Microfinance – State of the Sector

Professor C.K.Prahlad, of the University of Michigan and an IIMA alumnus introduced the idea of tapping into the fortune at the “bottom of the pyramid” by providing value, in terms of product and services, to the poor. However, business models based on financial services for the poor are a recent development, and have faced significant challenges.

The global microfinance industry is based on the principle of financial inclusion- to let people who have very limited access to lending avail of the benefits of timely capital. Commercial banks often face transaction costs that far outweigh the commissions earned by servicing the accounts of poor and needy people. This has given rise to the establishment of a separate set of lending institutions dedicated solely to the poor. The unsteady income of many of the borrowers, coupled with the lack of collateral, is the primary reason why microfinance institutions often charge high interest rates, which has been quoted as a cause of concern in the news. Microfinance institutions do reduce the risks they face through the practice of solidarity lending in which groups of borrowers in the community are made collectively responsible for repayment of loans of each member of the group. However this reduced cost of lending is still around 20% to 40%, which is usually charged by these institutions in India, and is much lower than the rates charged by local moneylenders, which are, on average, around 100%, and can go up to 500%.

Regulatory and Political Risks and Moral Considerations
Recently India-based SKS microfinance has been widely reported in the news for being a colossal failure in the MFI industry. SKS was funded by Bajaj Allianz and later raised Rs. 75b (the largest ever, for an MFI) through equity investment. While SKS charged rates of 26-34%, it nevertheless incurred a loss of Rs. 1360 crore in 2011, and an equally large amount of private debt. However, it should be noted that this loss can be attributed to politically motivated intervention and interference in the industry following suicides amongst borrowers. Although India does have a problem of farmer suicides, and the borrowers in question did have larger outstanding loans at higher interest rates from moneylenders, the suicides wer attributed to the MFIs. Calls from politicians encouraging borrowers to default on Microfinance loans lead to recovery rates plummeting from close to 100% to around 20%. SKS Microfinance also had to ground staffers following arrests of its field workers.

Another take on the issue of profitability and high interest rates is provided by Mohammed Yunus, the founder of Grameen Bank, the world’s most renowned microfinance institution, who claims that agencies should not be charging more than 15% of their long term operating costs as the interest rate. Dr. Yunus had also expressed his dissatisfaction towards SKS for raising an IPO. According to him this was a signal to investors indicating prospective profits at the bottom of the pyramid, which he believes is undesirable. However, SKS’ case remains moot- in Bangladesh, Grameen Bank could obtain deposits to fund its operations but that same activity is not possible in India due to a restriction on banking licenses. Thus, most of SKS’ deposits originate from commercial capital markets. However, with the new Microfinance Institution (Development & Regulatory) Act on the anvil, MFIs would not have to register themselves as lending institutions, taking them directly under the purview of the RBI and outside the jurisdiction of local anti-usury laws.

Online Lending
Shifting the perspective to online lending, global MFI portals such as Kiva Microfunds have demonstrated stable profitability over the years. Closer home, founded in 2010, peer-to-peer foundation Milaap is the first online lending platform designed for NRIs and non-Indians make loans to the poor. Based in Singapore & Bangalore, Milaap allows lenders to browse through a list of borrower profiles and their specific needs and then select their preferred borrower. Disbursement and repayments are done via field partners and Milaap also claims a repayment rate of 100%. The interest rate charged in 12-18% which is half the available microlending rate in the market. So far, Milaap has raised $200,000 from Atlanta based First Light Ventures and $40,000 from Spring Singapore, besides getting various Singapore based VCs to pitch in $1-1.2m in July 2012. As illustrated by these reports, the business model of online lending is one of the most promising solutions for the MFI sector and probably we shall see ever more development in that direction worldwide.

Shift back to Individual Financing
According to a report published by the Microfinance Information Exchange for the Latin American & Caribbean region, while debtors grew at an annual rate of 17% between 2006 & 2011, creditors grew at 24%. Meanwhile the gross loan portfolio rose at 23% per year to $15.8b. This shows a clear profitability trend emerging in South American nations, where microfinance penetration is the deepest and businesses have successfully implemented models based on solidarity lending, joint liability and local lending networks. However joint liability models have the potential to promote moral hazard and a hesitance towards taking responsibility among the debtors. Moving away from joint liability, several lenders have started using individual credit contracts, repayment schedules, subject monitoring and non-refinancing threats, which have made individual financing a more viable option. Brazil’s Banco do Nordeste, which has one of the most sophisticated microlending platforms, the CrediAmigo, has targeted individual urban microentrepreneurs and had achieved both stable profitability as well as low risk portfolio risk. The urban segment usually involves better business sense on the debtor’s part and a greater probability that the business launched with the help of the microfunding would actually be both liquid as well as sustainable in the long run.

Microfinance across the world
Recently, Forbes launched the rankings of the 50 best microfinance providers in the world by comparing them on categories like gross loan portfolio, %loans overdue by more than 30 days, operating expenses per active borrower and return on assets and these parameters were graded on scale, efficiency, risk & returns. Although Indian and Bangladeshi firms were prominent in the list (9 & 8 entries respectively), among the best managed were also 3 Moroccan & 3 Colombian microfinance funds. The Moroccan govt. has secured $46m in funds for better internal control over MFIs. Political instability in the region has greatly compromised MFI’s ability to operate and more and more number of loans had to be extended in 2011-12. However again, whatever profitability that the MFIs could salvage existed due to the group liability model.

Asia remains microfinance’s largest market with 74m borrowers in 2011, and 37m deposit accounts. While $15b has been mobilized by depositors, there are $34b worth of loans outstanding, primarily from India and Bangladesh. The return on assets ratio has hovered around 3% in the last 5 years but with the downside that portfolio risk has shot up 5-fold. On the other hand in North Africa and the Middle East, outreach and scale are extremely low with loan balances being just 16% of per capita GNI. Corporates & SMEs compose only 5% of the total portfolio. Operating expenses are low, but this is attributed more to the inability to secure funding rather than funding at low cost, leading to RoA being highest among all regions at 4.7% and only 2.1% of the portfolio being at risk (overdue).

– by Sai Deo
Sai is a PGP-1 student at IIM, Ahmedabad. She graduated from BITS Pilani (Goa Campus) in 2012 with a B.Tech in Chemical Engineering. Sai’s interests include business in emerging markets, sustainable growth, new business development. She also follows the venture capital and financial services space


Effect of the Andhra Pradesh Crisis on the Indian Micro Finance Industry

In rural India, capital has been a scarce resource for the most deprived sections. On one hand, local money lenders charge exorbitant rates and on the other, traditional financial institutions hesitate to extend credit to these borrowers. It is this gap in the lending market that micro-finance institutions (MFIs) have bridged by introducing the innovative concept of disbursing small loan amounts to a large number of clients repayable at short intervals. There are mainly two variations of the MFI model:

Self Help Groups

SHGs typically start off as loosely-linked groups of 10-20 members who meet regularly and pool their savings and disburse micro-loans from these savings. After roughly 6 months of stable savings, banks or other MFIs start providing credit to these groups. Further disbursement of loans happens according to the criteria developed by the group.

Grameen Model

In this model, each village has one or more centres with 6-8 groups of 5-6 members each.  The groups are very tightly bound together, resulting in high social pressure to repay the loans. Any member who fails to pay, risks social exclusion, but additionally, his group still has to repay his loan, thus ensuring nearly 100% repayment rates. MFIs under this model have shown the fastest growth both geographically and in the number of customers. But, developing such self-regulating centres requires a lot of training and effort.

Growth Drivers

Untapped Market: The MFI model made it possible to extend credit at affordable rates to the deprived sections of the society. As there was a dire need for credit in this segment and they did not have other comparable alternatives, MFIs were a welcome relief for them and thus there was a huge influx of customers.

Government Policies: Favorable policy changes, namely the 2004 RBI decree that included lending to MFIs through intermediaries under the purview of priority sector lending, led to an exponential growth of the microfinance industry; currently a total of Rs. 60,000 crores has been sanctioned by banks for lending to MFIs.

The Beginning of the Crisis

Most of the phenomenal growth witnessed by the industry was concentrated in Andhra Pradesh. Some of the big players like SKS were alleged of charging exorbitant interest rates and employing unethical loan recovery practices. The interest rates charged by the MFIs seemed inelastic to the steep decline in primary lending rates. The industry in general and SKS in particular continued to grow tremendously. In order to raise more funds to widen its reach, SKS decided to go for an IPO and with the backing of big PE players, SKS pulled off a highly successful IPO despite widespread criticisms of commercialization of the industry. This was soon followed by stories of SKS employees cashing out their stock options, becoming instant millionaires and the then CEO being sacked, leading to questions about corporate governance at SKS.

Major Issues

The problems at SKS exposed just the tip of the iceberg of issues plaguing the Indian microfinance industry. PE investors, the financial backbone of the industry, were pressurizing the MFIs to focus on growth. Many issues arose as a result:

Lending for Consumption: The pressure from PE investors to focus on aggressive growth led MFIs to extend loans for purchase of lifestyle items and consequently created a debt trap for the poor by encouraging extravagance.

Deviation from the SHG concept: The relentless focus on growth led to spending little time and effort on developing mutual trust within SHGs that is required for timely repayments.

Multiple Lending: Faced with an inability to pay back earlier loans that were used for consumption, many customers took loans to repay them, thus falling into a vicious debt trap.

Suicide of Borrowers: Unable to pay their loans, many borrowers committed suicide and many regional political parties exploited this to cast the MFIs in an evil light, resulting in the drop of repayment levels from 99% to 20%.

The Aftermath

To bring about changes in corporate governance of the MFIs and hoping to regulate the profit-motive of these institutions, the AP government passed the Microfinance Institutions Ordinance 2010. The salient features of the Ordinance were:

Registration of MFIs: MFIs have to be registered and have to furnish details such as interest rates charged, area of operations and methods used for loan recovery. They have to submit monthly reports of their operations which would be open to scrutiny.

Regulation of Interest Rates: a) Interest payable on a loan should not exceed the principal amount and this should be implemented with retrospective effect.
b) MFIs have to make the interest rates charged publicly available. And no costs other than the ones laid down in the application should be charged.

Curbing Multiple Lending: a) Second loan to be granted only on clearance of the first loan.
b) Membership only in one SHG and SHG members require permission of registering authority to take a second loan.

Directives for Loan Recovery: a) Only MFI personnel with identity cards to go for recovery, which would take place at Gram Panchayat offices and not at the borrowers’ residence.
b) Fast courts to be setup to handle grievances and loan sharks to face up to 3 years in jail and/or Rs.1 lakh fine.

Long- Term Implications

These measures are short-term fixes and have created a moral hazard problem for MFIs.The restrictions on multiple borrowings would mean non-renewal of a lot of current loans. And since most groups were made by MFIs and were not social groups that came together themselves, there is little social incentive to repay. Also due to the combined effect of political opportunism and the general anti-MFI environment, borrowers are exploiting the recovery laws to escape from repayment. If the trend continues, it would become increasingly difficult for the MFIs to get loans from banks for their operations. Thus, we see that the very laws which were meant to facilitate and regulate MFI activity in the state are now curbing all of MFI operations.

The authorities should realize that microfinance is in principle, capable of providing access to capital for the most deprived sections and the current failure was systemic, due to lack of regulation. This can be rectified by bringing proper policy changes through a regulator like RBI, which has a long history of good policy making. This would ensure that regulation of this sector is immune from political influences. Only then can the firms hope to survive through the current times and prosper and replicate the model in all parts of the country.

The Curious Case of Microfinance – a Boon or a Bane

The recent series of suicides by committed by the poor borrowers from Microfinance Institution (MFI) in Andhra Pradesh, the state where it all began in India, brings the fundamental question of whether the MFIs are really a boon to the poor that are underserviced by the banking system or merely vultures that are replacing the moneylenders that were already charging usurious interest rates.

Let us begin by looking at the cost structure of the industry. There are three main cost components: cost of capital (11-12% for the top ones, 1-2% more for others), loan loss provisions (2%) and transaction costs (SKS reported 12.66% for fiscal 2009 in its prospectus). The transaction costs are high because of the mode of collection of repayments which is usually done on a weekly basis and the personnel costs. The sum total of these works out to be roughly around 26-30%.

In the wake of the spate of suicides, there is a call for the interest rates to be capped. But, the MFIs defend by saying that the interest rates they charge are probably what the credit card or a personal loan from a bank would cost, may be even a little lesser than them. (Average interest rate charged on credit cards in India-hold your breath, is a whopping 34%). They argue that though the proposed cap of 24% offers client protection, the needy might find excluded from this institutional credit system altogether! The logic is that the start-up MFIs and other smaller ones in remote areas will make losses for many years before breaking even. This also would mean that MFIs would avoid remote areas where process of delivering loans and collecting repayments is people intensive and quite expensive. Also, small ticket loans might not be issued because of the huge transaction costs involved. Hence, needy people cannot be brought into the ambit of Microfinance. Thus, it appears as if there is a trade-off between the availability of institutional finance and the reduction in interest rates.

Further, the argument is that as MFIs establish their business model in each market and start competing for customers, capital, employees and banking relationships, the economies of scale kick in and as they adopt new technologies, they would innovate in products and means of delivery/repayment to reduce the transaction costs and hence, the interest rates. Another thing that is used to oppose interest rate cap is the Raghuram Rajan Committee on financial sector reforms which says that liberalizing interest rates would allow the formal sector to lend to the poor and not the interest rate ceilings.

The proponents of a need for regulatory system for MFIs including a cap on the interest rate spread argue that the MFIs are making hyper profits at the expense of the poor robbing them of the meager surplus. Also, they point out various irregularities in the current MFI system, which include usurious interest rates, lack of transparency, cheating and using coercive mechanisms to recover loans like moneylenders.

They allege MFIs of indulging in multiple lending without due diligence exercise on the capacity to repay, purpose for the loan and its end use which is in direct violation of prudential norms. This raises the possibility of large scale defaults leading to a large chunk of Non Performing Assets (NPAs) which could have cascading effects on the balance sheets of the banks. They are also worried about the lack of transparency on effective interest rates and explain that because of weekly recoveries, poor unable to understand the usurious rates and that they are being taken for a ride by the MFIs.

The high transaction costs could also be because of the exorbitant sums of compensation the CEOs pay themselves in the large MFIs as pointed in the literature (Sriram, 2010). There is a total lack of transparency in this regard.

In the case of AP, critics point out that the state has had a community based SHGs existing more than 10 million women organized and federated at the village, mandal (an equivalent of Taluka) and the district levels. Further, Society for elimination of rural poverty (SERP) has achieved financial inclusion by linking SHGs with the banks. It holds more than 20,000 crores of outstanding loans on its books. MFIs are merely piggybacking on this system by showing them as Joint liability groups (JLG) formed by them. They are resorting to inducing SHG members to join the JLG by wooing the group leaders through freebies. Unlike SHGs MFIs getting hyper profits In case of non-payment or default, coercion and unethical means of recovery ranging from confiscating household articles using goondas, to forcing defaulters to take further loans for repayment and so on, which leads to distress and an increasing number of suicides.

They argue that currently there is a regulatory vacuum and the RBI needs to step in with a framework. The AP government itself is in the process of issuing an ordinance to regulate the activities of the MFIs.

The regulators must focus on improving MFIs’ lending practices, make them more transparent, ensure the clients understand the terms of loans and make sure that measures are in place to reduce multiple lending to segments like agricultural labourers for personal purposes rather than merely putting a cap on the interest rate spread.

In all, it is pretty clear that all is not well with the way MFIs are conducting themselves in the guise of NBFCs. It is definitely not working the way one leading MFI put its purpose as- Our purpose is to eradicate poverty. We do that by providing financial services to the poor and by using our channel to provide goods and services that the poor need. However, one positive to emerge out of this discussion is that these excesses by MFIs are being debated in the public domain is because of them being in organized space. The faceless moneylender who might’ve caused much more grief to the poor was never in such a spotlight.

Reference: “Commercialisation of Microfinance in India: A Discussion on the Emperor’s Apparel” by M S Sriram, March 2010