Thursday, November 11, 2010

The Indian Microfinance saga

Over the past few weeks, I have watched in consternation as the malice and hatred inside and towards the MFI industry has spilled onto the streets, and in the media, and the paragons of virtue (the promoters of MFIs) have perceptibly fallen from grace. The drama has all the ingredients that a Bollywood blockbuster requires - the poor looking for messiahs, greedy MFI promoters, husband-wife battles, politicians hungry for power, red-tape and bureaucrats, billion dollar IPO valuations, the inevitable suicides, and the clamping down. From the glowing and rich praises heaped upon the work of Nobel laureate Md Yunus of Bangladesh, to a typical corporate-political potboiler is quite a distance travelled by the MFI industry, in South Asia.

For any entrepreneur, management student, or a policy-maker, the MFI saga presents an excellent ground for learning.

Before I get into the nitty-gritty of this story, let's run through the basics.

What is the concept of "microfinance"?
When you lend money to tiny businesses, you are doing 'microfinancing' of those tiny enterprises. A tiny enterprise could be as small as just one individual.

What are MFIs?
Imagine the scenario in small villages and towns, when people who have very little steady streams of income want to grow and meet their financial obligations and chase their dreams.. and no established source of credit comes to their rescue. Big banks surely do not. Governments are - generally speaking - tardy enough not to be very effective. So who helps these guys, if at all? It's the Microfinance Institutions (MFIs). These companies (or institutions) extend "loans" to these small guys. So naturally, it all sounds good. The small guy needs small sums, the MFI hands it over to them, and everyone is happy. So, microcredit is given to many borrowers by microfinance institutions (MFIs).
Microfinance firms typically give loans to small businesses that have no access to banks and charge an effective rate of 28-32 per cent a year, about double the rate on bank loans.

How does the business model actually work?
Surprisingly it was found in many countries (starting with Bangladesh) that these small guys have a better repayment rate as compared to 'big guys' who borrow from big commercial banks. So much for society's progress!
The system of microfinance (including that of the famous Grameen Bank, Bangladesh) is based on the idea that the poor have skills that are under-utilized. A group-based credit approach is applied which utilizes the peer-pressure within the group to ensure the borrowers follow through and use caution in conducting their financial affairs with strict discipline, ensuring repayment eventually and allowing the borrowers to develop good credit standing. Thus, in India, the leading company SKS Microfinance would give loans not to individuals but to groups of 5 women. Even their logo shows this fundamental business tenet. In the event of any single woman's default in loan/interest repayment, the others have to make good. So, borrowers (who are all women) take loans from SKS for a range of income-generating activities, including livestock, agriculture, trade (such as vegetable vending), production (from basket weaving to pottery) and new age business (photography to beauty parlours). SKS also provides members with interest-free loans for emergencies as well as life insurance and loan cover insurance to borrowers.
In theory, and practice, all this sounds good, and worked well.

So, a business model can be built around microlending. What's the Bangladesh story?
Yes, as we saw, it can be. And that is what many companies tried to do. And were successful. In Bangladesh, this concept was tried first as early as 1974. Muhammad Yunus was inspired during the terrible Bangladesh famine of 1974 to make a small loan of US$ 27.00 to a group of 42 families so that they could create small items for sale without the burdens of predatory lending. Yunus believed that making such loans available to a wide population would have a positive impact on the rampant rural poverty in Bangladesh. The greatest recognition of the bank's achievements came on October 13, 2006, when the Nobel Committee awarded Grameen Bank and its founder, Muhammad Yunus, the 2006 Nobel Peace Prize "for their efforts to create economic and social development from below.

Why so much negative news in the past few weeks?

More than 50 suicides have been reported in Andhra Pradesh alone. These are all clients of some or the other MFI. And a conclusion has been drawn - rightly or wrongly - that due to wrong lending practices, these people over-borrowed (from multiple MFIs) and hence were in no position to repay the various loans. The MFIs started putting pressure for recovery, and many committed suicides.
These suicides by the poor suddenly attracted mainstream media attention, and of course, presented a great opportunity to various political parties to strengthen their mass appeal with grassroot voters.
Hence, the whole situation turned volatile suddenly. To be fair and honest to the MFIs, I do not think that they played any active role in ensuring these suicides! They were doing their job - recovering outstanding dues in a competitive local environment. The factors that led to the suicides must have been part systemic, part personal.

Overall, what is going wrong with the industry dynamics?
Basically, 6 things have gone wrong in tandem. Some may be cause, and others the effect. Or vice-versa.
  1. The fundamental structure of formal Banking, which is not flexible enough or deep enough to reach those living on the fringes of society quickly and effectively - this led to the rise of the MFIs in the first place. Because Banks have to work under the government's priority sector lending obligations, at times they find it better (provided the local situations allow) to lend to one MFI rather than thousands of tiny businesses, and that makes it easy for MFIs to raise funds.
  2. Excessive and quick success of SKS which bred tremendous motivation in other players to enter this field of fundamental social service - Many players entered in a competitive corporate manner (a basic mismatch of ideologies!). This was matched in ferocity only by the IPO scandal, the firing of the SKS CEO and the damaging revelations by the ex-wife of Vikram Akula gave strength to all industry distractors - "yes, they can be attacked". In less than 100 days, the messiahs have all turned pariahs! Astonishing.
  3. Aggressive loan-giving without creating adequate personal relationships leading to drop in realisations and tearing apart of the delicate fabric of community shame that's a basic pillar of MFIs' long term success - When they give the microloans, they ensure that the group of women they lend the monies to forces any defaulter to pay up in time. This keeps the system accountable and operationally stable. But as more players entered, everyone pushed loans onto the poor people by compromising the basic tenets.
  4. Changing habits of the 'poor' when they realise that multiple MFIs are competing to offer loans - to put it crudely, beggars suddenly become choosers and can play one MFI against the others. To hell with prudent lending norms! And expect the inevitable.
  5. Poor economic factors in some regions - leading to poor repayment capabilities, more aggressive recovery tactics, culminating in suicides by the indebted
  6. Involvement of political parties to settle their mutual scores (especially in AP) - this created a suddenly adverse environment for operational working of MFIs, and it was topped by an extremely stringent ordinance regarding interest rate capping and loan-recovery practices of MFIs (in AP)
As they say, microfinance used to work on two tenets: income generation and social capital. Unless the loans would help create income-generating activities, women could not repay the 30% interest without driving themselves into destitution. Simultaneously, the MFIs had to forge a form of social capital that would encourage repayment. Both these tenets were compromised with as the MFIs chased growth. They started thinking that their role was only of giving credit, and focused on making processes idiot-proof and scalable. They left income generation and social-capital building to the groups and the government. This marked a big downfall in their working style.

Meanwhile, the easy money changed the villagers' outlook towards loans. Instead of feeling ashamed about being indebted, they may make rival MFIs compete with each other on the rate of interest!
The volatile political situation in states like AP (homestate of SKS Microfinance, the largest of them) fanned the fire even more. The Congress government, which was losing political space due to aggressive stand taken by opposition on the suicides related to microcredit, hurriedly introduced a strong ordinance. It was aided by the bureaucracy, which never liked the MFIs in the first place!

As per a newspaper report - Vikram Akula, the executive chairman of the company, had announced his decision to slash interest rates from 31.08% (inclusive of insurance and registration charges) to an all inclusive 24.55% immediately after the ordinance was passed. The company now says it will levy 24% in all states where it has operations. SKS, the first microfinance institution to be publicly listed, said that its business has taken a beating as the ordinance disrupted the company’s field level operations. “AP accounts for 27% of the total portfolio, the proposed change in the operating model, the disruption in customer connectivity, resultant reductions in collection and the drop in interest rates, if not redressed are likely to have a material impact on profitability,” the company said.

All this ruckus is said to have impacted their business as collections were hit. SKS now has a 94% repayment against 99% earlier.

As a closing note, colour was added to the whole sordid saga by a scandalous expose by Ms Malini Byanna (ex-wife of Mr Vikram Akula). The letter can be read here .

The MFI industry will take its own time now to recover from this sudden turn of events. It will be wrong to say that all of them are crooks; it would be better to understand the alignment of forces that has led to the present state of affairs.

Before I propose some solutions, I would like to quote Mr Swaminathan S A Aiyer, who defended the MFIs in a recent article. He wrote and I quote -
"Should lending rates of microfinance institutions (MFIs) — often 28-36 % — be capped? Some folk think so. Officials in Andhra Pradesh once closed down MFIs for usury, but the RBI came to the rescue, declaring there could be no cap on lending rates. Banning MFIs would only drive poor people into more expensive loans from moneylenders. MFIs have provided finance to 20 million poor people, whom nationalised banks could not reach. The RBI itself has promoted microcredit by classifying bank loans to MFIs as priority sector loans.
But now capping has again come to the fore. The finance ministry has apparently told banks to ensure that MFIs to whom they lend cap their lending rates at 22-24 %. This directly contradicts the RBI policy that there should be no interest rate caps, and the RBI is the regulator of banks. It remains to be seen whether the RBI will assert itself or give way on this.
Charging poor people 30% interest sounds terrible. Resentment is building up after the IPO of SKS Microfinance, India’s biggest MFI. Its shares were launched at Rs 1,000 and have soared to Rs 1,400. Other MFIs are queuing up for fresh IPOs. A sector that started as a service to the poor now looks a moneyspinner , attracting private equity funds with no social aims whatsoever. Some MFIs have a return on assets of 5-6 %, much higher than banks. 
Is this unwarranted loot? Not at all, say the poor. They clamour for more such loans, and repayment rates exceed 99%, suggesting the interest rates are affordable. Critics say the poor are financially ignorant and being duped. Wrong: the poor are astonishingly sophisticated money managers, simultaneously handling multiple assets and liabilities. Indeed, their annual financial turnover, as they juggle assets and liabilities, can be three times their net assets. This is detailed in a seminal new book, Portfolios of the Poor by four microfinance experts — Collins, Morduch, Rutherford and Ruthven. It should be compulsory reading for the finance ministry and all other critics."

Are solutions possible?
Yes, indeed. Most of them lie hidden inside the problems.

Solution 1. Rigorous supervision of lending practices by the RBI and State Governments
This will ensure that accountability at all levels is maintained. Of course, this is a generic solution, but this is always the first and the most important step.

Solution 2.
Numerical cap on various critical numbers of MFIs

Since MFIs are in a socially sensitive sector, they must be treated not like full-fledged corporates. At the same time, they cannot be treated like charities. So create a new category of companies - Quasi-corporates, if you will. Once this is done, then legally the government can put a cap on certain critical ratios of these Quasi-corporates. One such ratio will be the No.of loans disbursed per employee. This is a direct control on quality of relationships that the Quasi-corporate will maintain with their microcredit clients. This solution may seem stifling at first sight, but in light of what is happening to the whole sector now (everyone may sink together), it is better to grow slowly and steadily.

Solution 3. Ban MFIs from the capital markets

The capital markets don't go well with the charter of MFIs. The greed factor that drives a capital market is the perfect recipe for disaster with an MFI. So new sources of funds need to be created - which the government can, with some thought - and this risk factor needs to be permanently eliminated. No stock market listing, no IPO, no scandal, no huge bonuses, no mind-boggling billion dollar valuations ... just plain simple social service with a clean profit. That's all. A perfect balance.

Solution 4. Integrate the UID project with MFI operations
Again, this may sound fanciful at this stage, but the UID project (Aadhar project) can be integrated (using an IT backbone) with the operations of microfinance institutions, so that habitual or regular defaulters are automatically debarred from utilising certain government benefits, and non-habitual defaulters are penalised differently.

Other solutions that come to mind - capping the number of MFIs that can operate in a region etc. for ex. - bring to mind the horrible memories of licence-quota-permit-inspector raj, and hence are best avoided.

All said and done, it seems that in the short run the worst sufferer, as always, will be the aam aadmi. In this particular case, the one on the remote fringes.

The Devil's Advocate : Let me play the devil's advocate here. Is there a chance, just a chance, that all this ruckus is created out of the fear of local politicians who now see their power of granting patronage to villagers and these small-guys getting eroded, due to easy credit availability from the MFIs? If yes, then this is perhaps the most telling comment on what India has become in 60+ years of independence. "Keep them ignorant, keep them powerless, for that is where the power will be derived from!"


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Rajan Alexander said...

“I’ve made a tonne of money… more than I ever thought I would make in my lifetime and my kid’s lifetime combined,” says Vikram Akula in a recent interview to Business Standard.

If blood diamonds are boycotted, we should boycott blood MF.

Micro-Finance to Face Slow Painful Death. SKS Share to enter Free Fall. Sell, Sell, Sell!
Read more:

Test said...

Pratik Agrawal - Wonderful analysis of the situation. The main problem lies with the situation is bringing extreme Capitalism in this good profit led social service...As pointed out in the solution no. 2 by you, it is the best solution for this problem.

These two articles by Mr. Swaminathan S. Anklesaria Aiyar can add more knowledge to the reader.

Ishita Singh - Taking a profit-oriented approach in a social cause is always risky, though many have been talking of sustainable social development. This saga serve to show how far we have yet to go.

Test said...

Shephali Dhawan -

Following the crisis in Andhra Pradesh .........

According to a news last month in ET.........

wherein the state government had asked local MFIs to close down operations as they competed with the state lending programme called Velagu, microfinance institutions (MFIs) are seeking non-banking finance company (NBFC) status from RBI to get wide access to funding, including bank finance....................

And also that banks are becoming increasingly skeptical to lend to non-NBFC MFIs....

MFIs and NGOs are looking at broad-basing their sources of funds......

So i believe the An NGO and an MFI could operate in the form of a trust registered with an NBFC under RBI norms.

By this they can widen their capital base lowering the cost of borrowers.

Test said...

Sachin Udepurkar

• Vide me thre are certain questions which needs to taken into account.......Although microfinance sector is new in india but as per me i dont think controls those are applicable in other financial services industry are different in this sector eventhough amount transacted is comparatively less than other financially services/products. Controls will be same. Then why such events are occuring ? Is there lack of willingness towards transparent work ? bcoz there are many seniors in corporates who believes that TRANSPARENCY IN BUSINESS IS NOT POSSIBLE (VERY BAD AND WEAK SORT OF LEADERS ACTUALLY) asthis top leaders have not understood what exactly the transparency means in BUSINESS......Shame on such incompetitive peoples who are on that position just becoz of development that took in india (late 90s and not bcoz of there skill or competitiveness). As per them to survive/sustain one has to be intransparent. Besides if this people are experienced then where does the problem lies? Experience of what ? as every situation that arises is new and the ECONOMIC development cycle of country that comes every moment is in itself very much NEW wherein such experienced people too are new to such situations ? (as opposite to our personal family life cycle wherein major activities are static i.e Father and mother expects there child to get married, new generation will follow on wherein this father and mother helps and share there experiences with there children)

Thereby as per me lack of willingness to apply there experinces due to feeling of insecuredness/incompetitiveness and to be transparent, not allowing the employees under them to excel and being under assumption that if we are not transparent then we cant succeed/profit in BUSINESS i.e a sign of insecurity gives rise to such deeper malaise.

Test said...

Arpit Gupta - I did hear the removal of their Indian operations head a couple of months back and maybe the stock is also not doing good for SKS. Well the concept is good and maybe its going through the tough times. Same happens for almost all the industries that are new and have yet to prove their mettle. These are testing times and if some companies come out with flying colours in these turbulent times, they are here to stay for a much longer time.
The market sentiment keeps changing from time to time, its upto the company to remain focused and do the necessary changes that align them better to handle current and future needs of capital and financing.

Thinker said...

Hi Sandeep,

According to Swaminathan - "Is this unwarranted loot? Not at all, say the poor. They clamour for more such loans, and repayment rates exceed 99%, suggesting the interest rates are affordable."

If the repayment rate is 99% and the 1 year PLR is less than 10% then in a free-market economy, the interests rates should be close to the PLR. According to the standard risk-return theory, many players will enter the market until the interest rates become close to the PLR. Unfortunately, here the markets are working in the wrong direction. Many players have indeed entered the market, but have forced the default rate north, rather than forcing the interest rate south.

So we have a situation called the "tragedy of the commons". The honest borrowers have to finance the loot of defaulters. What is the solution? A law that aligns incentives to reach a socially desirable outcome. Any suggestions on what such a law would be?

Thinker said...

Hi Sandeep,

According to Swaminathan - "Is this unwarranted loot? Not at all, say the poor. They clamour for more such loans, and repayment rates exceed 99%, suggesting the interest rates are affordable."

If the repayment rate is 99% and the 1 year PLR is less than 10% then in a free-market economy, the interests rates should be close to the PLR. According to the standard risk-return theory, many players will enter the market until the interest rates become close to the PLR. Unfortunately, here the markets are working in the wrong direction. Many players have indeed entered the market, but have forced the default rate north, rather than forcing the interest rate south.

So we have a situation called the "tragedy of the commons". The honest borrowers have to finance the loot of defaulters. What is the solution? A law that aligns incentives to reach a socially desirable outcome. Any suggestions on what such a law would be?