'Opaque MFI contracts can lead to sort of sub-prime crisis'

Stressing on transparency more than capping of interest rates, the pre-Budget Economic Survey today asked the government to take steps to ensure borrowers understand the contract when he borrows from micro finance institutions.

"The government has to take measures to ensure that MFIs make the terms of contract transparent to the borrowers. This is more important than setting caps on interest rates and other restrictions on the terms of the contract," the Survey said.

Highlighting the need for transparency, it said misunderstanding of contract could translate to higher interest rate, similar to the sub-prime crisis that happened in the United States.

"To misunderstand (the contract) this can lead the borrower to make huge losses and the lender to make huge unfair profits. We have seen these kinds of phenomena even in advanced economies like the US where the sub-prime home borrowers took on loans without understanding the terms they were signing on to," it said.

As of March 31, 2010, there were 1,659 MFIs availing a total credit of Rs 13,955 crore from the banking system, and benefiting about 30 million people.

The Survey said that even as some MFIs adopt coercive recovery tactics, however, a blanket ban on their business terms would not be good for the system.

"To react to this (unfair threats by MFIs) by announcing blanket amnesties and encouraging farmers to default enmasse will do more damage than good.

"Such practices would lead to the MFI sector disappearing since no MFI whether it is a profit making one or a non-profit NGO, would want to give out loans knowing that these will not be recovered," the Survey said.

The MFI sector has come under scanner after cases of suicides were reported in Andhra Pradesh over allegations of coercive recovery tactics and high interest rates.

In October 2010, the Reserve Bank constituted the Malegam Committee to study the state of MFIs in the country.

The committee, which submitted its report on January 19, suggested among other things capping interest rate at 24% for MFI loans.

The committee also suggested that small loans cannot exceed Rs 25,000 and asked for creating a separate category of non-banking financial companies (NBFC-MFI) for the MFI sector.