Whatever happened to microfinance?

Within a relatively short time, perhaps just a decade, micro finance has gone from being hero to zero in the development discourse: from being lauded as the silver bullet to solve the problems of development and poverty reduction, to being derided as the progenitor of financial instability and enhanced vulnerability among the poorest people who can ill afford to take this additional burden.

Nowhere has this been more evident than in India, where the overwhelming enthusiasm for microfinance among policy makers, aid donors and development experts has been replaced with not just much greater caution but even revulsion in some cases.

Around the middle of the previous decade was the high watermark of national and international support for microfinance. One of the founding fathers of this strategy, Mohammad Yunus of the Grameen Bank in Bangladesh, received the Nobel Prize (for peace, not economics) in 2006.

The global surge in enthusiasm for this concept also extended to the active promotion of microfinance as a viable commercial activity to be engaged in for profit. The mushrooming of MFIs of both non-profit and profit varieties was very quickly followed by crises in many of the same developing countries that were earlier seen as the most prominent sites of success, in the typical manner of most financial bubbles that burst.

Credit sans collateral

Microfinance is most fundamentally the provision of credit without collateral, usually in relatively small amounts and for short periods of time.

The excitement around microfinance (and microcredit, in particular) has generally been based on the perception that it allows formal financial institutions to enter into forms of lending that are otherwise dominated by informal arrangements, such as traditional moneylenders.

The phenomenon of group lending, whereby borrowers are clubbed into small groups whose members typically received sequential loans, has been seen as the fundamental innovation that allows microfinance institutions (MFIs) to service clients without collateral, who would otherwise be excluded not only because of the risk of default in general but because of the difficulties and high transaction costs involved in sorting more and less reliable borrowers. This is achieved through peer monitoring (Stiglitz 1990), since the members of the group now have a direct interest in ensuring that no individual member defaults.

This reduces both ex ante moral hazard and adverse selection since the borrowers (who are presumed to have greater knowledge of one another) will not choose to be in groups with potential defaulters.

Risk is on borrowers

What this effectively means is that all the costs and risks of the lending process are transferred from lenders to borrowers.

So the joint responsibility condition, combined with the sequential payments that function as a sorting mechanism, allows banks to avoid the problem of choosing more risky clients even though the bank remains as ignorant as ever about who is safe and who is risky.

Proponents argue that this process of voluntary self-selection among borrowers allows price discrimination whereby riskier groups pay higher rates, so that safer borrowers no longer have to bear the burden of riskier ones. This reduction of cross-subsidisation, in turn, implies some reduction in average interest rates.

However, this particular route to financial inclusion imposes a heavy cost on borrowers, who are forced directly or indirectly to undertake the supervisory, monitoring and penalising activities that are usually seen as the responsibility of lenders. For one thing, all borrowers may not want (or have the time) to engage in these activities.

The process can also be destructive of social cohesion or aggravate existing forms of economic and social hierarchy and discrimination.

The self-selection into groups can be based on existing stratification, with the poor or marginalised within a population getting disproportionately excluded from groups containing viable borrowers.

Further, the sanctions imposed on potential or actual defaulters typically involve not just economic actions but social discrimination and tension that can become unpleasant and oppressive for all concerned.

Indeed, it has been noted that better-off borrowers tend to get more rapidly dissatisfied with the group lending contracts so that several more established MFIs (including Grameen Bank in Bangladesh and BancoSol in Bolivia) have been pushed to introduce individual lending contracts for more successful or better off borrowers.

‘For-profit’ format

Charts 1 and 3 are based on data provided by the Microfinance Information Exchange (www.themix.org) on MFIs in India. A sample of 26 reasonably large MFIs for which data are available from 2005 to 2011 has been taken.

These include some of the more prominent NGO providers (such as SEWA Bank and SKDRDP) as well as some not-for-profit companies some of which “transformed” into for-profit companies (such as Share Microfin Ltd, Spandana, BASIX and SKS Microfinance).

The charts show clearly how the main indicators of MFI performance peaked in 2010, and thereafter have been coming down.

The gross loan per active borrower is the only one that shows some increase — but that is probably illusory, since many loans that should be written off because of low possibility of being repaid are still being kept on the books.

How did this decline occur? The answer must be sought in the recent pattern of growth of microfinance in India.

This originally began as part of a developmental and poverty reduction project, led by NGOs who thought this would be an effective way of allowing the poor to lift themselves out of poverty by their own bootstraps.

Many NGOs began the process of group lending based on Self-Help Groups, and the linkage with commercial banks (whereby banks were allowed to lend to groups with a proven track record of repayment) further enlarged its scope.

Unlike Grameen Bank and similar institutions around the world that are funded primarily by deposits raised from their own borrowers and non-members, Indian MFIs are prohibited by law from collecting deposits.

When donor funds were not forthcoming, they could not access private investors because they could not distribute the profits made, which made it harder for them to access adequate capital for expansion.

This led to the drive for “transformation” of the industry — the move from not-for-profit to for-profit format.

While the MFIs of the 1990s were all started with the explicit intention of broader public purpose, and therefore spearheaded by NGOs, in the 2000s, several of them transformed into for-profit entities and new ones emerged that originated with a for-profit intention.

This process was actively assisted by the public sector bank SIDBI (Small Industries Development Bank of India).

In addition, the former development bank ICICI Bank, which had itself transformed into a commercial bank that aggressively sought new profit-making opportunities, launched a securitisation product in 2003, wherein it would buy out the portfolio of the microfinance institutions in return for an agreement for collection of the loans — every time a portfolio was bought out, the MFI would get the ability to lend and borrow more and therefore expand.

‘Get rich quick’

At the time this process was widely celebrated as a “win-win situation” as private profit could be associated with financial inclusion, reaching formal financial institutions to the poor who were otherwise excluded.

However, the problems with this for-profit model speedily emerged, as the excessively high interest rates and often unpleasant and undesirably coercive methods that were used to ensure repayment showed that these new “modern” institutions were no different from the rapacious traditional moneylenders that were supposed to be displaced by the more supposedly acceptable norms of institutional finance.

Most MFIs charge interest rates of anywhere between 30 and 60 per cent per year, with added charges and commissions and penalties for delayed payment. The rates are, therefore, not dissimilar to the rates charged by traditional moneylenders and other informal lenders in rural India.

M S Sriram (“Commercialisation of microfinance in India: A discussion of the Emperor’s apparel”, Indian Institute of Management Ahmedabad , Working Paper No 2010-03-04 ) has also pointed to another aspect of this transformation that has more in common with the various other methods of “get rich quick” capitalism of the past decade in India.

In a study that examines in detail the “transformation” of four prominent MFIs in India (SKS Microfinance Ltd, Share Microfin, Asmitha and Spandana) he notes that in some cases this was also associated with the private enrichment of the promoters through various means.

These included inflated salaries and stock options provided to the top management who were usually the promoters.

A more “interesting” legal innovation was the use of Mutual Benefit Trusts that aggregated the member-borrowers of SHGs as members.

The grant money received for the purposes of “developmental” microcredit could then be placed in the MBT, which would, in turn, contribute to the newly created for-profit MFI.

In the case of two of these companies (Share Microfin and Asmitha) the matter was compounded by cross-holding since the promoters of the two companies were the same.

The Initial Public Offering of SKS Microfinance in 2010 was attended by a media blitz in which the Who’s Who of the international private philanthropic community joined hands with other investors in singing the praises of this new model that supposedly combined private incentives with public purpose.

Ironically, this was also the most apt representation of hubris before the collapse, as the for-profit microfinance model then suffered severe blows to both its prestige and its viability, from which it has yet to recover.

Rise of agents

The explosion of MFIs in India was heavily concentrated in two States — Andhra Pradesh and Tamil Nadu, which by 2010 accounted for more than 90 per cent of all borrowers and value of loans of MFIs.

The problems with the model — and particularly the profit-driven version — were becoming sharply evident by the middle of the year 2010. By then, media reports were talking of more than 200 suicides in the year in AP alone, related to the pressure of repayment of MFI loans.

M. S. Arunachalam (The Journey of Indian Microfinance: Lessons for the future, Chennai: Aapti Publications 2011 ) has pointed to a number of causes for the microfinance crisis, particularly in Andhra Pradesh, which are closely related to the very functioning of the sector in both for-profit and not-for-profit variants.

In particular, the explosion of multiple lending and borrowing was a prime cause, and it was positively encouraged by MFI lenders. Poor households took on multiple loans from different sources, often only for the purpose of repaying one of the lenders, and this was actively fed by the combination of aggressive expansion in the number of clients and strict enforcement of payments.

Further, despite the claims about personal involvement and group solidarity being the basis of the lending process, Arunachalam notes the widespread use of agents.

There are two main types of microfinance agents: local grassroots politicians, who use the loans to add to their political clout; and the heads of federations of borrower groups (or Self Help Groups) who make an additional profit by controlling or appropriating the flow of loans. Such agents also exercise tremendous power vis-à-vis not just the borrowers but also the MFIs themselves, as they ensure clients for the MFIs or cause them to lose clients, and have their own means of (usually extra-economic) coercion to ensure payments.

These agents have become essential to the functioning of the system, as MFIs benefit from them and yet can claim that they are arms-length from any malpractices involved in loan recovery.

The Andhra Pradesh state government blamed the MFIs for fuelling a frenzy of over-indebtedness and then pressuring borrowers so relentlessly that some took their own lives.

It immediately brought in regulations to control their activities, and particularly measures to prevent the forcible recovery of loans from poor borrowers.

This generated an acute crisis of the MFIs, which was then aggravated by a wave of defaults across the State, which have since made most of their functions financially unviable.

The level of confidence that many MFIs will remain has further reduced the incentive to repayment, thus leading to a stalemate. An Economic Times report in 2011 quoted the high flying Chairman of SKS Microfinance Vikram Akula as saying that the loan recovery rate in Andhra Pradesh had dropped to 10 per cent — he resigned from that post shortly afterwards.

Draft legislation

At present there is a draft legislation that has been placed in Parliament on the regulations of MFIs - “The Microfinance Institutions (Development and Regulation) Bill, 2012”.

The legislation is supposed to deal with the regulatory issues and make it possible for MFIs of both non-profit and for-profit varieties to function again.

The main concern, however, is that the regulation as it is currently drafted puts more emphasis on “promotion of the microfinance sector” than it does on the necessary regulation and the need for developing mechanisms to ensure strict compliance with the regulations, that will limit phenomena such as overlending, multiple borrowing and coercive means of repayment, especially through agents.

More worryingly, the draft legislation implicitly seems to be driven by the belief that microfinance is an effective way of poverty reduction — a claim that is less and less valid on the basis of international and national experience.

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