Microfinance in India

.11Ashutosh Jaiswal * (2" Prize 2006-07)What is Microfinance?

As the name suggests, the term Microfinancemeans 'very small credit facilities provided to theneedy and most poor section of the society'. It is notjust a tool for poverty eradication but also forindividual development, growth in entrepreneurialactivities in economically backward areas.

So, microfinance is a system for providing smallloans to poor entrepreneurs, typically self-employed and running a home based business.

However, now the microfinance revolutionaries aresetting their sights on a more ambitious goal, oftrying to create a more professional, inclusivefinancial system that reaches deep into rural andurban areas. At the same time, microfinance ismoving past its small business base to offer a widerange of financial services including savings,insurance, money transfers and broad array of loanoptions, to the poor.

The modern origin of microfinance dates back tomid '70s. Among the key innovators was ProfessorMuhammad Yunus of Bangladesh who advocatedloaning to very poor people, especially women. Hestarted the Grameen Bank project in 1976 andtransformed it into a bank in 1983. The bank nowhas 6 million borrowers - 90% of them being womenand almost 2000 branches in 64,000 villages. Therepayment rate for loans is 98% and bank hasearned profit almost every year except. for threeyears since its inception.

The Grameen Bank experiment shows that it ispossible to make profit while doing good. It gives

Microfinance is a systemfor providing small loans topoor entrepreneurs, typicallyself-employed and runninga home based business.

one the opportunity to do good to oneself whidoing good to others.

Over the last decade, banks' outreach to srn:borrowers (below Rs.25,000) has progressivedeclined, both as a proportion of credit and in ternof total bank accounts. Microfinance institutior(MFls) have, since emerged as key providersfinancial services for the poor. Majority of lndi:MFls are not-for-profit organizations that facilitathe formation of self-help groups (SHG) and lirthem with formal banks, often as a subsetactivities that extend beyond microfinancChampioned by the National Bank for Agricultuand Rural Development (NABARD), this modaccounts for 70% of microfinance in India. SHCtypically consist of 15-25 members and utili;revolving savings funds. The size of individualloaris determined either by the volume of individusavings or by the group's savings as a whole, arinterest rates are determined by members. SHCmay borrow directly from an MFI / a bank and aoften organized into federations to obtain externfunds in bulk. Currently, the predominant financirmodel for SHGs is one in which the MFI acts cfacilitator between banks and SHGs, while in othcases lending goes to SHGs through the financiintermediation of MFls. In addition to the SHmodel, the remaining MFls employ the Grarner(group lending) model or offer individual loans. Wi75 million poor households potentially requirirfinancial services, the microfinance market in Indis amongst the largest in the world. Estimatehousehold credit demand varies from a minimumRs. 2,000 to Rs. 6,000 in rural areas and Rs.9,000urban settings. Given that 80% of poor househohare located in rural areas, total credit demarranges between Rs.255 billion and Rs.500 billioSupply of microfinance services, however; fasignificantly short of demand. Planet Flnamreports that in 1997-1998, banks disbursed Rs.!

*Regional Office, Reserve Bank of India, Mumbai.July - September 2007 THE JOURNAL OF INDIAN INSTITUTE OF BANKING & FINAN(

In terms of scope, themicrofinance sector in India isconcentrated in the southern

states of Andhra Pradesh, TamilNadu, Karnataka, and Kerala,with Andhra Pradesh aloneencompassing 50 to 70%of microfinance activities.

to combating poverty is hardly a new phenomenon.Over the last forty years, the Reserve Bank of India(RBI) has encouraged a significant expansion ofbank branches in rural areas in order to extendcredit services to the disadvantaged group,including small and marginal farmers, rural artisans,and other small borrowers. RBI has also requiredcommercial banks to direct 40% of their lending topoorer members of society and to priority sectorssuch as agriculture. The Government's 1982Integrated Rural Development Program (IRDP) wasone of the largest poverty alleviation programs toinclude a microfinance component. Today, nationaldevelopment banks play a crucial role in the growthof microfinance. Despite general support formicrofinance, there appears to be a tensionbetween promotion of the. sector and clientprotection. RBI has thus forbidden MFls from takingpublic savings that would reduce their cost ofcapital. A similar tension exists at the state level aswell, though some states are more active inmicrofinance than others. Andhra Pradesh's (AP)Mutually Aided Co-operative Societies Act, which isbeing replicated in other parts of the country, greatlysimplifies the formation and supervision of groupsthat can access microfinance services on behalf oftheir members. AP's populist mandate, however,sometimes serves to undermine credit, as isexemplified by the decision that farmers need notrepay the principal on a loan for the first six months,unless they are borrowing from a bank.

National Initiatives

NABARD was established in 1982 as an apex bankto provide and regulate credit for the promotion anddevelopment of agriculture, small-scale industries,cottage and village industries, and handicraftsin rural areas. Its SHG Bank Linkage Programconsists of encouraging the formation of SHGs andlinking them with banks. Collaboration with externalfacilitators such as NGOs, MFls, banks, andGovernment agencies is an integral aspect of thestrategy. In addition to concessional refinancing forbanks, NABARD provides policy guidance andcapacity building support. Since its 1992 pilotproject, NABARD has provided 16.7 million familieswith financial services through the formation andcredit linkage of 1,079,091 SHGs as of March 2004,far exceeding its goal of one million SHGs by

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THE JOURNAL OF INDIAN INSTITUTE OF BANKING & FINANCE July - September 2007

billion in credit to the poor, while MFls andNABARD's SHG Bank-Linkage program disbursedRS.1.4 billion covering 20% of the estimateddemand. More recent data suggest that while thegap between supply and demand may be shrinking,it continues to exist. In March 2003, outstandingloans of the SHG Bank-Linkage Program amountedto Rs.10 billion while MFls held RS.2.4 billion inloans outstanding. Moreover, SHG memberhouseholds received an average of RS.1766 incredit. Hence, not only did the bulk of demandremain unmet, but borrowers generally receivedsmaller loans than required. Additionally,microfinance services remain predominantly in theform of credit and do not address the poor's need forsaving and insurance services. Regulation preventsmost MFls from mobilizing savings; and, insuranceschemes are limited. In terms of scope, themicrofinance sector in India is concentrated in thesouthern states of Andhra Pradesh, Tamil Nadu,Karnataka, and Kerala, with Andhra Pradesh aloneencompassing 50 to 70% of microfinance activities.Banks, prompted by priority lending targets andprofit motivation, are increasingly investing inmicrofinance. To date, however, they have shownlittle or no interest in retail microfinance, and thepredominant providers of microfinance services inIndia continue to be SHGs and MFls.

lCICI, the largest private bank in India, has begun topartner with MFls to serve their clients and in somecases has bought out their portfolio in lieu ofopening microfinance retail branches directly.

Policy Support

Given the Government's pledge to deal witheconomic reforms with a "human face," it is notsurprising that the current finance minister issupportive of microfinance. The state's commitment

-2007. NABARD has since increased its target to585,000 new SHGs by 2007.The Small IndustriesDevelopment Bank of India (SIDBI) was establishedin 1990 as the main coordinator and principalfinancial institution forthe promotion, financing, anddevelopment of industry in the small scale sector.The SIDBI Foundation for Micro Credit (SFMC) wasestablished in 1999 to promote the growth andsustainability of the microfinance sector byproviding a range of financial and non-financialservices to MFls, including loan funds, grantsupport, equity, and institution building support.

MicroFinance :The Paradigm

The financial .sector reforms motivated policyplanners to search for products and strategiesfor delivering financial services to the poorMicroFinance - in a sustainable manner consistentwith high repayment rates. The search for thesealternatives started with internal introspectionregarding the arrangements which the poor hadbeen traditionally making to meet their financialservices needs. It was found that the poor tended toand could be induced to come together in a varietyof informal ways for pooling their savings anddispensing small and unsecured loans at varyingcosts to group members on the basis of need. Theessential genius of NABARD in the Bank SHGprogramme was to recognize this empiricalobservation that had been catalysed by NGOs andto create a formal interface of these informalarrangements of the poor with the banking system.This is the beginning of the story of the Bank-SHGLinkage Programme.

Microfinance-Credit lending models

MFls, the" world-over, are using various CreditLending Models; some of which are as listed below:

Associations:

This is where the target community forms an'association' through which various microfinance(and other) activities, including savings, areinitiated. Associations or groups can be composedof youth, or women; they can be formed aroundpolitical/religious / cultural issues and can createsupport structures for micro-enterprises and otherwork-based issues.

In some countries, an 'association' can be a legalbody with certain advantages viz., collection of fees,

Guaranteed funds may beused for various purposes,including loan recoveryand insurance claims.

insurance, tax breaks and other protective measurDistinction is made between associatiocommunity groups, people's organizations, Ion one hand (which are mass, community basand NGOs, etc., which are essentially exterorganization.

Bank Guarantees:

As the name suggests, a bank guarantee is U!to obtain a loan from a commercial bank. 1guarantee may be arranged externally (througdonor / donation, government agency, etc.)internally (using member savings). Loans obtairmay be given directly to an individual, or to a sformed group.

A Bank Guarantee is a form of capital guaranscheme. Guaranteed funds may be used for varfpurposes, including loan recovery and insuraiclaims. Several international and UN orqanlzathhave been creating international guarantee futhat banks and NGOs can subscribe to, to onlemstart microcredit programmes.

Community Banking:

The Community Banking model essentially trethe whole community as one unit, and establishesemi-formal or a formal institution through wtmicrofinance is dispensed. Such institutionsusually formed by extensive help from NGOs ,other organizations, who also train the commumembers in various financial activities ofcommunity bank. These institutions may hsavings components and other income-generaprojects included in their structure. In many cascommunity banks are also part of larger commudevelopment programmes which use financeinducement for action.

Co-operatives:

A co-operative is an autonomous associatiorpersons united voluntarily to meet their comreconomic, social & cultural needs and aspiratithrough a jointly - owned and democraticalcontrolled enterprise. Some co-operatives incl

July - September 2007 THE JOURNAL OF INDIAN INSTITUTE OF BANKING & FINAl

member - financing and savings activities in theirmandate.

Credit Unions:

A credit union is a unique member-driven, self-helpfinancial institution. It is organized by and comprisemembers of a particular group or organization, whoagree to save their money together and loan to eachother at reasonable rates of interest.

The members are people of some common bond:e.g. working for the same employer; belonging to thesame church, labour union, social fraternity, etc.; orliving / working in the same community. A creditunion's membership is open to all who belong to thegroup, regardless of race, religion, colour or creed.

A credit union is a democratic, not-for-profitfinancial co-operative. Each is owned and governedby its members who have a vote in the election ofdirectors and committee representatives.

Grameen:

The Grameen model emerged from the poor-focussed grassroots institution, Grameen Bank,started by Prof. Mohammed Yunus in Bangladesh.It essentially adopts the following methodology:

A bank unit is set up with a Field Manager anda number of bank workers, covering an area ofabout 15 to 22 villages. The manager and workersstart by visiting villages to familiarise themselveswith the local milieu in which they will be operating.They identify their prospective clientele, and explainthe purpose, functions, and mode of operation ofthe bank to the local population. Groups of fiveprospective borrowers are formed; in the first stage,only two of them are eligible for, and receive,a loan. The group is observed for a month to seeif the members are conforming to rules ofthe bank. Only if the first two borrowers repay theprincipal plus interest over a period of fifty weeks dothe other members become eligible for a loan. Dueto these restrictions, there is substantial grouppressure to keep individual records clear. In thissense, collective responsibility of the group servesas collateral on the loan.

Group:

The Group Model's basic philosophy lies in thefact that the collective responsibility and securityovercomes shortcomings and weaknesses at the

Non Governmental Organizations(NGOs) have emerged as a keyplayer in the field of microcredit.

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individual level afforded by the formation of a groupof such individuals.

The collective coming together of individual membersis used for a number of purposes: viz., educating andawareness building, collective bargaining power,peer pressure, etc.

Individual:

This is a straightforward credit-lending modelwherein micro loans are given directly to theborrower. It does not include the formation of groups,or generating peer pressures to ensure repayment.The individual model is, in many cases, a partof a larger 'credit plus' programme, where othersocio-economic services such as skill development,education, and other outreach services are provided.

Intermediaries:

Intermediary model of credit lending position is a'go-between' organization between the lenders andborrowers. The intermediary plays a critical role ofgenerating credit awareness and educating theborrowers, apart from starting savings programmesin some cases. These activities are geared towardsraising the 'credit worthiness' of the borrowers to alevel attractive enough to the lenders.

The links developed by the intermediaries couldcover funding, programme links, training andeducation, and research. Such activities can takeplace at various levels from international andnational to regional, local and individual levels.

Intermediaries could be individual lenders,NGOs, microenterprise / microcredit programmes,and commercial banks (for govemment financedprogrammes). Lenders could be governmentagencies, commercial banks, intemational donors, etc.

Non-Governmental Organizations:

Non Govemmental Organizations (NGOs) haveemerged as a key player in the field of microcredit.They have acted as intermediaries in variousdimensions. NGOs have been very active in startingand participating in microcredit programmes. Thisincludes creating awareness about the importance of

THE JOURNAL OF INDIAN INSTITUTE OF BANKING & FINANCE July - September 2007

microcredit within the community, as well as variousnational and infernational donor agencies. They havedeveloped resources and tools for communities andmicrocredit organizations to monitor progress andidentify good practices. They have also createdopportunities to learn about the principles andpractice of microcredit, through publications,workshops and seminars, and training programmes.

Peer Pressure:

Peer pressure uses moral and other linkagesbetween borrowers and project participants toensure participation and repayment in microcreditprogrammes. Peers could be other members in aborrower's group (where, unless the initial borrowersin a group repay, the other members do not receiveloans. Hence pressure is put on the initial membersto repay); community leaders (usually identified,nurtured and trained by external NGOs); NGOsthemselves and their field officers; banks, etc. The'pressure' applied can be in the form of frequentvisits to the defaulter, community meetings wherethey are identified and requested to comply etc.

Rotating Savings and Credit Associations:

Rotating Savings and Credit Associations(ROSCAs) are a group of individuals who cometogether and make regular cyclical contributions toa common fund, which is then given as a lump sumto one member in each cycle. For example, a groupof 12 persons may contribute Rs.1 00 per month for12 months. The Rs.1 ,200 collected each month isgiven to one member. Thus, a member will 'lend'money to other members through his / her regularmonthly contributions. After having receivedthe lump sum amount when it is his / her turn to'borrow' from the group, he / she then pays back theamount in regular / further monthly contributions.The decision about who receives the lump sum isarrived at through consensus, by lottery, by biddingor other agreed methods.

Small Business:

The prevailing vision of the 'informal sector' is one ofsurvival, low productivity and very little valueaddition. But this scenario has been steadilychanging, with increased importance being placedon small and medium enterprises (SMEs) forgenerating employment, for increasing income andproviding services which are lacking.

The real potential of microfinanceis far from being realised, owing

to various institutional andpolitical factors.

Policies have generally focussed on directinterventions in the form of support systems such astraining, technical advice, management principlesetc.; and indirect interventions in the form of anenabling policy and market environment.

A key component that is always incorporated as asort of common denominator has been finance,specifically microcredit - in different forms and fordifferent uses. Microcredit has been provided toSMEs directly, or as a part of a larger enterprisedevelopment programme, along with other inputs.

Village Banking:

Village banks are community-based credit andsavings associations. They typically consist of 25 to50 low-income individuals seeking to improve theirlives through self-employment activities. Initial loancapital for the village bank may come from anexternal source, but since the members themselvesrun the bank: they choose their members, elect theirown officers, establish their own by-laws, distributeloans to individuals, and collect payments &savings. Their loans are backed, not by goods orproperty, but by moral collateral: the promise thatthe group stands behind each individual loan.

Problems with the existing Microfinance system

Even after half a century since independence, Indiastill has the dubious distinction of having the world'slargest number of poor people in a single country. Ofits nearly 1 billion inhabitants, an estimated 350-400million are below the poverty line, with 75% of themstaying in the rural areas. In such a scenario, theimportance of microfinance as a tool for povertyeradication can't be overemphasised.

Microfinance has been promoted in differentversions through various delivery channels. So far,the experience has been a mixed one with varyingresult across the states. However, the real potentialof microfinance is far from being realised, owing tovarious institutional and political factors. The majorstumbling blocks in microfinance in India areenumerated here:

July - September 2007 THE JOURNAL OF INDIAN INSTITUTE OF BANKING & FINANCE

1) Lack of awareness / education about microfinance

2) Lack of enabling policy for MFls.

3) Skill development.

4) Politicisation of Government funded \ subsidisedprogrammes.

5) Non availability of intermediary between the Flsand the borrower who lack collateral security.

6) High administrativecost where multiple intermediariesare involved.

7) Lack of skilled labour with the knowledge of locallevel accounting.

8) Highly disorganised and fragmented intermediationbetween Fls and the borrowers.

9) Dominance of informal / deregulated financiers.

Apart from these factors, the attitude of the financialinstitutions towards lending to the poor has beennon-supportive. The banking system was not ableto internalise lending to the poor as a viable activity;it did so only as a social obligation something thathad to be done because the authorities wanted it so.

This was translated into the banking language of theday : loans to the poor were part of social sectorlending and not commercial lending; the poor werenot borrowers, they were beneficiaries; poorbeneficiaries did not avail of loans - they availed ofassistance.

This language resulted in an attitude of carefullydisguised cynicism towards the poor. The attitudewas that the poor are not bankable, that they cannever be bankable, that commercial principlescannot be applied in lending to the poor; what thepoor require are not loans but charity. Once thismindset hardened it became more and more difficultfor commercial bankers to accept that lending to thepoor could be a viable activity. It is significant to notethat the system had to wait for almost a decade forthe concept of microfinance to become credible.

An Alternative Approach

Given the plethora of research papers available onmicrofinance and its various aspects, it is difficult tofind an altogether new approach of improvingefficiency of microfinance models to achieve itsstated objective. It is also to be realized that theground situation varies drastically from place toplace; depending upon the spread of financial

services in the area and availability of viable optionof entrepreneurial activities.

However, an attempt is made here to explore areaswhere improvements can be made or the processmay be redesigned and the guiding principles maybe redefined. As we have already discussed theexisting models and problems with microfinance inIndia, we take a fresh look at it by dividing theentire research in areas of Guiding principles ofmicrofinance, Role of Government and NGOs /MFls and Financial Institutions, delivery channeland effectiveness of assessment methodologies.

Guiding Principles of Microfinance :

The following assumptions should form the basicprinciple of microfinance lending in order to achieveits stated objective:

Poor are bankable.

Poor are ready to pay higher than market rateof interest.

Administrative cost is a major stumbling block forbanks in providing the loan to the poor.

The government subsidy should be channelisedto the really needy and viable projects.

Poor should be instilled with the spirit of savings.

Technical knowledge is integral to skill developmentand viability of any entrepreneurial activity.

Government role should be that of facilitatorrather than of a regulator. Model of Self-regulatory organisation can be adopted toformulate best practice code.

Existence of speciality microfinance institutionsto provide a focussed approach to the sector.

Role of Government:

The diagram below describes the manner in whichthe microcredit is generally delivered-

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I Directlending>

Microcredit can be provided by the financialinstitutions either directly or through intermediaries

THE JOURNAL OF INDIAN INSTITUTE OF BANKING & FINANCE July - September 2007

like NGOs, MFls, & Government agencies.Government agencies provide various subsidies forprojects under specified schemes. Bankers arequite comfortable in lending under such schemes asthe subsidy is directly given to the banks. However,bankers have to use their own assessmenttechniques to evaluate the viability of the project.

Role of NGOs :

NGOs / MFls provide the most effectiveintermediation in microfinance lending. They not onlyidentify the right kind of borrower but also ensure thesuccess of the project through development of skillsand community participation. Their direct regularcontact with the borrower, pressurises him / herinto timely repayment. However, their involvementonly adds up to the cost of financing. This highercost may be sustainable in the short run but as thecompetition intensifies, the high interest cost makesthe microfinance entrepreneurs uncompetitive inthe market.

Delivery Channel:

In any delivery channel, the lesser the number ofintermediaries, the better it is as, it reduces the costof operation. Owing to prevailing atmosphere, itbecomes very difficult to foresee any substantialdirect lending to the poor in near future, untilenabling policies are framed for MFls.

Creating an environment conducive for MFlsto access low cost funds can reduce the cost offunds substantially. Government intermediationthrough subsidies is the most abused part inentire microfinance system. Instead of leavingthe decision of subsidy to respective BlockDevelopment Officers' discretion, it should allow taxbreaks to financial institutions for lending undermicrofinance. This will induce more banks to build apositive attitude towards this sector. Access to lowcost funds through deposit mobilisation from thegeneral public is another source of low cost funds.Hopefully, the Government, in consultation with theRBI will come out with policies that are supportiveto this idea.

Effectiveness Assessment:

The microfinance effectiveness assessmentshould go beyond the traditional parameter ofvalue of loan disbursement and repaymentrate. It should evaluate the extent to which the

scheme has been successful in providing newemployment, generating income, improving healthand literacy level, etc. While repayment ratecan be an indicator of income generation, thefrequency of loan disbursement and repaymentrate show how fast the productivity is improvedand cash cycle is reduced.

Additionally, the number of MFls working in thearea, total number of beneficiaries, proportion ofwomen in the total beneficiaries, geographicalspread are some of the tools that can be used toassess the reach and effectiveness of microfinance.

The MFls should get themselves rated so as toreduce their cost of borrowing / deposits.

Conclusion

Banking on poor can be a profitable business whichhas been successfully demonstrated by GrameenBank, Bangladesh. Deposit mobilisation is themajor means for MFls to expand outreach byleveraging equity. In order to be sustainable,microfinance lending should be grounded onmarket principles because large scale lending can'tbe accomplished through subsidies.

Microfinance can contribute to solving the problemof inadequate housing and urban services as anintegral part of poverty alleviation programmes.The challenge lies in finding the level of flexibilityin the credit instruments that can make it matchthe multiple credit requirements of the low incomeborrowers without imposing unbearably high costof monitoring its end use upon its lenders.

A promising solution is to provide multi-purposeloans or composite credit for income generation,housing improvement, and consumption. Carefulresearch on demand for financing and savingsbehaviour of the potential borrowers and theirparticipation in determining the mix of multi-purposeloans are essential in making the concept work.

Eventually, it would be ideal to enhance thecreditworthiness of the poor and make them more'bankable' to financial institutions and enable themto qualify for long term credit from the formal sector.

MFls have a lot to contribute to this by buildingfinancial discipline and educating the borrowersabout repayment.

July - September 2007 THE JOURNAL OF INDIAN INSTITUTE OF BANKING & FINANCE