Microfinance, Financial Inclusion and Inclusive GrowthMonday, 03 January 2011 22:33

Microfinance refers to a broad range of financial services, primarily credit, made available topeople who don’t have access to formal banking services. Normally, these services would berequired in areas with small population and ‘ticket-size’ entailed would also be relatively smaller(factors making banks’ presence unviable). Therefore, Micro-financial institutions (MFIs)facilitate the reach of financial services at a more ‘micro’ level.

What was being praised for its positive societal impact is today attracting flak for being profitdriven.  But is this change of opinion justified? Does Microfinance make a meaningful societalimpact or is it a over-hyped phrase? Is the dichotomy between ‘social good’ and ‘profit-motive’indispensable? In the light of these questions that are all over the place today, this articleattempts to provide a perspective.

Why microfinance makes sense?

• Cost-effectiveness (Believe it or not!)

o Money lenders charge exorbitant rates (50-100% p.a.) and the lending too is normallysecured by land/ property; So if crops fail, the farmer loses his income (crop proceeds) as wellas his asset (land)

o Commercial Banks charge much lower officially viz. 6-8% p.a. but the overall cost to theborrower far exceeds this number

o Loans can be rarely availed without kickbacks to credit officers

1 / 5

Microfinance, Financial Inclusion and Inclusive GrowthMonday, 03 January 2011 22:33

o Borrower has to make multiples visits to the distantly located bank branches. A normalprocess would require him to visit the bank, once each for understanding the process,completing the documentation, getting disbursement and subsequently for each drawdown/repayment

• Better monitoring of end-use of funds; Improved Credit Discipline

o MS Swaminathan Committee highlighted that defining end-use of funds was crucial toensuring farmers’ prosperity.

When a farmer takes a loan to (allegedly) buy seeds/ fertilizers/ tractor, he can still use thecredit to fund his daughter’s wedding / dowry (debt fueling consumption). The SHG model oflending used by MFIs ensures that funds are used for the purpose that they were first availed(debt facilitating creation of productive asset) and therefore foster improved credit discipline.

o More than 99% of the outstanding MFI-generated credit is still categorized under ‘standard’ orperforming loans, much higher than corresponding ratios (in food credit) for any banks

• Vital tool for Financial Inclusion

o Financial Inclusion is key to inclusive growth and the role played by MFIs in the processleading to employment generation and sustenance cannot be over-emphasized

o Banks lend to MFIs to fulfill their Priority Sector Lending (PSL) targets - 40% for Domesticbanks, 32% for Foreign Banks  - and MFIs use those funds for onward lending

o MoF and RBI’s credit policies constantly pressurize as affirmative action has resulted in allbanks preparing a 3-year target-driven roadmap for enhancing and strengthening financial

2 / 5

Microfinance, Financial Inclusion and Inclusive GrowthMonday, 03 January 2011 22:33

inclusion

o This development is also in sync with RBI/ MoF’s views that the banks reach out to thesegment which is currently being served by MFIs and the MFIs start targeting those who arenow dependant on private money lenders

o Although Micro-credit commands the lion’s share, Micro-finance also includes Micro-savings(generates income for savers and channels savings into productive uses) and Micro-insurance(Crop insurance, cattle insurance, etc.) both of which are vital tools in financial intermediationand consequently financial inclusion

Are For-profit organizations bad?

• ‘High’ rate of interests

o Although there is a case for capping interest rates and regulating the MFIs (which is likely tohappen soon), the high rate of interest is needed to cover

o cost of funds (remember, MFIs don’t have access to low cost CASA funds),

o cost of service (MFI agents visit the borrower for all his requirements and the borrower isrequired to visit the office only once), and

o higher level of risk (lending in not secured by borrowers’ immovable property)

• Sustainability

3 / 5

Microfinance, Financial Inclusion and Inclusive GrowthMonday, 03 January 2011 22:33

o Profits are needed to make the model self-reliant and robust and to incentivize innovation,both of which are crucial to a more sustainable (MFI) business model

Why then did MFIs get into trouble?

Possible triggers :

• Huge rally in the first few months of SKS Microfinance share s (SKS IPO hit markets in July2010) perhaps prompted greed which lead to an unpleasant battle in which CEO was oustedand the Chairman returned to executive role. This public display of boardroom battle (in whichthe outgoing CEO is also reported to have been offered a valuable golden parachute) severelydented the perception of MFIs.

• Political maneuvering of Suicides in Andhra Pradesh (by borrowers)

o None of the borrowers who committed suicide had defaulted on their loan payments (as toldby Chairman, SKS)

o We have long known that most farmer-suicide cases have been reported in Telangana,Vidarbha and Bundelkhand, mostly due to failed government machinery and wrong-doing on thepart of money lenders. Compared to the latter, MFIs were easy scapegoats for Andhra Pradeshpoliticians

Silver lining

• Government and RBI will use this opportunity to bring MFIs under regulatory ambit before theypose any signs of systemic risks

4 / 5

Microfinance, Financial Inclusion and Inclusive GrowthMonday, 03 January 2011 22:33

• MFIs will be forced to innovate to lower costs for borrowers and what would finally emergeshould be a win-win situation

• Given the concentration risk involved in banks lending solely to MFIs to fulfill their PSL targets,banks will be forced to use alternative means to disburse credit to the rural household in generaland farmers in particular

To be avoided

• Statements by legislators and executives provoking borrowers not to repay loans

o This has the potential of undoing the credit discipline that takes years to get fostered

o If MFIs default on their loan, it may cause more than hic-cups in the Indian Banking System

Financial Inclusion is a process which leads to a system wherein every individual has access tofinancial services (primarily credit and savings); alternatively, a system where no one isexcluded from basic financial services. Greater access to financial services enables moreeffective and efficient availability/ deployment of capital thereby generating livelihood, alleviatingpoverty, improving access to basic health & education requirements and fostering entrepreneurship – thetenets of sustainable growth. Micro-finance is a significant and sustainable way of bringinggreater financial inclusion and, consequently, more inclusive and sustainable growth.

About the Author : Ashwini Kumar is an analyst with a leading ratings, research andpolicy advisory firm. Views are personal.

5 / 5