crisis in indian microfinance and a way forward: governance reforms and the tamil nadu model

FIELD REPORT

CRISIS IN INDIAN MICROFINANCE AND AWAY FORWARD: GOVERNANCE REFORMS

AND THE TAMIL NADU MODEL†

ANA MARR* and PAOLA TUBAROIBE, University of Greenwich, London, UK

1 INTRODUCTION

In recent months, microfinance practitioners worldwide have been holding their breathover events unfolding in India. Beginning in summer 2010 with controversies surround-ing the IPO of SKS, a large microfinance institution (MFI) and a major player in themarket, the crisis subsequently deepened in the state of Andhra Pradesh, with borrowersdefaulting on payments and even taking their own lives. Echoed by the media, hostilityto microfinance rose to unprecedented levels, and some politicians even encouragedborrowers not to pay back their microloans. Fearing deterioration in MFIs’ financialsolidity, numerous banks suspended flows of funds to them, leaving them severelycash strapped.Nevertheless, until recently, Indian MFIs were widely praised for their contribution to

the fight against poverty. By providing financial services to low-income clients, particularlywomen who would otherwise have limited or no access to them, microfinance has enabledthem to develop small businesses and to reduce the volatility of their incomes. Even tinyloans have often been sufficient to empower the Indian poor. How, then, can the currentturbulence be explained?Our field study of microfinance in India during January 2011, at the end of the

second year of a three-year Leverhulme-funded research project, addresses these con-cerns in a two-fold way. First, the study looks at the global picture of the whole setof interorganisational partnerships that relate MFIs to relevant stakeholders and

*Correspondence to: Ana Marr, Reader in International Development Economics and Principal Investigator ofthe Leverhulme-funded research ‘Optimising the Dual Goals of Microfinance’ at the University of Greenwich,London, UK.E-mail: [email protected]†We acknowledge, with gratitude, the financial support of The Leverhulme Trust to the research project‘Optimising the Dual Goals of Microfinance, of which this field report is part.

Copyright © 2011 John Wiley & Sons, Ltd.

Journal of International DevelopmentJ. Int. Dev. 23, 996–1003 (2011)Published online 7 August 2011 in Wiley Online Library(wileyonlinelibrary.com) DOI: 10.1002/jid.1823

regulators; as such, it is best positioned to bring to light systemic issues of the micro-finance market and to identify suitable policy responses. Second, our analysis focuseson the state of Tamil Nadu, which is geographically close to Andhra Pradesh and simi-lar to it in terms of size and maturity of the microfinance market but to which the crisishas not spread. It thus enables us to identify differences in the operations of MFIs inthe two states that, despite a common landscape, may explain their differential capacityto achieve financial and social performance. On this basis, our analysis aims to contributeto the definition of a more sustainable model of microfinance, possibly to be extended toother parts of India.

2 SYSTEMIC BOTTLENECKS IN INDIAN MICROFINANCE: A NEED FORENHANCED GOVERNANCE

To understand the nature and development of the Andhra crisis, it must be acknowledgedthat microfinance is a network of partnerships and relationships: between poor clients andthe microfinance institutions (MFIs) that provide financial services to them; between MFIsand their funders, may they be multilateral institutions, donor governments, nongovern-mental organisations (NGOs), for-profit companies, banks or cooperatives; and betweenMFIs and regulators. The intrinsic complexity of the system, consisting of many layersand involving multiple actors, results in a great deal of uncertainty about where risk liesand how it spreads. It also makes it more difficult to track the chain of direct and indirecteffects of regulatory measures and to assess their global impact.To shed light on the intricacies of the system, at least, in part, we have mapped the

complete network of ‘wholesale’ relationships through which MFIs based in TamilNadu obtain credit from various institutions and organisations in order to support theiractivities. We have built an original database of lending relationships for 2006–2009,including all MFIs that are either headquartered in Tamil Nadu, or have operationsthere (36 organisations) and their wholesale lenders (89 organisations). The databasehas been built from multiple sources, primarily audited financial statements and ratingreports of MFIs, which are verified by accredited third parties and are therefore highlyreliable. Complementary information has been obtained from the 2009 MicrofinanceReport of Sa-Dhan, a network of microfinance actors in India; MixMarket, a specialisedweb-based data service; and annual reports and web sites of MFIs. Finally, qualitative insighthas been obtained through fieldwork, with a series of interviews performed by the authorswith relevant MFIs and other stakeholders in 2009, 2010 and 2011.The figure below represents the wholesale lending network of Tamil Nadu for the

financial year 2008–9. MFIs are represented as grey circles and lenders as black orwhite squares, a tie between a square and a circle corresponds to a lending relationship.Black nodes are banks and white nodes are other types of lenders (NGOs, governmentagencies, multi-lateral institutions, and specialised microfinance funders). The size ofround nodes (MFIs) is proportional to their number of lenders, and conversely, the size ofsquare nodes (wholesale lenders) is proportional to the number of their MFI borrowers inthe state. Figure 1.The cohesiveness of this network reveals similarities across MFIs in terms of their

providers of wholesale loans. The 2006 and 2007 data, not visualised here, display a similarpattern. MFIs in Tamil Nadu share a tendency to borrow from a large number of domesticbanks (70% of all lenders in 2008). They diversify their sources of funding by increasing

Crisis in Indian Microfinance and a Way Forward 997

Copyright © 2011 John Wiley & Sons, Ltd. J. Int. Dev. 23, 996–1003 (2011)DOI: 10.1002/jid

the number of banks from which they borrow, but they hardly seek diversity in termsof type of lenders; indeed, the presence of governmental and intergovernmental agencies,voluntary organisations, and specialised investors is limited compared to other countries.Among the largest lenders are HDFC bank, ICICI bank, and Axis bank. Very fewnonbanking lenders occupy central positions, namely, Small Industries Development Bankof India (SIDBI), a governmental agency; Friends of Women’s World Banking (FWWB),a non-profit organisation; and the specialised microfinance investor Oikocredit, through itslocal subsidiary Maanaveeya Holdings. Only 20% of all lenders are international (Citibank,BNP Paribas) and operate through their Indian offices or subsidiaries.By and large, this configuration is shaped by requirements imposed by the law as well

as the national regulator, the Reserve Bank of India (RBI). In particular, the so-called‘Priority Sectors Lending’ (PSL) rules oblige banks, both public and private to direct40% of their net credit (32% in the case of foreign banks) to agriculture and weakersectors, including small businesses and deprived segments of society. Many banksfind it cheaper and easier to meet these requirements indirectly, through loans to MFIsand leave to them the task of ‘covering the last mile’ to reach out to rural or poorercommunities. Hence, a large and growing amount of wholesale loans has flowed frombanks to MFIs, with an increase of about 200% over the years, has been considered inour study (Lok Capital, 2010). The global financial crisis has not weakened this trend asthe presence of public-sector banks remained substantial even when some foreign andprivate banks slightly reduced their exposure in 2008; when conditions eased at the

Figure 1. The network of wholesale lending relationships for microfinance in Tamil Nadu.

998 A. Marr and P. Tubaro


beginning of 2009, large domestic banks, such as HDFC and ICICI, increased theirexposure, while new ones entered the market (Srinivasan, 2010).Though it had good intentions, this measure has backfired, producing an excess of easy

credit from banks to MFIs that has yielded unwanted consequences. MFIs have felt underpressure to use these massive amounts of money quickly but with little control over qualityand integrity of their services; and incentives for them to seek funding from other bodieshave weakened, with a form of ‘crowding out’ favouring domestic banks over moresocially oriented investors. As a result, microcredit has swollen but has not beenaccompanied by comparable progress in the provision of financial literacy trainingprogrammes, preparation, follow-up and support services nor has their governanceimproved, as most banks usually limit their monitoring activities to checking the capacityof a sample of clients to repay, but do not have the resources and competencies toassess their overall socio-economic situation. Finally, many MFIs complain that,although banks’ loans are of relatively easy access, interest rates are higher than thosecharged by governmental agencies, charities, or other socially oriented investors andtherefore induce them to raise the interest rates that they themselves charge to finalclients. Ironically, as a result, the riskiness and fragility of poorer clients has increasedinstead of diminishing.This effect, which is present nationwide, has certainly contributed to fuelling the

crisis in Andhra Pradesh and may still render MFIs in other parts of the country fragile.Excessive rapid growth of the sector, lack of sufficient monitoring of clients and exorbitantinterest rates have often been blamed for triggering clients’ over-indebtedness, inability torepay and suicide.The crisis-induced hesitation of banks to provide new loans has been a widespread

concern for MFIs throughout India as few alternative sources of funding seemedaccessible. Indeed, by law, foreign ownership of Indian nonbanking financial companies(NBFC, a category that encompasses most MFIs) cannot exceed 50%, a measure thatdiscourages international equity contributions and increases appetite for debt. Access to thelatter, in turn, is largely limited to the domestic wholesale market, because it is not allowedto borrow from foreign companies unless they are listed in a stock exchange. Finally,relatively high minimum capital threshold and capital adequacy ratios are necessaryfor MFIs to be authorised to take deposits and savings; as a matter of fact, only 8% of thosein our sample are in a position to offer such services. Such restrictions obviously reinforcethe dependence of MFIs on PSL rules for banks, and their vulnerability in case of achange in the law (not expected at the moment, i.e. at the time of writing this report).Other systemic issues, noticed by many commentators of the recent crisis, are the

absence of a national ID system and of credit bureaus, which make it difficult for MFIsproperly to assess clients’ over-indebtedness and overall risk (The Indian Express, 2010).These considerations point to the need of devising a more sustainable regulatory frame-

work for Indian microfinance, opening the way to a wider choice of funding sources forMFIs to sustain their operations. It would not be advisable to remove PSL requirements(at least not in the short run), but new measures should be introduced to facilitate accessto alternative providers of loans. There have also been suggestions that interest rates needto be regulated by the RBI. It is potentially harmful, however, to set interest rates based onpolitical considerations rather than on economic and financial determinants. Economicprinciples tell us that calculations for establishing interest rates are dependent on costsand risks assessments, including the costs of funding and the risk levels of borrowers ofmicrofinance. Therefore, a diversification of funding sources for MFIs with higher



degree of competition in the market, on one hand, would help lower the cost of wholesaledebt and could eventually be passed on to final clients in the form of lower interest rates.Assessing clients’ risk levels, on the other hand, is a more complex issue given informationasymmetries betweenMFIs and their clients; in this regard, indirect monitoring of clients’ risktypes through specific microfinance technologies, such as the group-based model has, sinceits origins, been hailed as an effective way for microfinance to assess clients’ risks, as opposedto setting high interest rates for all customers in the believe that risks are high for all, leadingto moral hazard and loan default, as it appears to have happened in the present Indian crisis.Higher involvement of wholesale lenders that are social investors, public-sector bodies,

development agencies and charities rather than banks, may also improve MFIs’ corporategovernance, especially disclosure of financial, operational and other information as well asmonitoring practices and customer services. This will, of course, require some necessary,and perhaps painful, adjustment in the short run but will certainly benefit the sector in thelong run. The RBI is now working on new rules that may possibly include some of theseprovisions but whose features will only be known later in the year.

3 THE TAMIL NADU MODEL: CONSORTIA OF FOR-PROFIT ANDNON-PROFIT ORGANISATIONS

The above issues relate to national regulation, and therefore, one may ask why they havedifferentially affected the two neighbouring, and otherwise similar, microfinance marketsof Andhra Pradesh and Tamil Nadu. To answer this question, it must first be recalled thataccording to many commentators, for-profit orientation of MFIs in Andhra, epitomised bySKS’s IPO earlier in 2010, was excessive and played a significant role in triggering the cri-sis. Greed, as often claimed, prompted many MFIs to expand their client base aggressivelywithout much consideration for the fragility of the poor communities they targeted. In fact,these accusations renew a debate that has been recurrent in the microfinance literature sincethe 1990s, namely, the potential trade-off between financial and social goals. While today’sconsensus is that microfinance should strive to achieve both goals, some doubt that this isdoable. In India, SKS’s move was criticised by many as opposed to the interests of the poor.However, MFIs in Tamil Nadu offer interesting examples of how the dual goals of

microfinance can be reconciled. A number of interviews conducted in January 2011 withleading practitioners in Chennai, Villupuram and Pondicherry, convinced us of howgenuinely keen they are about their social mission. They have in fact devised a variety ofsolutions to combine the provision of financial services to the poor with social initiatives.A commonmodel involves the creation of a consortium of specialised organisations, typicallya non-banking financial company (NBFC) in charge of microfinance, formally for-profit anda non-profit body (usually under the legal status of NGO or Trust) to provide social services.For example, our focal institution, BWDA, is an NGO that runs, among other things,a college of arts and sciences; its commercial arm BWDA-BFL provides financial services.The children of BWDA-BFL’s clients are the primary target for the educational servicesof BWDA’s college. Similarly, Sarvodaya Nano Finance Ltd. consists of a networkof non-profit primary schools that parallel its microfinance provision services, whichis organised in a separate NFBC. Hand-in-Hand is a Public Charitable Trust that runsseveral social programmes and has expanded from its original Tamil Nadu location to otherdeveloping countries including Brazil, Afghanistan, and South Africa; its microfinance armis Belstar, again an NBFC. Another prominent example is Equitas, which also includes an



NBFC in charge of microfinance provision and a non-profit Trust that operates a number ofsocial programmes for microfinance clients, including a healthcare service, primary schools,after-school tuition for children, and a subsidised grocery store. The NBFC is committedto contribute 5% of its annual profits to this Trust.This model is worth further exploration and may set the example for renewal of

microfinance activities in India as a whole. When financial service provision is closelytied to social services and sometimes funds them at least partly, mission drift is lesslikely, and the growth of micro-credit can be expected to accompany growth in theprovision of supporting services. To some extent, this solution may address one ofthe causes of the recent crisis in Andhra Pradesh, by ensuring a more comprehensiveapproach to development, empowering clients in a broader sense, and ultimatelyincreasing their capacity to repay their debts.The legal separation of the two bodies, one for profit and the other non-profit, also has

the advantage of ensuring greater transparency and better governance, as well as someprotection for the social entity in case the commercial one experiences financial difficulties(see also Lazar and Kogila, 2010).Further studies are also needed on how to measure the impact of microfinance when it is

accompanied by a whole set of social services. A broad long-term set of criteria to measureimpact will be needed in order for this model to expand beyond Tamil Nadu.

4 CONCLUSIONS AND RECOMMENDATIONS

Our report from the field suggests that the recent Indian crisis is fundamentally related toexcessive liquidity in the microfinance system that led to the over-supply of microcreditunaccompanied by basic monitoring of clients’ ability to repay. In this concluding section,we outline some underlying factors in this process and attempt to compare both AndhraPradesh and Tamil Nadu models in order to speculate the extent to which the latter couldhelp restrain the crisis from spreading into other parts of India and beyond, or at leastprovide some lessons for the future of microfinance.Some of the underlying factors explaining the current crisis can be identified at three

levels of analysis:

1. Macro level. Compared to other countries, such as those in Latin America, the Indiangovernment is highly intervening with respect to the microfinance market. PSL rules, inparticular, have locked MFIs into high dependency on local banks for funding.Although this has guaranteed increasing finance for MFI growth, it has not come withsufficient regulation and supervision on the quality of loan portfolio. The lack of creditbureaus in the country also seriously restricts MFIs’ ability to detect multiple borrowingby final clients. In Andhra Pradesh, excess liquidity has led to rapid MFI growthassociated with multiple lending and clients’ over-indebtedness. In Tamil Nadu,interviewees report that, although multiple lending exists, over-indebtedness isnot prevalent. One of the reasons for this disparity appears to be the governancemodel followed by most MFIs in Tamil Nadu and their credit technologies.

2. Governance model. While the fast-growing MFIs in Andhra Pradesh are for-profitinstitutions that were formed as private NBFC from the start, Srinivasan reports thatby 2010, these were growing at 80% per year, the majority of Tamil Nadu MFIs wereoriginally NGOs that were later created for-profit NBFCs but now maintain a tightly



close relationship between the two independent entities. The difference in governancemodel is significant because the interests of microfinance clients appear to be betterpreserved by the continuing presence of the NGO. This manifests itself through theprovision of supportive services to clients, such as capacity building, financial literacy,healthcare services, educational opportunities and value-chain support. Together withmicro-credit provided by the NBFC arm, a more holistic approach is taken to livelihooddevelopment, which is conducive to a better ability to repay loans. Crucially, there is alsoan element of cross-financing of NGO activities by the NBFC, which partly acknowledgestheir value in maintaining a healthy clients’ performance and therefore a good loanportfolio for the financial institution.

3. Credit technology. The excessively rapid growth of MFIs in Andhra Pradesh has beencharacterised by an over-supply of micro-credit that led to clients’ over-indebtednessand loan defaults. CGAP (2010) reports that MFIs in the region use the standardgroup-based technology, as is common in South Asia, or the Self-Help Group (SHG)model, whereby clients save and then borrow. It is also suggested that these credittechnologies were relaxed in the rapid-growth period: (1) loan sizes increasedabove the standard group-based methodology; and (2) loan sizes stopped beinglinked to levels of savings as is common in the SHG model; and loan amountsincreased many times above savings. In contrast, our observations from the fieldare that most MFIs in Tamil Nadu follow the SHG methodology and tend to spendsignificant resources in building capacity throughout the life of groups. Considerableattention is given to the formation of groups in order to achieve cohesive teams thatwould select, monitor and enforce rules amongst members. Economic theory suggeststhat information asymmetries can be overcome through this type of credit technologyas group members would be in a better position to assess peers’ risk levels and theirability (as well as willingness) to repay loans. What appears evident in the Andhracrisis is that these principles have been obliterated, and interest rates have been set athigh levels in order to account for lenders’ perceived high risks, which in turn mighthave increased moral hazard and induced loan default.

In the final analysis, it is still difficult to assess whether the Indian crisis is a symptomof a broader crisis in global microfinance. Certainly, there are particularities in theIndian microfinance system that do not allow for application to other contexts. Thereare, however, general issues of regulation, governance and credit methodology thatcould be replicated, with local adaptations, more widely. In principle, a regulatorysystem that is more conducive to allowing a variety of funding sources for MFIs islikely to lead to reduced cost of funding, which could bring interest rates down forthe final clients; carefully designed credit technologies are also useful in the assessmentof risk and monitoring of loan performance; and a model of consortium of a for-profitNBFC in charge of microfinance and a non-profit body providing social services, withfocus on its potential to improve the capacity of MFIs to strive towards financial sustainabilitywithout losing sight of their social mission, is likely to help develop clients’ livelihoodsand maintain the financial health of institutions.

REFERENCES

CGAP. 2010. ‘Andhra Pradesh 2010: Global Implications of the Crisis in Indian Microfinance.’Washington DC, USA. Focus Notes. No. 67, November 2010.



Lazar D, Kogila G. 2010. Microfinance and SHGs in Tamil Nadu and Pondicherry, India. Ingram.Lok Capital 2010. Microfinance industry in India. Lok Capital: Gurgaon.Srinivasan N. 2010. Microfinance India: State of the sector report. Access Development Services.

Sage Publications: New Delhi.The Indian Express. 2010. ‘Help Microfinance – Don’t Kill It’ Comments from Abhijit Banerjee

(MIT), Esther Duflo (MIT), Erica Field (Harvard), Raghuram Rajan (Chicago), Dean Karlan(Yale), Pranab Bardhan (Berkeley), Rohini Pande (Harvard), Asim Khwaja (Harvard), andDilip Mookherjee (Boston). http://www.indianexpress.com/news/help-microfinance-dont-kill-it/716105/0 (accessed 28.4.11)



crisis in indian microfinance and a way forward: governance reforms and the tamil nadu model

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