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

1. http://en.wikipedia.org/wiki/Microfinance

2. http://www.businessweek.com/magazine/content/07_52/b4064038915009.htm

3. http://microfinance-in-india.blogspot.com/

4.http://www.bsp.gov.ph/downloads/regulations/attachments/2001/circ272.pdf

5.http://economictimes.indiatimes.com/opinion/comments--analysis/Getting-it-right-on-microfinance/articleshow/6979476.cms

6.http://economictimes.indiatimes.com/opinion/interviews/For-profit-MFIs-worse-than-money-lenders/articleshow/6973551.cms

7. http://www.livemint.com/2010/11/22232535/Hollowness-in-banking-a-major.html

Tale of two persons: The Financial Meltdown of 2008

It is Sunday fifth of October 2008. It is shashti (Sixth day according to Hindu Calenders) and the first of festivities of Durga Puja. But I am here to write about something totally different thing. It is about the global financial meltdown, or a small part of it.

No, No, Absolutely not, I am not writing about the reasons, the culprits, the causes, the tools of such destruction. We have enough literature on that, or even more than enough. But what I will write is about the human implications that had, the causes of such implications, and why people are not seriously feeling sad about it.

I was moving my eyes over the headlines of the morning newspaper, when I caught up with this article, I read only what was there in the first page itself, I need not go further, whatever I had to get I got it there itself.

What is loss? Are two losses are same? Lets go through this example.
Once there were two friends Ravi and Anand. Both passed out of the same school, both went to the same college. However, Ravi chose to do his MBA from a prestigious College and Anand, due to strained financial circumstances, begin working in a brokerage at a meagre salary.
Years passed on, both them were still friend, both were in touch with each other, but they have seldom met for years. Both were married with kids. Ravi, after doing his MBA, joined a bank as trainee, salary is five figured and in denominated in dollars, now he a investment banker, his salary is left to your imagination. Anand, since he had started working earlier, didn't went for regular post graduation, he did it from correspondence. He left his first job and changed many since then, his current job pays him a salary of six figure, denominated in rupees. Ravi, stayed in an upmarket enclave in Manhattan. Anand was in his old government flat.
As the banks began to collapse in 2008, Ravi, in a single day, lost his job, but he always has expenses to meet, the rent of his upmarket home, insurance, grocery etc., leave alone savings that he has to make. Anand on the other hand, too have tougher time, his raise was freeze, adding on to that, the crippling inflation in the country was eating into his daily grocery budget and future planning. One day, both of day met at IM, and began to share there feelings, Ravi was distraught, for him, it was a great loss, now he has to meet his rent and other expenses, the upmarket apartment, which provided him the serenity, now was pinching, they had to move out. Anand kept wondering, who was at great loss, himself who was at place, when he started his career, or Ravi whose monthly expenses amounts to his two years annual salary.

This is the question that struck my mind immediately. Those who had lost in this meltdown, had lost a great deal. But what about those who did had anything to lose at all, but still at a loss. To fall from a position in tip always hurts, but when it is shared with persons whose income is all but your expenses. What if the other guy falls, and if he did he falls down he falls to the dumps. Which fall is bad, which one is more pathetic.

Going back to the example again, both Ravi and Anand worked for 10 hours a day at least, whereas Ravi has access to best food and gym, Anand had to content with television only, and few visits to mall in the weekends if the pocket permits. Ravi dined in the best restaurants in the world, whereas Anand loved the local canteen or dhaba, or a good local restaurant once in a blue moon. Both of them love their families, but their work permitted them to meet them only on weekends, Sundays in case of Anand.

One thing I do believe in is this, that every level more or less all people work equally hard. Only difference is there qualifications, and nothing else. But should it make the disparity that big that one man's expense is other man's yearly income. Well, it can be attributed to the survival of fittest. The move of the smarter one. However, their falls should not make paeans, odes or ballads, because still they are practically not in dumps.