Chennai, India, January 03, 2009 - These are exciting times for microfinance. While competition bodes well for efficiency of the sector as a whole, unregulated and mindless competition could well end up hurting the entire industry and cause irreparable damage to the vulnerable segments of society that it seeks to serve, says P. N. Vasudevan.
With about 180 million poor households in India, poverty alleviation commands a significant portion of our policy-makers’ attention. Financial inclusion is widely accepted as a crucial step in this direction. In the past few years, the RBI has mandated that banks open many more no-frills accounts for the poorer sections. In parallel, the profusion of microfinance has brought a wide range of poorer people (especially women) into the formal financial services fold.
However, the over 100 per cent y-o-y growth rate of microfinance institutions (MFIs) has triggered comparisons with the rapid rise of sub-prime mortgages in the US. In both cases, loans are provided to the less affluent sections of the society with few credible credit appraisal mechanisms. The credit appraisal of individuals with no prior relationship with formal financial services sector is almost impossible.
This was the precise problem creatively addressed by Dr Mohammad Yunus’ Grameen model. By requiring community members to cross-guarantee each other’s loans, the model leveraged the knowledge and peer pressure embedded in the members’ social network in ensuring prompt repayment among members. The credit appraisal is, in effect, out-sourced to the members themselves!
Pioneering this model, Grameen Bank has been serving the poor in Bangladesh for a few decades now without giving rise to any sub-prime crisis. And the global success of microfinance players following the Grameen model is a mark of its robustness.
The usefulness of the model, coupled with the vast untapped demand, has led MFIs to move from an NGO model to a for-profit corporate format and, in parallel, elicited the interest of private equity players. Ironically, the success of the Grameen model could prove its undoing.
A large majority of customers may not have the skill-sets to scale up their businesses substantially to absorb the additional loans available. This may result in consumption-led loans than income-generating loans, with its natural consequences.
While the competition between new and existing MFIs bodes well for efficiency of the microfinance sector as a whole, unregulated and mindless competition could well end up damaging the entire industry. More importantly, it could cause irreparable damage to the vulnerable segments of society this industry seeks to serve.
The fall of the small-ticket personal loans (STPL) segment in India provides vital clues on how not to run a lending business. Initially, a couple of players provided STPLs successfully over many years.
However, in 2006, with the entry of as many as eight new players into this segment, the supply-demand equation dramatically shifted. The massive growth of STPL portfolios of all lenders was facilitated by their tendency to find a competitor’s customer and provide an additional loan to the individual — instead of finding a new credit-worthy customer.
Credit appraisal was limited to verifying that the individual had repaid his loan from other STPL players promptly. This led to a ballooning of an individual customer’s indebtedness and, with time, a sufficiently large number of customers defaulted to bring the entire STPL industry to its knees.
NPAs increased four-fold to 20-30 per cent. Almost all STPL players found such poisoned portfolios unsustainable and exited the segment. Thus, a segment that had only a couple of years ago proved profitable for a few players sank with the entry of too many new players.
Over the past year, MFIs and their partner banks have recognised that there is a clear danger of the rapid infusion of finance exposing members to unsustainable levels of debt.
However, with concerted action, MFIs could still deliver on the dream of financial inclusion for the masses, without exposing the most vulnerable in society to hard times.
MFIs in Tamil Nadu and Karnataka have formed associations to formulate a concerted plan to tackle these problems.
Such associations play a vital role in enabling sharing of information among MFIs. We also urgently need coordination amongst the various MFI practitioners so that a focus on too few customers and consequent over-burdening of clients is prevented.
MFIs are in the process of designing a mutually agreeable code of conduct that would include, among other aspects, a commitment to prevent multiple lending.
A comprehensive communication campaign has also been proposed to help members understand the perils of over-borrowing. This campaign would work in tandem with rigorous training to customers and skill-building exercises. Coordination among MFIs is a must to build sustainability into this sector. Many of the institutions have also built portfolios of allied products to induce prompt repayment.
Through these initiatives, MFIs provide their members access to financial as well as non-financial products and services. This carrot-stick approach is expected to keep the repayment rates at acceptable levels.
Most MFIs are, however, constrained from expanding their suite of financial services under the prevailing regulatory framework.
The Raghuram Rajan Committee had proposed the establishment of small finance banks as a crucial step towards financial inclusion. Regulatory intervention to enable MFIs to grow into such banks would strongly empower the microfinance industry.
Microfinance has the potential to positively impact millions of poor Indians. Dr Mohammad Yunus and Grameen Bank richly deserved the Nobel Prize for conceptualising and implementing such a creative framework to deliver credit to the poor.
To scale this model for it to be able to address the large potential in India, MFIs will need to collaborate in building a sustainable and successful industry. They have made an impressive start in this direction.
Regulatory intervention for transforming MFIs into small finance banks and for leveraging m-banking as a tool for expanding financial inclusion would help nurture the microfinance industry.
These are exciting times for the microfinance segment. The next few decades could truly transform the nation through the largest financial inclusion programme in the history of mankind, duly supported by the Government, policymakers, regulators, bankers, investors and MFIs, and with the active involvement of client groups.
By integrating 180 million poor households into the India growth story, the slogans of ‘Garibi Hatao’ and ‘India Shining’ can truly become a reality.