So the Malegam Committee’s recommendations are out. They do much, to affirm the value of microfinance, and define its identity and activities. There remain some implications which are less clear. We will try to summarise them in this article.
As we have stated elsewhere, the Malegam Committee’s recommendations are welcome simply for recognising and legitimising the important role of microfinance. However, the constraints that the Committee has placed around defining the borrower (at or below an annual household income of Rs 50,000) and the loan amount ( Rs 25,000) may merit revisiting.
The mandatory cut-off is hard to enforce. Poor households’ income is inherently erratic, and it is difficult to ensure that it will not exceed Rs 50,000 during the tenure of a loan.In addition, it effectively discourages families from improving their income – or at least from reporting improvement. Once a household’s income crosses Rs 50,000, it has no alternative but to go back to moneylenders (or conceal some income).
Similarly, in restricting the loan amount, the Committee allows (justifiable) concern over multiple lending to over-ride the reality that a borrower seeks multiple loans simply because no single MFI or Self Help
Group meets her needs.
The Committee reiterates that MFIs should not take deposits. Still, is it possible to ask for an open mind on the possibility of MFIs, with their demonstrated reach to the poor, functioning as Banking Correspondents, with appropriate safeguards?
The Committee also made recommendations that moderate some provisions of the AP Act. The recommendations do specify that all interaction with the borrower must be in public places, and that severe penalties will be imposed in case of coercive practices. These, we believe, provide adequate safeguards for the borrower.
The Committee has made some recommendations which are likely to raise some barriers to hitherto easy entry into this business.The first is the enhancement of capital requirements. The Committee has recommended that net owned funds should be in form of Tier I capital,and has set the minimum capital for NBFC-MFIs at Rs 15 Crore.
These recommendations essentially restrict MFI promoters to corporates, or individuals backed by investors with significant capital. However, we cannot recall any MFI currently operating in India that started with that kind of capital backing. Given the restrictions on commercial upsides, we are unsure if any promoter can do so in future.
The minimum capital exceeds the amount required to start a regular NBFC or even a Housing Finance Company. It might make sense to raise it in stages, and uniformly for all categories of NBFCs.
The Committee’s recommendations on provisions are stringent, but perhaps required for the sector. But given the widespread defaults that have occurred in AP recently for obvious reasons, most MFIs with any significant presence there could see their entire net worth potentially wiped out, if the recommendations are strictly enforced. Since these defaults have occurred under exceptional circumstances, would the Committee consider some interim relief?
The recommendation to establish a domestic Social Capital fund is potentially exciting, though there is little precedent of domestic investor participation in social venture funds already operating in India. Still, we welcome the move.
The Committee’s recommendations on interest rate caps and margin caps are still being debated. We suggest that a cap on the lending rate without a cap on the borrowing rate is asymmetric. We recognise and welcome the intention to protect borrowers, but if the Committee must cap, we wish it had capped both sides.
The margin-based pricing policy is interesting but could lead to some skewed results. Our analysis shows that when an MFI starts operating under margin cap pricing, any decrease in borrowing cost impacts the PAT negatively. This is because its impact only applies to a proportion of the portfolio (the debt-financed portion, assuming there is some equity), whereas the impact of the margin cap on the income side applies to the entireportfolio. Hence, any reduction in borrowing cost actually impacts the MFI’s bottom line negatively.
Additionally, a start-up MFIcannot raise debt from the banks at the same rates as the larger MFIs. Typically, it is charged 100 to 200 basis points more. We would therefore suggest there should be some relaxation of the pricing cap for smaller MFIs.
More broadly, since the pricing recommendations are based on calculations of various cost elements, we would strongly recommend that the ratios (especially for the smaller MFIs) used in the Committee’s recommendations are validated using a bigger sample. The report itself admits that these numbers are significantly skewed as they do not take into account assigned portfolios which are not reflected on the MFIs’ balance sheets.
The Committee’s recommendation that MFIs should not levy an insurance administration charge is difficult to justify. There is a real expense involved in negotiating and arranging insurance, and paying premiums to the insurance company. Further, the Committee has asked MFIs to recover insurance premium as part of loan repayments, and not up front. Hence the premium amount has to be financed by the MFI. The IRDA allows fees or commissions up to 10% of the premium; it ignores business realities for the RBI to compel MFIs, with capped rates, to provide this service for free.
In summary, the Committee’s recommendations will moderate enticements for players to become NBFC-MFIs. Some MFIs may redefine themselves as “financial service providers” and continue to serve households at slightly higher, but still financially excluded, income levels.
Returns for Investors
In order to ascertain the impact of the Committee’s recommendations, we created a number of financial projections for a start-up MFI under different growth scenarios. The details are provided
There are many assumptions,but our analysis suggests that a start-up MFI on reaching steady state is able to generate an ROA of only 2.0-2.5%. The post-tax ROE barely reaches 11-15%. The Malegam Committee hopes that “domestic social capital funds” will accept “muted” returns of 10-12%. Based on these projections one could argue that theCommittee got itsnumeric target spot-on; but not manyother funds will be willing to take early stage risks, wait five years and then be satisfied with such ROEs.
So, does it mean that there is no longer a case for commercialinvestors in microfinance? Actually, there might still be. We computed returns for an Angel Investor, a Series A Investor, and a Series B Investor under the same assumptions as above.Our Angel Investor generates an IRR in the range of 20-22% over a five-year period even in the most conservative scenario.This would be adequate to meet the hurdle rate for most social investors, microfinance funds and Development Finance Institutions. It may not be sufficient to meet the requirements of purely commercial Venture Capital and Private Equity funds.
However, commercial funds who come in as Series A or Series B investors, after the business has broken even and started generating steady-state returns,can expect IRRs in the range of 25-35%.
Clearly, these returns pale in comparison to those of the last 5 years. But this exercise does demonstrate that equity investment in microfinance remains a viable proposition (even if not as spectacular as before), under these very conservative estimates.
Microfinance will no longer create overnight billionaires, but remains a value-creating business,while continuing to achievesocial impact.Rumours of its death, as Mark Twain might have said, are “much exaggerated”.
In conclusion, we offer the following summary of our key recommendations:
1. Increase the limit on annual household income to Rs 1,50,000;
2. Provide flexibility to MFIs to design their products around appropriate tenure, loan amounts, and interest rates, while retaining measures that protect borrowers;
3. If the minimum capital requirement for NBFC-MFIs must be raised, we suggest it be done in stages, and uniformly for all NBFCs;
4. Revisit pricing recommendations based on calculations of operating efficiency;and offer some relaxation of the pricing cap for smaller MFIs;
5. Moderate the applicability of the new provisioning norms with some interim relief for MFIs affected by the crisis in AP;and
6. On the principle of recognising business imperatives, remove the requirement that MFIs should pass on insurance at cost.
All said and done, we remain optimistic about the microfinance sector, and unabashedly positive about its potential to continue contributing to financial inclusion in India.
K Sree Kumar is the CEO and Anurag Agrawal is Senior VP 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 released by Intellecap.