Questioning the Intent of Indian Microfinance Institutions

Author: Priyanka Joseph

Micro finance institutions (commonly known as MFIs) were created with the socio-commercial objective to provide low income population, an access to credit and thereby aid in poverty alleviation. Microfinance loans serve the low-income population in multiple ways: providing working capital to build businesses; infusing credit to smooth cash flows and cushioning against the economic impact of shocks such as illness, theft, or natural disasters. Moreover these loans were meant to rescue the borrower from the high lending rates imposed by traditional moneylenders.

There seems to be an uncanny resemblance between the business models practised in microfinance lending and sub prime lending. However, the main differentiator between the two is that a sub prime loan charges a high rate of interest assuming a high probability of default by the borrower. In the case of MFIs the high rate of interest arises from high operational costs due to smaller sized loans. Therefore the success of the MFI scheme would largely be dependent on the firms’ ability to assess the repayment capacity of the borrower, as many of them would not have a so called “credit history” to begin with as against the case of unfavorable credit history in the case of sub prime lending.

The Indian microfinance sector is noted to have one of the smallest loan sizes of around $150 as well as the lowest yield on portfolio of 21.2%. Despite the global recession and subsequent liquidity crunch, the Indian microfinance industry sustained growth and continued at an increased rate in the second half of 2009. As of March 2009, the MFIs in India reported a client base of 22.6 million with an outstanding portfolio of more than $2 billion. Since 2005, the sector has delivered a CAGR of 86% in the number of borrowers and 96% in portfolio outstanding.

Despite this promising performance, the industry has come under the scanner in the last couple of months for reasons varying from alleged suicide cases induced by high interest rates, coercive collection methods and corrupt and unethical practices of the top honchos of some of the largest MFIs.

In response, the Andhra state government (Andhra Pradesh having the largest concentration of microcredit borrowers) has published an ordinance that is an attempt to exercise greater control over the activities of MFIs. As media frenzy and speculation among government, investor and other stakeholder groups surrounding the crisis ridden microfinance industry heightens, it is worthwhile to go back to the basics and examine key characteristics and principles that will help define and assess the long term sustainability of Indian microfinance companies.

While measuring the metrics, it appears that we have lost sight of equating progress or ‘growth’ with poverty alleviation. In the Indian context, the achievement of the commercial component within the “socio-commercial” objective is clearly evident. Apart from lending, MFIs have broader responsibilities of limiting credit dependence. Moreover, microcredit is meaningful only if it is a part of a range of offerings including microinsurance, financial literacy, and entrepreneurship skills training.

Over the last five years, as MFIs chased growth, the nature of microfinance delivery has changed. The job of income generation and social capital building was left for others to tackle. As competition intensified, and markets reached saturation, MFIs took on the additional risk of lending to households with uncertain cash flows. If this trend persists, there is a huge likelihood that the industry will follow some of the flawed practices of the sub prime lending models, resulting in huge collective losses over a period of time.

Since self regulation within the industry has not been completely successful, government imposed regulations become unavoidable at this juncture. Government intervention does not necessarily mean the death of the micro finance industry as we know it. But it will definitely have certain implications on the workings of these institutions.

Short term challenges will include shelving of IPO plans by some MFIs and more state level regulations similar to the Andhra Ordinance. However, this could negatively impact some of the smaller MFIs and push them into bankruptcy.

From an investor perspective, growth in the future is likely to be much more muted than it has been in the past.