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The Indian Microfinance Crisis

08 November, 2010

To some in the investment industry, microfinance seemed to offer almost miraculous redemption.  Here was proof that venture capital could be benign, and still deliver Gordon Gekko-esque rates of growth, reminiscent of the dot-com boom era, while still contributing to uplifting objectives such as poverty alleviation. Was it all too good to be true? The recent fall from grace of the microfinance industry, to the accompaniment of sleazy stories about promoters, and links to thuggish recovery practices and borrower suicides, seem to suggest as much.

In fact the current demonization of the industry is as much an oversimplification as the earlier beautification beatification. The facts tell a more complex story, from which both industry and government emerge flawed – but neither irredeemably so.

The Different Microfinance Models

To understand the present crisis, it is necessary to go back to its origins. Microfinance in India actually originated in a government-sponsored model,which linked groups of village women to banks, and relied on grants or public funds for group mobilization. This is the Self-Help Group (SHG) model. The model used by most privately-funded microfinance institutions (MFIs) is the Grameen-style Joint Liability Group (JLGs). Unlike the SHG model, the JLG model creates individual credit histories, if skewed by group guarantee.

The state of Andhra Pradesh (AP) made particularly significant investments in subsidizing financial inclusion through SHG programs but, at least till last month, also allowed private-sector MFIs following the Grameen/JLG model to flourish, largely unregulated. In this welcoming climate,at least four of the country’s largest MFIs originated in AP, alongside numerous other mid-sized MFIs.

Since around 2005 large sums of private equity began to flow into the sector, and private MFIs grew rapidly, as microlending became a replicable, systematic, and profitable business.

Unfortunately the government programs, despite being well-intentioned, had neither the discipline nor the sustainable business model to compete. The AP Government’s 2004 interest rate subsidy scheme (Pavalavaddi) only added to the subsidy burden.

Government and Private Enterprise

The State believed it was serving its poor through low-cost loans via SHGs, yet commercial microfinance lenders were able to attract clients and achieve a better repayment rate, despite higher interest rates, by dint of their door-step service and frequent small-value repayments.

Tension between the government and the private sector led to the Krishna Crisis in 2005-06, when several MFI branches were closed down at the behest of the local government in Krishna District of AP. This crisis, complete with headlines almost identical to this year’s, foreshadowed this year’scrisis, which came to a head with the passing of the Andhra Pradesh Microfinance Ordinance on the 15th of October, 2010.

This Ordinance was promulgated partly in response to sensational media reports on suicides attributed to indebtedness to MFIs. The Ordinance was built on the premise that MFIs are exploitative, charge “usurious” interest rates, and use coercive collection methods.

Regulation – or Victimization

In fact, with a median Operating Expense Ratio of 11.8%, Indian MFIs are amongst the most cost-efficient in the world (and their interest rates among the lowest). Larger MFIs generally have greater operating efficiencies, and are therefore able to charge slightly lower rates than smaller ones, as their operating and financing costs are generally lower. The often talked-about cap on interest rates would only reduce incentives to scale. The stipulations of the AP Ordinance could lead to increased service delivery costs and higher interest rates, thus defeating its intent entirely.

An initial analysis suggested that far from making microlending more poor-friendly, the Ordinance could delay or even block service delivery due to onerous registration requirements, and result in haphazard implementation of discretionary provisions. In the limit, it was possible to see the Ordinance as threatening to close the entire sector by imposing unimplementable requirements on the sector.

Emerging From the Crisis

However, events in the last fortnight have significantly changed stakeholder perceptions. Both government and industry appear to be moderating extreme positions. The government has toned down some of its rhetoric, and the industry has acknowledged that the Ordinance has forced some desirable cleaning-up.  It is possible that the current crisis could become a turning point, leading to a more balanced, better-governed and better-understood microfinance industry.

The current situation is by no means entirely rosy. Investors are understandably reluctant to invest in the sector at this time. VineetRai, founder of Aavishkaar Goodwell and chairman of Intellecap, says the sector will see a short-term drop in valuations. However this offers a “huge opportunity to invest … in real value deals”. Meanwhile some Foundations and development agencies with a long-term outlook are still investing. CDC, the UK government’s development finance arm, recently put $10 million into Lok Capital.

The industry in the field is struggling, with collections having dropped from their usual 98% and above to 30% and below. However, the crisis seems to have catalyzed the process of putting a code of conduct in place, and tracking multiple lending through the establishment of credit databases. Acknowledgements by the industry that all was not wellissome augury for future improvements.

In addition, as compliance with the Ordinance progresses, some anecdotal evidence has come in showing Government in a far more responsive light than it is usually given credit for. The registration process has been substantially web-enabled,allowing MFIs to register and upload data quickly and with less opportunity for localized variations in interpretation of rules.

There is a faith-restoring anecdote of the state Principal Secretary having responded to a request made after 10 pm one evening with a resolution by the following morning. These anecdotes suggest that the industry is working towards accommodation with government. Intellecap is monitoring these developments, and will report on them in more detail.

Looking Ahead

We set out to tell the basic story of the industry in India. Ultimately, industry and government both share responsibility for the current crisis – and for bringing the industry out of the crisis.

Looking ahead, stakeholder education is clearly critical. Much of the commentary on the crisis has revealed appalling ignorance of the benefits the industry brings, the value of private capital, and (important in this context) why interest rates are what they are. The industry associations, Sa-Dhan and MFIN, have important roles to play. The media could also play a more responsible role.

The industry clearly needs to establish visibly more ethical practices, in a sector which has the potential to help millions of poor people. Importantly, there must be industry-owned and industry-administered channels to penalize transgressors.

More regulation is now inescapable; principles that the best in the industry fully recognized, but were unable to implement fully through self-regulation. India’s interests, and the cause of poverty reduction, will be best served by skilled and co-operative regulation. There are, we believe, grounds for cautious optimism. Time will tell if it is justified.

(K Sree Kumar is the CEO of Intellecap, a leading Indian social business advisory firm that has intermediated over $120 million investment in the social sector.  This article is based on a White Paper released by Intellecap, the full version of which is available at  )


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6 Comments
Ashish Abrol . 6 years ago

I am attaching here a response I wrote to an article on the wonders of MFI on VC Circle dated August 1, 2009. The article was titled microfinance: Swimming fully clothed with an obvious comparison being made with the calamity that had embraced all other parts of the economy. I’m myself surprised that the unravelling i had predicted in my response on Sep 2, 2009 happened much quicker than even i had anticipated. To add to what i had written then, i would like to reiterate that the MFI model at the current ROI’s is unsustainable whether this is eventually mandated by the government or not. The strongest argument the MFI supporters seem to be harping on is financial inclusion. Financial inclusion is a farce and a metaphor for a mismanaged idea. I shirk to use the word exploitation because I sincerely don’t think it’s exploitation. It is just a model which was never meant to be scaled up much like the credit card crisis in America where everybody averages 7 credit cards at 24-30% p.a. interest rates whether they can afford to pay back or not. MFI was truly an industry meant to benefit a few on the fringes. Democratization and scaling up the industry in the name of financial inclusion should have been a non starter but we all know we only learn from mistakes!

Ashish Abrol

__________________________________________________

The rapid growth of this industry over the past decade has not been short of fascinating. Besides the obvious economic gains to be derived by the industry participants, the industry is an incredible source of social change. Despite all the positives that surround the industry, I cannot conceal my concern with the long term soundness of the business model. Here is why.

1. You have cited a few reasons for the superior repayment track record in the industry. To my mind, this pattern cannot and will not continue forever. As borrowers at the bottom of the social structure, you claim, they exhibit a different social behavior. Maybe. However, as these same people integrate into the mainstream (5 – 7 years), their behaviors will begin to resemble those from a higher social strata. Unfortunately, “higher” in this case implies morally more undesirable. For the purposes of this writing, I will refrain from passing moral judgment but suffice to say I see no reason why a superior repayment track record will continue forever. Consequently, this will hurt margins.

2. “Interest rates of 24-32% are affordable because the alternative is 100%!” Smoking might lead to slower death than consuming heroin but is that enough reason to make a case in favor of smoking? I think not. Both smoking and heroin are undesirable just as 24-32% ROI is unsustainable over a long period of time.

3. Over time, there will be consolidation of means of production at the village level. As that happens, individuals will consolidate or perish. As consolidation occurs, the higher interest rates will not only be unaffordable (read-economically unviable) but the same people will have access to alternative financing options (banks) at lower interest rates.

The years 2008 and 2009 have been instrumental in educating us all on the ills of excess. Even more importantly, the downward spiral in the economies world over has helped demystify a few popular myths: (a) India is decoupled from the world economy, (b) India’s hallowed 300 million consuming middle class, (c) equities, commodities, real estate and fixed income are uncorrelated asset classes. In hindsight, we all know, these were myths. Similarly, it is important for MFI’s not to fall prey to the statistics of the past –most importantly about repayment track record and ability of the consumer to absorb higher interest rates. I’m in no way implying that the MFI is a fad but it might serve the industry well to consider not where it is today but where it is likely to be 5-7 years from now. The idea in your article of using your network as a distribution arm for retailers I think is a brilliant one. I feel strongly about this because of the extremely rickety and inefficient distribution system that exists today for reaching end consumers in India. Owning this distribution channel, I feel, is a gold mine. Over time, I will not be surprised if this revenue stream continues to gain a larger and larger share of a MFI’s overall profits. Eventually, there might be money to be made as intermediaries for bank loans! Radical but likely. Instead of having to raise your own funds, it might be worthwhile to act as intermediaries for banks without risking your capital. Needless to say, such a model is some time away. However, it may not be entirely impossible to imagine a MFI as the new Wal Mart for the disenfranchised –a fee based model for money transfers, demand drafts, insurance policies, mutual funds and maybe advise for that crazy family holiday to Honolulu?

Ashish Abrol

Rajan Alexander . 6 years ago

What else can INTELLECAP that survives on MF say?

Micro-Finance to Face Slow Painful Death. SKS Share to enter Free Fall. Sell, Sell, Sell!

SKS, the Indian micro-finance giant’s IPO was supposed to signal the coming of age of the micro-finance (MF). Instead, it contained the seed for the destruction of the entire industry. Their Rs 10 share on listing attracted a premium of Rs 975 and such was the investor confidence, it touched a high of Rs 1,490 in a matter of days. Then hell broke loose with the industry hit by charges of them profiteering and causing farmer suicides. Its reverberations were so strong that it had been felt by the industry all over the world. The stock plunged to Rs 890 before recovering to be a tad over its listing price and hovering around this range for the last one week. We expose the dark underbelly of a Frankenstein unleashed by NGOs.

Read more: http://devconsultgroup.blogspot.com/2010/11/micro-finance-to-face-slow-painful.html

K Sree Kumar . 6 years ago

To Mr Rajan Alexander:

Thanks for your interest. However, I have to say your phrase, “Intellecap that survives on MF” is factually inaccurate. If you would care to set up an appointment to visit us, I will be happy to share the facts on how we survive :).

To Mr Ashish Abrol:

Thanks for your comments. However, I will respectfully repeat the point I make in the article – the current demonization of the microfinance industry is as much an oversimplification as the earlier beatification.

(And I did originally write beatification, meaning a step in the canonization process, and the opposite of demonization – not “beautification”, as VC Circle has incorrectly edited it!)

Regards

Sree

p.b.ramesh . 6 years ago

I am not seasoned expert in microfinance, but as a practising microcredit professional, I foretold my colleagues, almost a year ago, that this present situation was inescapable. I have seen the reckless means SKS adopted; SHGs which were being trained in capacity building and internal lending practices for eventual credit linkage by smaller MFIs were simply snatched away from their hands. Customers were instantaneous, but so were defaults. Quite like the present day credit card issuers, SKS and several others of its ilk pumped in crores of rupees in rampant multiple lending. Some of the industry bigwigs gave an intellectual justification to this charade: Multiple lending is not bad, over borrowing is ! SKS disappeared from several places just as fast as they appeared, scorching the earth as they left. There was no vision audit to their operations; it was not microfinance,but just money lending. Credit appraisal techniques were observed only on paper. KYC norms were breached with impunity. Microfinance was seen as bringing suicides and not development. With no self regulation in sight, either at tbe behest of Sa Dhan or Assn of MF network, regulation had to come only this way.

It is high time industry leaders sat together to build a strong lobby to save the industry interests, bring about self regulation, (so that self regulatatory mechanism and self regulatory organisations become part of external regulatory mechanism). No one can deny the role for MFIs in future. The present episode should serve as an opportunity to reform and move forward. (p.b.ramesh)

pratap singh . 6 years ago

Little surprized that seasoned players in MFI also are talking about corrections, controls & regulations now – while fate of MFI industry was known good 2 years back. Like Any other industry MFI industry was approaching the end of its cycle fast & even if all self controls (offered today) would have been exercised good 2 years back – we wd have just been able to elongate the cycle by 1-2 years – however this situation if not due to AP ordinanace it wd have come thru some other means.

In huge developing economy like India & that too in an era of such quick communication & networking- Any industry Depending upon the investments, returns & attractiveness is bound to have a life cycle which is shortened (not more than 5-6 years unless regulated by strong regulators & monitored/reviewed on a periodic bais for corrections.

MFI was no different & attractiveness of MFIs was also made little better by Banks supplying huge money as part of their short term goal to meet PSL & inclusive banking obligations.

Mad rush of MFI registrations, PE money flow, attractive spreads & hope to make money faster led to herd mentality of Entrepreneurs started setting up MFIs. Shortage of Quality talent coupled with quick growth to inexperienced manpower to manage larger scales hence higher salaries leading to increased operating cost (alternatively a higher attrition of Employees – as new players were willing to pay higher w/out understanding the business model & cost implications) leading to lack of disciline & control coupled compulsion to stay afloat for superior valuations thru scale up were all visible across many MFIs.

Moreover lack of patience & hence move with a cut paste business model that too in existing overcapacitized locations with no clarity of target market, demand supply gaps & no intent to support the social equilibrium – only motive being quick money/valuation led to wrong selection of places (already serviced locations being overcrowded) & hence multiplied the problems & a quick death to a promising Industry that should have been the back bone of economic development of people at the BOTTOM OF THE PYRAMID.

Worst part we did not even try to learn from a recently concluded similar disaster in an Unsecured lending space of Personal Loans in urban & semi Urban towns – wherein story was not very different & same set of bankers are a mute spectator to another disaster being supported. There are 40 Plus NBFCs that lost huge amount of money (some were written off by leading pvt & nationalized banks as well) in unsecured Personal Loan mad rush – be it Standard Charted (Prime FInancial), HSBC (Pragati Finance), ICICI (retail PL), HDFC Bank (HDFC Express) Barclays, CITIBANK (CITIFINANCIAL), GE money, Reliance Money & the list is Endless – I am sure Gold Loan segment is next.. & stroy continues…

Malolan Cadambi . 6 years ago

Welcome to India’s sub-prime sector! Have fun guys!

The Indian Microfinance Crisis

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