfinance in India” International Journal of Marketing & Financial Management, Vol. 5, (issue 11, Nov-2017), are Microcredit, Microinsurance, Micro savings and Microfinance institutions. Microcredit are the small loans given to people who lack to give collateral and have no steady income, poverty alleviation and empowerment of women. Microinsurance are the insurance catering lowincome individuals which has low coverage and premiums, micro saving are like saving accounts which have small deposit requirement, and no service charges and microfinance institutions are the organizations that provide these microfinance services to the low-income individuals which has unique features like high transactions costs, high repayment frequency, short loan durations, no collateral and higher default rates.
3 The Primary aim of microfinance institutions is to ensure financial service of the individuals or community who lack access to the traditional banking system. These services help the lowincome individuals, women, rural communities that are remote to banking services and are the underserved sector of the society who are not able to get qualified to get loans due to the inability to offer required collateral or credit history. A variety of financial products and services are offered by the Microfinance Institutions like micro saving, micro insurance, micro credit and money transfer services that are both flexible and accessible. The Micro finance institutions assess creditworthiness unlike the traditional banks using nontraditional methods according to the factors such as community reputation, character and social collateral.
The methods they adopt are the Group Lending Model where the borrowers from a small group act as guarantors, reducing the default risk while fostering social cohesion. Micro finance institutions also emphasize financial education, training on budgeting, saving for financial literacy and empowering the client. Financial Inclusion The Khan Commission was set in 2002 by the Reserve Bank of India to investigate the financial inclusion in India and the recommendations of the committee were later implemented. Reserve Bank of India took many steps to ensure financial inclusion in India such as the opening of the no frills account which had basic banking facilities with minimum or no balance, relaxation to KYC norms which led to simplified procedures, the permit to banks to use business facilitators https://www. researchgate.
net/publication/351287978_A_CONCEPTUAL_STUDY_OF_MICRO_FINANCE_I N_INDIA 3 Neha, Bhupender & Pathsk (2017) “ A Conceptual Study of Microfinance in India” International Journal of Marketing & Financial Management, Vol. 5, (issue 11, Nov-2017), (https://www. researchgate. net/publication/351287978_A_CONCEPTUAL_STUDY_OF_MICRO_FINANCE_I N_INDIA) and correspondents as intermediaries to provide financial and banking by the Reserve Bank of India4. India has a huge network of banks to provide financial services across the nation yet there are regions remote to the basic financial services. Particularly for those regions Microfinance institutions play a crucial role in bridging the gap by providing financial services for lowincome groups remote to traditional banking service.
Banks in India frequently join hands with the NGOs for initiatives like the Self-help groups bank linkage Program, Micro finance institutions have become a boon for developing countries like India to support the low-income individuals, community and women remote to the banking facilities thus promoting financial inclusion. But the adoption of Microfinance institutions is not uniform in all parts of India with evident regional disparities5. The distribution of Microfinance institutions, Banking Services and availability of policy incentives across the whole nation is uneven, which shows the need for more accountable, targeted and rational policy for expanding the Micro finance Institutions to the underserved Areas of the country6.
Legal Framework for Micro Finance Institutions and Banks Microfinance institutions use various legal forms and frameworks for a regulated and better governance of such institutions and banks, these frameworks are there to ensure credibility, transparency and accountability in the financial services provided by the microfinance institutions.
1. Societies Regulation Act, 18607
The NGOs are registered under the Societies Regulations Act, 1860, as they are established for non- profit development organizations voluntarily, the micro finance activities performed by them and registered under this Act. The Societies Registration Act, 18608 states that the society can be formed for promotion of literature, science or fine arts or the diffusion of usual knowledge/political educational of for charitable purposes. The Act has been amended by
4 Handbook on Microfinance Institutions, ( https://openknowledge.worldbank.org)
5 Prakash Singh, “Understanding the Structure of Microfinance Institutions in India and suggesting a Regulatory Framework, (https://www.iibf.org.in/documents/reseach-report)
6 Muhammad Mustafa, 2019, Vision of Microfiance in
India,(https://www.pwc.in/assets/pdfs/consulting/financial-services)
7 Societies Registration Act, No. 21 of 1860, (India)
8 ibid
various Staes yet keeping the charitable purpose as core purpose of the registration. The term charitable purpose was defined by Lord McNaughten as relief of poverty, advancement of religion and education and purpose benefit to the community or section of the community9. The benefit of this legislation is that there is ease of registration, record keeping and simpler regulations, there is low possibility of regulator interferences, tax exemptions dur to being charitable in nature and operations and appropriate source for taking up microfinance institutions on behalf of insurance agency.
The disadvantages involved are that the profit for financial sustainable strategic goal of microfinance operation is not met as it is for charitable purpose, tax exemptions are challenged as the question of microfinance services being charitable remains an issue, as there is no equity investment system there are no commercial investors interested moreover the Societies Registration Act is considered an unincorporated body thus by Section 4510 of the Reserve Bank of India Act, 1934 they are not allowed to accept deposits from the public.
2. Indian Trust Act, 1885
Few Micro Finance Institutions in India are registered in the Indian Trust Act, 188211 being a public charitable trust or a private trust with a specific number of beneficiaries. The section 612 of the Indian Trust Act, 1882 “gives the essential constituent of a trust as: a. three parties – the author, trustees and beneficiary. b. declaration of a trust. c. certainty of the subject matter of a trust; and d. certainty of objects of the trust”13 In a Micro finance Institution, the Author is an individual or entity aiming to provide financial service to the poor, arranges fund and deploys through the trust, Trustee in Micro Finance Institutions is the governing body or board who are responsible for the policy decisions and 9 Raj, Manisha, 2011, “Microfinance Institution in India and its Legal Aspects, Available at SSRN 1884186. 2012, (https://dx.doi.org/10.2139/ssrn.1884186)
10 The Reserve Bank of India, 1934, § 45, Act of 1934.
11 The India Trust Act, 1882, Act 2 of 1882,
12 The India Trust Act, 1882, § 6 Act 2 of 1882,
13 ibid
management and the beneficiary are the people for whom it is crated. Public trusts are for the benefit of the public mostly for religious or charitable purpose and private trust are for specific individuals registered, the microfinance Institutions are mostly registered as private trusts. Though the registration through the India trust Act, 1882 is a simpler and hassle-free procedure with tax exemptions yet there are problems as it is an unincorporated body, and not recognized by the IRDA regulations as agents for insurance services14.
3. Not For Profit Companies Registered Under Section 815 of the Companie Act, 2013
An organization with limited liability is given the license to be registered as a company and exemptions from the Companies Act, 201316 only when the central government is convinced that the sole purpose of the organization is restricted to religious, art, science or charitable purposes. There is exempti0n to taxes for such company being a part of charitable purposes there is easier registration procedure without being registered in Reserve bank of India or the Non-banking Financial Corporation as well as they are allowed by the IRDA to be registered as a corporate agent. Though there has been an ease to register yet there is no deposit mobilization available.
4. Non-Banking Financial Corporations
Non-Banking Financial Companies play a very important role in the Indian Sector by bridging the gap in demand and supply of financial services, particularly for low-income clients. The growth of these non-banking financial companies is because of the localized access, customer centric services and lower documentation requirements though having higher interest rates. The depositors enjoy having high returns than traditional banks and the entrepreneurs are attracted due to low entry barrier and high profitability. For the regulation of such non-banking financial companies and integrating them to financial system the Reserve Bank of India introduced compulsory registration, credit rating for deposits and prudential norms from 199617.
As per the Section 518 of the Reserve Bank of India Act, Non-Banking Financial Companies engage in activities such as lending, deposit taking, investment in securities, chit funds, lotteries. The 14 Fancis Lwesya & Adam Beni Swebe Mwakalobo, “Frontiers in microfinance research for small and medium enterprises (SMEs) and microfinance institutions (MFIs): a bibliometric analysis, Future Business Journal (April 2023), (https://link. springer. com/article)
15 The Companies Act, 2013, §8, Act 18 of 2013.
16 ibid
17 The Reserve Bank of India Publications, (https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=)
18 The Reserve Bank of India, 1934, §5 Act 2 of 1934.
Micro Finance Institutions qualify as Non-Banking Financial Companies which must mandatorily get Reserve Bank of India registration certificate. Conclusion Microfinance Institutions and banks are crucial for fostering the financial inclusion in the country and reducing poverty as they are responsible to provide financial services to the underserved population of the country who are remote to the traditional banking methods. The influence of Microfinance institutions in India is quite visible as there has been an increase in the use of microfinance institutions by the low-income individuals, communities and underserved population.
Yet the legal framework governing those institutions carries significant gaps in providing transparency, reducing overlapping of the legals frame works, lack of consumer redressal mechanism, and equitable access to the public that are leading to affect the financial inclusion. The legal framework needs to be strengthened by inclusion of consumer protection and dispute resolution mechanism, a streamlined registration procedure and flexible interest rates which will ultimately lead to a long-term sustainable Microfinance in India ensuring financial inclusion and economic growth.