Sunday, December 5, 2010

The Microfinance Muddle

The saying goes ‘the whole is more than sum of parts’ and when it is applied to the Microfinance institutions, it couldn’t be more appropriate. After all, it is the small foundation of microloans upon which their empires of millions are being built.

It is not the criticism of the business; in a capitalistic economy everyone has the right to do ethical business within the framework of law. Such endeavor is entitled for its benefits, that is, profits. However, a business whose foundation is usually based upon service of the downtrodden without any expectation of profits and this very fundamental character of being not-for-profit gets altered with growth of business surely raises eyebrows. It is the business of Microfinance, where such thing has happened and is happening. It not evil though, provision of credit to the poor, banking to the unbanked. But it is the way and manner of conducting of business which puts this sector into spotlight.

The model of microfinance is not unique to India; it first gained prominence when it was introduced in Bangladesh by Nobel Laureate Prof. Muhammad Yunus. As success has got many relatives, from there it spread across the world from Mumbai to Mexico City touching as many rural and urban poor who are in need of credit.

Microfinance can be defined as provision of broad range of financial services like loans, deposits, payment services, money transfer, insurance products etc to the poor or low income households, for their microenterprises and small businesses, to enable them to raise their income levels and improve their living standards. But what differentiates it from normal banking is its willingness to provide credit without any collateral and for taking such risks it charges rate of interests, which are normally twice or thrice the bank rate. The Microfinance Institutions or MFIs usually bets on the reputation of its customers, because irrespective of any hardship the poor will payback. It is a business of informality, personal touch, relations and contacts, therefore not surprisingly given the scale; millionaires can be made out this very basis of small loans.

In an editorial in The Economic Times, Delhi Edition, Mr. Arvind Panagariya, Professor at Columbia University and Non-Resident Senior Fellow at the Brookings Institute, expounded that there are three players in the microcredit market; the Self Help Groups or SHGs which are principally promoted by the government, the Microfinance Institutions of MFIs which are either NBFCs or Body Corporate or NGO or a not-for-profit enterprise and the local money lender. These three constitute the entire spectrum of microcredit to the needing masses.

SHGs works on the principle of applying collective wisdom of the group and peer pressure by which it tries that credit is productively used and loan is repaid. MFIs can be in form of NGO, not-for-profit enterprise or an NBFC, it accepts almost no collateral and since it seldom gets any help from the government it charges interests which can be twice or thrice of bank rate. Local money lender can be any person who may not be registered with any authority and provides credit at a high rate of interest with or without collateral.

From an analysis of the characters of these players it can be deduced, as Dr. Y.V. Reddy former Governor of Reserve Bank of India puts, that MFI is essentially a leveraged money lender, whereas the local money lender normally lends out of his own funds, MFIs are actually borrowing monies from depositors, bankers or from shareholders, private equity funds etc and lending the same. SHGs on the other hand depend primarily on government, and given the political compulsions that ruins a democracy, the government usually shows an eagerness to waive loans. This very tendency creates a moral hazard which leads to non-payment and when a financially strapped member of SHG approaches another SHG for loan it makes the entire structure of SHGs weaker and steroidal. This in turn also gives an impression that for profit MFIs are sound, hiding their weaknesses and coercive practices.

Having come this far, it would be prudent to focus on the type of customers on which MFIs usually cater. Usually at the fringes of the society, they are primarily unbanked and do not have any recourse to credit. Even if they have any, it is usually the money lender who can charge high interest and is coercive in recovery of his loans. These people rank really low on creditworthiness and solvency. On these people MFIs with their borrowed money bank upon.

I am not suggesting that poor do not have any right to grow or they do not have any right to do business, but easy credit is a tempting hazard and that is why more and more people are finding themselves drowned in perpetual debt trap. There can be two reason for this, firstly there is a stiffer competition amongst various MFIs to gain new members, irrespective of their solvency or credit history, and secondly the sources of funds of these MFIs. Since sources of funds of MFIs are banks who lend at commercial or market rate and investors who ask for good return, MFIs have to charge an interest rate which is usually charged on credit cards. Further, there are many MFIs in the market with similar sources of funds all wishing for good return on investment. These very pressures usually lead to cost control amongst the MFIs which can only be done through outsourcing and coercive collection practices.

MFIs cater a market which banks do not touch, that is, people with low solvency. Ultimately, as Mr. Reddy points out, it is some sort of sub-prime lending. This is type of lending where the credit is forwarded to person who have low ability or have no ability to pay back. As a MFI grows in size and institutionalizes, it’s very basis of informality and intimacy between the borrowers and lender ceases. In addition, when a MFI hits the stock market, it is then entrusted with newer responsibilities to governance, return, compliance and performance.

This very sector of microcredit is unregulated, that is, there are no standards of maximum interest to be charged or to whom loan is to be provided. Often it has been found that people, who have obtained loan from one MFI, take loan from another MFI for repaying their first loan and fall in debt trap. This practice plagues the MFIs with the same disease with plagues the SHGs. This story is same across the world wherever MFIs operate and have resulted in converting a boon into bane.

An effective regulation of the sector, in letter as well as in spirit, is the necessity of the moment. Already it is been speculated that many MFIs would shut shop as their sources of finance, that is the bank loans, have dried up and government diktat of controlling the interest rates would lead to loss. It is imperative that the sector is needed to be regulated but such regulation should be only from one authority, which will give some predictability and clarity to this sector. Multiple regulators can only act as nails to the coffins of this ‘sunrise’ sector.

It is a season of scams and scandals, and in this we are lost in the maze of Niira Radia, 2G and CWG. Why not? Once exposed they give us a good punching bag to trade punches without being hit back, and if there is any sense of ‘justice’ left we might even get a scapegoat. But just take out few minutes of time to think about this, whatever may call it, I’d prefer to say muddle, which directly affects our banks, economy and the very person who brings our milk, washes our dishes or even produces our food. This muddle affects them directly, and if you don’t think about it now, few months we might again be arguing. What is government is doing about poverty?

© Tarun Mitra