Microfinance in India

chillibreeze writer — Mohammed Afroze Ali

SKS Microfinance, the largest microfinance institution in the world, made waves August last year when its offering for equity shares received a thumping response from the investor community. It was the first-ever IPO to come from the Indian microfinance stable. It was, quite conveniently, the last bout of good news for the industry as its fortunes plunged soon after. So, what went wrong for an industry that was seen as an answer to India’s perennial problem of Financial Inclusion? Before we answer the question it is imperative that we understand the evolution and structure of the Microfinance sector in India.

Evolution & Structure
Government-backed National Bank for Agriculture and Rural Development (NABARD) through its SHG-Bank Linkage program pioneered Microfinance in India. Self-Help Group (SHG) is a group of 11-20 members, usually women. In this model, loans are given to the group as a whole. The money borrowed is then lent to the members at the discretion of the group. The idea is to inculcate financial discipline and formally link people to a bank, thereby promoting financial inclusion.

One of the problems with the SHG model, as is with most of the Government-run schemes, is the lack of margins in the model. The loans, simply put, are subsidized by the government. Hence, not surprisingly, there have been problems with scalability of this model.

If NABARD pioneered the SHG model, Grameen Bank in Bangladesh under the astute leadership of Nobel-laureate Muhammad Yunus made the Joint Liability Group (JLG) model worthy of emulation. In this model, the Micro-Finance Institution (MFI) is responsible for formation and management of the group. Here, the MFI borrows from banks and in turn lends this money to the rural folk in the form of various small-ticket loans. The loans are given to individuals but are backed by group-guarantees. The small-size-high-volume nature of loans pushes up the personnel and administration costs of the MFIs. However, with the freedom to pass on the costs to the end-clients, the JLG model allowed MFI decent margins. MFIs typically charge their borrowers 24-32% and raise money from banks at 9-12%.

With decent profits to be made, the Indian microfinance sector became the darling of Private Equity players as it attracted truck loads of equity funding. This gave rise to a paradigm shift in the way MFIs operated. Margins which were secondary till then now couldn’t be ignored. A debate ensued behind the motives of MFIs. Was it serving the poor or profit-maximization? The entry of PE players also gave rise to a healthy competition between MFIs. Their rapid growth soon outpaced the Government-run SHG scheme.

Role of Andhra Pradesh
Any discussion on Microfinance would be incomplete without a word on Andhra Pradesh, the hotbed of Indian Microfinance. Home to 4 of India’s biggest MFIs, Andhra Pradesh has been a state where both the models have thrived. The MFIs had innovative products and used fresh approaches aided by technology. Consequently, despite having a better product and low costs, the SHG model was losing its customers to the more aggressive MFIs. It was a challenge for the government as it did not like any sort of interference, especially in rural areas, where it wanted to be seen as the messiah of the masses. Thus, it was all but natural that this competition between the government and the MFIs would go out of hand.

All hell broke loose soon after SKS got listed. Corporate governance became a major issue as its CEO was ousted months later. The industry was yet to recover from this jolt when disaster struck in the form of media reports highlighting the “dark side” of the MFIs in the state of Andhra Pradesh.

It was alleged that MFIs charge interest rates as high as 60% besides using coercive methods for recovery of loans, which in some cases had led to suicides. The extent of truth behind all these allegations is difficult to ascertain. The state government which was all along looking to persuade back people into the SHG scheme, got its opportunity to hit out at MFIs. It immediately promulgated the AP Microfinance Ordinance in October 2010, which required MFIs operating in the state to register themselves, failing which they could neither grant nor recover any loans. It asked them to recover loans on a monthly basis rather than once a week as was the norm. It also made it mandatory for the MFIs to seek approval for every other loan lent out by the MFIs. As if this was not enough, the local politicians asked people to stop repaying their loans to MFIs. The state government asked the Reserve Bank of India (RBI) to look into the aspect of capping interest rates on the loans being lent out by MFIs. The RBI was against the proposal of placing any restriction on the interest rates.

Regulator…Who?
Subsequently, questions began to arise on the regulatory aspects of Microfinance. There was a lot of confusion on the body governing the MFIs. Was it the RBI or the state government? Owing to the uncertainty banks stopped lending to MFIs, which were functioning as Non-Banking Financial Companies (NBFCs) under the RBI.

The RBI, now under pressure from all quarters of the government, instituted a sub-committee under the chairmanship of Y.H.Malegam to study the working of MFIs and recommend appropriate steps to ensure the smooth functioning of the MFIs. The Malegam Committee submitted its report to the RBI in January 2011. The committee suggested the creation of a new category of Non-Banking Financial Company MFIs (NBFC-MFIs). It also recommended a cap of 24% on the interest rates on the loans lent by the Micro-Finance Institutions. This cap was based on the assumption that MFIs can procure funding at 12%. It also capped the loan limit to Rs. 25,000 for a single borrower. Not surprisingly, the proposals met with mixed reactions. Many experts opined that it would kill the mid-sized Microfinance entities.

The Union Government wishes to pass the Microfinance bill which would bring the MFIs firmly under the supervision of RBI. In March 2011, it appointed a committee under financial services joint secretary K.V. Eapen to factor-in the recommendations put forward by the Malegam panel into the Microfinance bill.

Conclusion
Microfinance serves the needs of the poor and has helped many a rural folk come out of poverty. The fact that it is worth Rs. 22,000 crore lends credibility to the claim. It is, thus, too important an industry to be allowed to ruin. There are issues that warrant introspection from both the MFIs as well as the government. Only if both sides get their act together, can the dream of Financial Inclusion be realized.

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Chillibreeze's disclaimer: This is a contributed article and was published on Chillibreeze in May, 2011. The views and opinions expressed in this article are those of the author(s) and do not reflect the views of Chillibreeze as a company. Chillibreeze has a strict anti-plagiarism policy. Please contact us to report any copyright issues related to this article. The relevance of the facts and figures cited (if any) could change after a period of time.

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—About our writer:

An alumnus of IMT Ghaziabad, Mohammed Afroze Ali, works as an Associate Consultant with a multinational corporation. A relative greenhorn to writing, it was only during his PGDM days that he discovered his passion and talent for the profession. He started blogging besides writing an article for an inter-BSchool magazine. And now he wishes to showcase his talent, learn and improve his skills in the process. Business research and Cricket are areas that he writes on. He is currently based in Hyderabad.

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