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MICROFINANCE IN INDIA: THE WAY FORWARD Analysis of non-ideal conditions for competition between MFIs in India

ABSTRACT:

Amidst immense optimism, microfinance industry in India saw a meteoric rise in past

decades, with the number of MFIs increasing from 2 in 1995 to as many as 121 in 2009.

Microfinance was lauded as a silver bullet for both eradicating poverty and for bringing

people under the folds of financial inclusion. Though after a shocking report by Associated

Press linking over 200 suicides to coercive loan recovery practices used by leading MFI SKS

microfinance, state government of Andra Pradesh waived off about $1.5 billion of loans,

bringing microfinance in micro lending “hub” of India to a standstill. This was attributed as a

direct result of the fierce competition between MFIs in India, which stem from lack of

necessary regulatory framework. The following essay focuses on the conditions leading up to

this predicament, and recommends regulations that would promote cohesion and coexistence

rather than cut throat competition and promotes interest for greater good.

INTRODUCTION:

Grameen Bank, taking wings from small project undertaken by Prof. Yunus of Chittagong

University in 1976 Bangladesh, has now grown into a noble prize winning organization with

branches in over 83,000 bangladeshi villages. Success of Grameen Bank in Bangladesh has

attracted a lot of attention in recent years towards microfinance, of policy makers and

academics alike. Advocates of microfinance argue that access to finance can substancially

reduce poverty (Dunford, 2006; Littlefield, Morduch and Hashemi, 2003).

Microfinance had been lauded as a silver bullet to eradicate poverty in developing nations.

With India being home to 1/3rd of the world’s poor, microfinance was touted as the next big

thing for poor borrowers and investors alike. Given that banks have as low as 7% penetration

in rural India, microfinance institutions were also envisioned as a promising conduit to bring

the unbanked section of the society under the folds of financial inclusion, which is a prime

national objective of recent times. When SKS microfinance, then India’s biggest

microfinance institution (MFI), went public in 2010, its IPO was oversubscribed 13 times,

which indicates the positive investor sentiment.

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Leading up to fall of 2010, microfinance institutions were experiencing a large influx of

equity and debt investment. Some institutions were doubling their size each year, aiming to

reach more customers and serve more areas.

But there was a darker side to this picture. The MF industry was plagued with numerous

issues, largely stemming from lack of governing regulatory framework, which has lead to far

from ideal conditions for competition. MFIs are forbidden from raising funds by collecting

deposits, which leads to MFIs converting to for-profit organizations and going public, which

puts greater strain to cut corners and achieve greater profits. As institutions scaled up quickly,

hiring and training processes were less thorough, resulting in employees who engaged in

inappropriate collection practices and lending models that led to customer over-indebtedness.

Microfinance suffered a huge blow in late-2010s when state government of Andra Pradesh

waived off nearly 1.5 billion worth of loans spread across over 9 million borrowers,

following a report by Associated Press that directly linked over 200 suicides in the state to

the coercive practices used by SKS to recover loans (Andra Pradesh Microfinance Ordinance,

20101). Andra Pradesh being the state of most extensive microfinance industry, this move

crippled the industry to a great extent. The industry is yet to recover from this decree, which

many believe to be politically motivated. Banks are, to date, still apprehensive about

providing loans to MFIs. SKS microfinance faced the worst of it, with its current stock price

being around Rs. 140, down from well over a thousand in 2010.

This entire debacle woke regulators from their stupor and a made them realize the need for

regulations in microfinance industry. Setting up of Malegam committee and tabling of

Microfinance Institutions Bill in 2011, are some major steps taken in this direction.

ISSUES WITH CORRESPONDING RECOMMENDATIONS AND REGULATIONS:

1. Collection Practices

As noted from the SKS experience, despite all the success of microfinance, there is

still lot of skepticism around it. Any reports and candid interview stating use of

abusive practices to collect loan results in dire consequence for the firm in question.

Therefore, collection practices needs to restructured, so as to avoid any such thing

from happening in the future. Some recommendations are:

• Sanctioning and disbursement of loans should be held at a central location.

• Collection of loans should be done in groups, rather than individually.

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• Agents should be forbidden to visit borrower at his place of residence.

• More than one individual should be responsible for sanctioning and

disbursement.

• MFIs and the management teams should be severely penalized if coercive

methods of recovery are used.

2. Documentation and Transparency

MFIs, in order to make their products look less expensive and more attractive, are

disguising their actual/effective interest rates (better known as the Annualized

Percentage Rates – APR) by including other charges like service charge, processing

fee etc. This limits the bargaining power of the barely literate borrowers and often

borrowers end up borrowing more than they can pay back, resulting in greater number

of defaults, which eventually hurt balance sheets of the MFIs itself. Steps that can be

taken in this regard include:

• Chalking out a standard loan agreement.

• Effective rate of interest should be displayed in all offices and relevant

literature.

• Borrowers should be provided with a loan card, containing information related

to the loans, acknowledgement of recent payments, and information to unique

identify the borrower.

3. Multiple lending and Defaults:

Presence of multiple MFIs, all eager to attain stronghold in an increasingly saturated

market, leads to a single borrower procuring loans from multiple source. In absence of

any collateral or legal instrument, this leads to a greater number of defaults (R

Shrinivasan, 20072). At times a single institution is responsible of issuing multiple

loans. Possible measures that can be taken in this regard include:

• Setting up of Credit Information Bureau and MIS, with mandatory

membership of the all MFIs. This would help MFIs to easily identify potential

defaulter, by looking into his/her credit history and pending loans.

• Based on credit history and current ability of paying back, maximum amount

of loan that can be disbursed to an individual must be capped.

4. Cluster formation (Margin and interest rate cap)

MFIs in India have very less penetration in rural India, which can be attributed to the

high initial costs of entering a new district. This not only leads to fierce competition

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within these districts, but also results in majority of districts not getting the benefits of

microfinance. This phenomenon is termed as Cluster formation. To make matters

worse, margin and interest rate cap are uniform. It further results in the reduction of

financial services in various areas and populations where returns do not justify the

operating costs. Following measures can mitigate this scenario:

• Logistical support and financial incentives in form of subsidies should be

provided to the MFIs for entering new districts.

• Margin and Interest rate cap should be vary with respect to the area and

specific section of the population.

5. Accepting deposits:

Primarily collecting deposits has funded many of the successful MFIs all around the

world. Government of India forbids Indian MFIs from doing so unless they obtain an

investment grade rating. Since, uncollateralized loans are considered risky by the

rating agencies, MFIs very rarely get this rating. This step was taken to ensure that

citizens deposit their savings only in those institutions that are considered as stable

and reliable i.e. the banks. This law was not formed keeping MFIs in mind, and thus

is clearly outdated. Therefore, MFIs should be allowed to collect deposits.

Furthermore, there is a cap on the maximum FDI on basis of capitalization of the

firm. And to make matters worse, Banks are very skeptical about lending to these

institutions.

6. Financial Education Training

Access to financial services is not the only component of financial inclusion. It also

entails person’s ability to read and interpret term and conditions of the loans before

signing a loan document. Many MFIs claim to have their own educational and

training programs, in many of these person is only taught to sign his/her name apart

from few other basic details. Therefore, these steps should be undertaken:

• Development of standard training modules designed to equip an illiterate

borrower with ability to choose optimum loan arrangement.

• Strong enforcement of these training standards.

7. Flexible payment cycles:

Currently, payments are collected in small and regular installments. It would make

much more sense if the payment cycle were made flexible according to the purpose of

loans. For example, in case of farmers it would make more sense to collect payments

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at the end of cropping season.

8. Hiring and Training processes

India has a huge potential market of MFIs to flourish. This is the prime reason of the

meteoric rise of MFIs in past decade. Even after being jolted in 2010, microfinance

institutions showed over 17% growth in number of borrowers in year 2010-2011. In

midst of such rapid growth, focus on hiring and training process in often lost. This is

undesirable because people at all level of the organization need to be fully aware of

the quantitative and qualitative performance objectives that clearly defines the

behavior expected such as honesty, respect, transparency etc.

This calls for rethinking more extensive and thorough training process for new

recruits, which stresses on social over financial returns.

CONCLUSION:

Learning from past experience, we observe that the neo-liberal theory of free markets fails in

microfinance, at least to some extent. Hence, to is essential to rethink how the market forces

and incentives structure for various stakeholders are structured. The industry is confined to

certain established markets, with firms engaging in cutthroat competition. Microfinance are

set up with primary objective to bring about social benefit, rather than financial benefit.

Though in current Indian scenario, turbulent grow and lack of regulations make it hard to

keep track of their objective. Therefore, it is incumbent to chalk out regulations to reap full

potential benefits of microfinance and to promote cohesion between different MFIs for

greater social good.

References:

1. C.P. Chandrashekher, “Whatever happened to microfinance?” The Business Line,

September 17, 2010, http://www.thehindubusinessline.com/opinion/columns/c-p-

chandrasekhar/article3907679.ece?homepage=true.

2. Status of Microfinance in India, 2012, NABARD,

http://www.nabard.org/departments/pdf/Status%20of%20Microfinance%202011-

12%20full%20book2.pdf.

3. Kenny Kline and Santadarshan Sadhu, “Microfinance in India: A New Regulatory

Structure”, http://www.centre-for-microfinance.org/wp-

content/uploads/attachments/csy/1602/IIM%20Regulation%20V11.pdf.

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4. Vishal Vivek Jacob, “Microfinance: Current status and Growing Concerns in India”,

Avant Garde, October 1, 2011,

http://www.iitk.ac.in/ime/MBA_IITK/avantgarde/?p=475.

5. Peg Ross, “Learning from the Indian Microfinance Crisis” CGAP, December 15,

2010, http://www.cgap.org/blog/learning-indian-microfinance-crisis.

6. R Srinivasan, “Measuring Delinquency and Defaults in Microfinance Institutions”

March, 2007, http://www.iimb.ernet.in/microfinance/Docs/MFIDelinquencyWP.pdf

7. State Government of Andra Pradesh, “Andhra Pradesh Ordinance 2010”, October,

2010. http://indiamicrofinance.com/wp-content/uploads/2010/10/Andhra-MFI-

Ordinance.pdf.

8. Vijay Mahajan, “Rebuilding a Stronger Microfinance Sector in India”, July 26, 2010,

http://knowledge.wharton.upenn.edu/india/article.cfm?articleid=4696

9. Elizabeth Rhyne, “On Microfinance: Who's to Blame for the Crisis in Andhra

Pradesh?”, February 23, 2013, http://www.huffingtonpost.com/elisabeth-rhyne/on-

microfinance-whos-to-b_b_777911.html

10. Margeriti Stancati, “A new beginning for microfinance in India?”, December 14,

2011, http://blogs.wsj.com/indiarealtime/2011/12/14/a-new-beginning-for-

microfinance-in-india/