Can microfinance attain industry status?

We all know that the target market, competition characteristics and the model itself expose microfinance to specific risks, over and above the financial services industry. Hence, for microfinance to achieve industry status, it is imperative to measure and mitigate these risks.

And herein lies the crunch. One of the two approaches — poverty alleviation or commercial sustainability — is likely to have a direct bearing on the measurement of risks as well as its mitigation. Currently with a larger play from the only-for-profit equity investors, the equation is skewed towards commercial sustainability (read profitability) alone.

The industry (if we can call it that) and its players are facing four key dilemmas — profit, relationship, managing risk and the best business model. Before delving deeper into each dilemma, let us quickly take a snapshot of the imperatives.

At a juncture when the microfinance sector aspires to access diversified sources of funds and is poised to integrate with the formal financial system, sector leaders must choose between commercial sustainability as advocated by the Washington-based Consultative Group to Assist the Poor (CGAP, a consortium of 33 development agencies that support microfinance), or the social goal of poverty alleviation.

Alternately, there is a hybrid model at hand: judiciously blend both in an efficacious mixture that works for all stakeholders.

Current discourse on microfinance-risk focuses on refinancing, over-lending, falling underwriting standards in pursuit of high growth, an inadequate management information system (MIS), unhealthy competitive and recovery practices, regulatory risks and concentrated geographies of operations, among others.

Instances in Kolar district in Karnataka and in Krishna district in Andhra Pradesh have confirmed that these risks are interrelated and sometimes manifest in the form of no-payment movements by borrowers.

The focus on financial parameters is not bad in itself, and a time-bound goal orientation to meet commercial expectations is critical in the growth phase. The adverse cost structure facing the service provider has rebounded on consumers in the form of a large unmet need for microfinance products, be it credit, insurance or savings.

The financial inclusion initiative of the Government potentially could address the policy level framework on provision of these services. Hence, it is quite obvious that anyone who targets this market segment will have to innovate to surpass the adverse cost structure barrier and, given the political sensitivity associated with the target market, it is important that entrepreneurs communicate this adequately to external stakeholders to manage risks.

Microfinance leaders have certain key issues to resolve, if the sector is to mature into an industry in a sustainable way.

The profit motive

There has to be a distinction between profit motive and profiteering. While the former contributes to the growth of entrepreneurship and better deals for the financially excluded, the latter will lead to exploitation. Micro-financiers should be able to boldly articulate profit as a legitimate motive and build necessary credibility through spirit and action to distance themselves from being perceived as profiteering.

Relationship approach

Another dilemma which needs resolution is that of relationship-building with the end borrower. Application of a retail banking framework with its almost hard-coded cycle of origination, underwriting, collection and recovery may not be suitable for microfinance, where enforcement of legal contracts is more illusionary than real.

The ‘cookie cutter model' and ‘McDonald's style' of highly standardised functioning might yield better efficiency ratios in the short-term, which aids valuation but in the long run it has to be relationship oriented. Given that in delivery of services the deliverer is not distinguished from the product itself, this relationship can be built only by a well-trained front-end field force adept in managing relationships.

Therefore, the larger question is in pursuit of higher valuation and operational goals whether the focus on human resource (HR) development is diluted and, if so, what would be the impact on portfolio quality. With a substantial percentage of the field force having low vintage, this aspect deserves far higher attention that what is being accorded today.

Ironically, the relationship management-led model of financial services delivery that is generally believed to be viable for wealthy clients, is the model that is deemed most effective in servicing microfinance clients.

The DNA change from faceless banking to relation-based banking is undoubtedly costly, and microfinance service delivery would need a viable cost structure. This would mean that the sector should constructively convey that business can be run only on a commercial basis, if it has to be scaled up in a meaningful manner.

In a high-growth scenario that focuses on ever-greater efficiencies, by reducing transaction time and cost, the relationship aspect takes a backseat and this can significantly impact portfolio quality in the medium-term. The need for improving profit and growth targets through higher efficiencies, without sacrificing the relationship with end borrowers, is a challenge to be traversed by microfinanciers.

Managing risk

Conceptually, microfinance has its own unique ways of managing risks. Direct application of retail banking practices without adequate consideration of market nuances could lead to dilution of credit-risk management features reflected in its processes. There are inadequate incentives for putting in place an appropriate risk management system in microfinance mainly due to the availability of debt due to the regulatory influence. This system should have a well-designed, documented and efficient fraud-control mechanism.

As long as the fortunes of this sector are inextricably linked to the performance of a select group of large microfinanciers, achieving industry status could prove elusive.

Managing industry risk at a larger level requires purposive creation and nurturing of a pipeline of MFIs at different lifecycle stages, so that the crowding of equity and debt investment in the top MFIs ebbs. This is a puzzle that remains to be resolved at the investor-lender levels.

Grant-led model?

Due to perceptions of poverty alleviation, the microfinance sector has its base built on donor money, the significance of which dwindles once commercial money flows in. Given the debate in the public domain about the nature of the initial funding of many MFIs (similar to that which followed the Compartamos IPO), and the RBI Annual Report which has raised a concern that the interest rate advantage provided by the PSL classification of bank loans to MFIs is not being transmitted to end-borrowers to the extent desired — MFIs need to introspect whether a return to a grant-led model is possible.

In other words, minus the money currently flowing into the sector from commercial or banking channels, are microfinance operations sustainable? If not, the sector will fall under its own weight as the grant-led model cannot cater to the continual and incremental nature of end-borrower loans.

This appears to be the most critical risk the sector currently faces, especially in the ‘post-Malegam report' era, which is likely to influence the quantum of credit flow from the banking system to the MFI sector.

The Ultimate Goal

Resolution of the aforementioned dilemmas will be critical to the maturing of the sector and becoming an industry where fixed income players such as mutual funds, insurance and pension funds find investments attractive; which, in turn, leads to true integration of microfinance into the formal financial sector.

Resolution of these dilemmas would also take care of symptoms such as multiple lending and unhealthy market practices at front-end operational levels to a great extent.

This would further release microfinance chief executive officers (CEOs) from daily crisis management, providing them adequate time to pursue growth plans, ambitions and aspirations — all essential to unlock innovations that may lead this sector into sustainable transition and its emergence thereafter as a full-fledged industry.

(The author is Mr Ganesh Sankaran is Executive Vice President (Credit and Market Risk), HDFC Bank. His views are personal.)

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