The Hindu Business Line : Best practices for micro-finance, please

The general literature on micro-finance leaves the impression that there are no best practices in place as yet but that a consensus is developing in this direction. Even as the best practices for MFIs/MCIs are laid down, as in the case of other financial institutions and sectors, can one consider what may be called `sound' practices that would be consistent with the spirit of dynamism associated with micro-finance, wonders A. Vasudevan.

THE subject of micro-finance has of late assumed considerable importance in the literature on finance and growth in view of the need to increase income levels, and reduce unemployment and poverty. It would not be surprising if micro-finance institutions (MFIs) or micro-credit institutions (MCIs) appear soon in the books on financial institutions and markets, as a subject that graduate students in foreign universities and post-graduate students in India take to rack up their credits.

Defining MFIs

MFIs may be defined as entities that build upon ideas from the informal credit mechanisms, mobilise resources from members, donors, governments and formal sector banks and other financial institutions, and facilitate the provision of such financial services as insurance, mutual funds, training and capacity-building. MFIs that do not provide financial services and concentrate on credit and resource mobilisation can be described as MCIs. The distinction between the two may be theoretically elegant, but has limited significance in practice.

For, micro-credit is the main, in fact the predominant, activity of most MFIs. The latter are supposed to meet the credit needs of the socially and economically disadvantaged, and those who do not have access to bank credit and financial services in the rural and urban areas. In the rural areas, the financial services may not be quite relevant and micro-institutions in these areas tend to be MCIs.

The general literature on micro-finance is built largely around the methodology that group, rather than individual, lending by MFIs helps realise objectives in an efficient manner, as borne out by the Grameen Bank experiment in Bangladesh.

The economic reasoning behind this methodology is that as a group of individuals, say, five, is formed voluntarily, there is no possibility of what economists call the `adverse selection' problemarising. Almost all the persons in the village know one another well so that they match themselves in a manner that safe borrowers ultimately group themselves.

Nor would there be moral hazard as group members have an incentive to monitor one another and avoid any potential social sanction in the event the member defaults on repayment.

The other members, who commit themselves to joint liability, have an incentive to make public the returns on the project being undertaken by the member and to avoid the social sanctions they may face in case the project fails or the member defaults on repayment. The group may have no collateral.

Access to credit

The efficacy of the idea of group-lending has been generally accepted in the literature on micro-finance in India as well. Group lending in the rural areas where villagers know one another, however, is different from group lending in the urban areas, where slotting individuals into the safe category of borrowers has to be done by some institutional mechanism.

Besides, the issue of collateral, even for group lending in the urban areas, would indeed arise because there is more than one alternative source of borrowing.

In the literature, the groups (styled `self help groups', or SHGs) are supposed to build their own funds before they approach a credit institution, be it a bank or an MFI, for credit. The access to credit, however, is facilitated by non-governmental organisations (NGOs) or civil society organisations. In effective terms, both such entities provide the `good signature' — an expression commonly used in the literature on cooperative banking in India for giving the credit provider the confidence to disburse funds.

Unlike the general literature, where MFIs can be a distinct component of financial architecture with the support of donors and governments, the model of financial development in India appears to rely essentially on the promotion and development of MFIs through credit flows from commercial banks. Cooperative and regional rural banks, the other two components of India's credit structure, hardly have a noteworthy role to play in the development of MFIs and MCIs.

The SHG-commercial bank linkage, facilitated as it is by NGOs, becomes vital as the financial strength and sustainability of MFIs or MCIs would be taken care of by the resources of commercial banks — besides, of course, the donor or government support.

Problems in India's financial architecture

There are, however, some downsides to the financial architecture as envisaged for India. One of these is that banks, in times of high buoyancy in credit demand from the industrial, trade, agricultural and retail sectors, may not be able to support the development of MFIs/MCIs, particularly if they find the deposit growth is less than required.

Yet another downside is that the pressure on banks to provide funds during periods of high credit demand would be considerable if cooperative banks and RRBs perform inefficiently in meeting the growing credit demand from agricultural and other rural activities. Finally, if for some reason, asset prices are not favourable for improving domestic market financing, or if the environment for external financing is not favourable, companies would depend on bank support for their financing needs, thereby reducing the incentive for banks to lend to the micro-finance sector.

One way to ensure sustainability in the sector would be to explore the possibility of promoting securitisation of loans provided to MFIs and MCIs. Or, of having derivatives of bank loans to MFIs and MCIs as an innovative way to ensure that banks have enough liquidity to meet buoyant credit demand during an upswing in the cycle.

From the policy point of view, external commercial borrowing is permitted in the case of government organisations in micro-finance. While this provides relief to the fisc, the government's external liability would increase. Besides, the government would have to ensure symmetry of treatment between government organisations and other corporations in mobilising external resources.

Again, private MFIs/MCIs would be forced to increasingly resort to external donor support to be competitive and as financially strong as their government-backed counterparts. In the process, the authorities would have to closely monitor the nature or quality of external support that flows in the form of donor financing to MFIs/MCIs or NGOs that act as `licensed specialised banks for the poor'.

Advantages of the Indian model

The Indian model, however, has the advantage of not needing to work out regulations specifically for the micro-finance industry. Bank credit flows are subject to surveillance under the present regulatory framework. Insurance and mutual funds are also subject to respective regulations. This does not mean there are no regulatory concerns. Some of the critical ones were highlighted in the form of exploratory questions in the RBI Governor, Dr Y. V. Reddy's address on August 6 at the Micro-Finance Conference in Hyderabad. It would be, as the Governor rightly stressed, useful to be light on regulation in view of the flexibility and informality that MFIs and MCIs operate under.

Could we, then, lay down best practices for MFIs/MCIs as in the case of other financial institutions and sectors? The general literature on micro-finance leaves the impression that there are no best practices in place as yet but that a consensus is developing in this direction. In the meantime, one could consider what may be called `sound' practices that would be consistent with the spirit of dynamism associated with micro-finance.

(The author, a former Executive Director of the Reserve Bank of India, can be reached at asurivasudevan@hotmail.com)

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