Microfinance in India Part 2

As I previously stated Andhra Pradesh emerged as India’s largest site of micro-finance activities due to the early efforts of the Indian government through its Self Help Group-Bank Linkage Programme with some financial assistance from the World Bank. The government built its robust MFI portfolio through cooperation with NGOs investing in new financial client education. Private MFIs and government MFIs – the Self Help Groups – provide a range of financial services at similar prices, which results competition. In some cases, SHGs have been used by political players as vehicles of patronage, thus further complicating the picture.


In the past five years AP, experienced two major MFI financial crises, one took place this past year and the other in 2006. The circumstances for the crises were similar and led to a state-wide lending freeze. MFIs faced accusations of usurious (unfairly high) interest rates, opaque pricing models, inappropriate collections methods, poaching clients from SHGs and culpability in suicides. Both crises brought to light improvements that the industry will want to focus on; improving client protection, developing credit bureaus, and creating an environment of sustainable growth.


Both crises brought out a number of grievances. 


High interest rates: Indian MFIs charge different clients between 24% and 40% interest per annum. Recent equity market studies indicate that a well run MFI charging 28% on a loan will have a return of approximately 8-10%. So what are alternatives for poor clients? Option 1: traditional moneylenders which still charge higher rates and tend to be a rougher crowd than MFI representatives. Option 2: borrowing from SHG (Self Help Groups), which receive preferential lending rates from commercial banks, thanks to a lending subsidy from the Indian government through a variety of financial vehicles. SHGs lend to clients at annual interest rates of 24-48%. 


Multiple borrowing: Although it happens, multiple-borrowing takes place rarely, due to two factors poor clients are more risk averse in general and once they join a group of similarly risk averse borrowers that will take a loan together, the resulting group of borrowers ends up even more risk averse than individuals. With that said, borrowers that take more than one loan tend to make national and local news as they are the ones that will likely take their own life in the event of inability to pay back borrowed funds.


Coercion in collections: Micro-lending relies on the model of lending to groups that have potential to maintain a high level of fiscal discipline, which is enforced by members of the borrowing group internally. Paying back as a group will open up opportunities for future loans. However this model relies on the ability of clients to make weekly repayments on their loans and everyone falls on hard times at some point in their life. Since the reality of default exists, protections for individual clients fallen on hard times can be instituted by financial institutions. Such regulation will protect the vulnerable individual debtors and MFIs lending to them from public outrage and liquidity issues associated with panics. Additionally, in a few rather rare instances some MFIs have hired a few less than upstanding collectors who have used less than reputable methods to collect on loans. Since abuse of customers by collectors has occurred in the past, regulation that codifies acceptable ways of collecting on loans may be a good idea.


Proposed Regulation


The Malegam Committee was born in October 2010 to look at the MFI crisis and propose remedies. The committee is part of the Reserve Bank of India. Implementing regulations coming from the RBI will supersede state level regulation already in force. Proposed regulations by the Malegam Committee will likely enter force around April 1, 2011. The new regulations aim at both protecting consumers and allowing MFIs conduct the business of lending. 


New regulation would cap interest rates offered to clients of MFIs at 24%, limit the size of the loan to 25000 Rupees ($550 USD) and restricts the number of loans per borrower two just two. In order to control the MFIs’ profit margin the Committee proposes a cap on the differential between the lending institutions’ cost of borrowing and lending to clients at 10%. The Committee proposed a separate regulatory category for MFIs; non-banking financial companies (NBFC-MFI), requiring MFIs portfolios to include at least 75% of loans for income generation, and allowing borrowers to choose frequency of payments; weekly, bi-weekly, or monthly payments. A microloan qualifying household must earn fewer than 50000 Rupees ($1200 USD) annually. The Commission also proposed capital requirements for micro-lending institutions. Regulation of MFIs is proposed through the National Bank for Agriculture and Rural Development in cooperation with the RBI. 


So what do these regulatory proposals mean? Regulation affects the MFIs, the SHGs (indirectly), their clients and the overall micro-credit industry in India. Implications for all three groups are different. What are the effects on micro-lending institutions? The good news is that regulation of MFIs remains under national and not state government institutions, allowing for a regulatory approach relatively far from local political and social upheavals. The downside is that no other non banking financial companies have a proposed interest cap looming. Self Help Groups (SHGs), which compete for MFI customers and vise versa, do not fall under the same set of regulation, potentially giving them a competitive advantage over MFIs. 


Market competition with other financial institutions offering similar services for a better price provide stronger incentive for efficiency than interest rate caps. Interest rate caps will not bring get customers improved and better priced products. While I outlined some of the more straight-forward recommendations by the Malegam Committee earlier, I found other recommendations either hopelessly confusing or contradictory. If all proposed regulations are passed and enforced, they will likely drive well run and relatively efficient MFIs out of business, because they may not be able to fulfill all regulatory requirements. On the other hand, additional regulation while expensive and painful  in the short term, may help rebuild MFIs’ credibility both as fair lenders to their customers, sound investments for both private funders and large multi-nationals, and borrowers of good standing for commercial banks. New regulation will also help unfreeze the micro-lending marketplace after the last financial crisis, giving more opportunities to MFIs and their customers.


The SHGs in the short term will gain a competitive advantage in providing financial services to current and new customers, while MFIs work through new regulations and ways to conforms to their new regulatory environment. In the short term, some SHGs may end up losing business, because of interest caps on MFIs. While it is unlikely that interest rate caps on MFIs will help them become more efficient, the caps are in fact lower than SHGs’ interest rates. So once the MFIs work out compliance issues they will at the very least offer less expensive financial services to customers, which may lead to some SHG customers choosing to bank with MFIs. 


The SHGs, the MFIs, and the Indian government see the micro-lending customers as their chief concern and the reason for new proposed regulation. Do they win? In my opinion, customers will likely lose. Why? Customers seeking micro-lending loans in the short term and possibly in the long term as well see less different options for sources of financing. Some MFIs are bound to go out of business. MFIs may close their doors due to inadequate capital in reserves, loss of investor confidence, inability to comply with new regulation, or continued large numbers of non-performing loans. Interest caps on MFIs will not incentivize them to become better and leaner lenders, thus regulation will not result in an improved and less expensive product. Through new regulation customers will gain more flexible payment plan options and protection in terms of the way that lenders may collect on their loans. At the end of the day, customers will see a micro-lending market with fewer options, pretty much the same interest rates, no drastically improved financial products, and slightly stronger consumer protection.


Sources:

1. Bansal, Hema "SHG-Banking Linkage Program in India." Micro Finance Focus 9 August 2009. <http://ifmr.ac.in/cmf/mrap/wp-content/uploads/2009/04/shg-bank-linkage-program.pdf>
2. “Malegam Panel Proposes 24% cap on Interest rate on MFI Loans.” The Hindu. 19 January 2011. <http://www.thehindu.com/business/Economy/article1103090.ece?css=print>
3. Moksim, Julie. “MICROCAPITAL BRIEF: Reserve Bank of India (RBI) Subcommittee Proposes Regulation for Microfinance Institutions (MFI).” Microcapital.org. 26 January 2011. <http://www.microcapital.org/microcapital-brief-reserve-bank-of-india-rbi-subcommittee-proposes-regulation-for-microfinance-institutions-mfi/> 
4. Rai, Vineet “India's Microfinance Crisis is a Battle to Monopolize the Poor” Harvard Business Review Blog , 4 November 2010. <http://blogs.hbr.org/cs/2010/11/indias_microfinance_crisis_is.html>
5. Ravi, Medha. “MICROCAPITAL BRIEF:  Reserve Bank of India (RBI) Proposal a Positive Step Argues Tripathi…But Andhra Pradesh Government Oversteps.” 19 July 2011 <http://www.microcapital.org/microcapital-brief-reserve-bank-of-india-rbi-proposal-a-positive-step-argues-tripathi%E2%80%A6-but-andhra-pradesh-government-oversteps/>
6. Rhyne, Elizabeth. “On Microfinance: Who's to Blame for the Crisis in Andhra Pradesh?” Huffington Post. 2 November 2010 <http://www.huffingtonpost.com/elisabeth-rhyne/on-microfinance-whos-to-b_b_777911.html> 
7. Shylendra, H S. “Microfinance Institutions in Andhra Pradesh: Crisis and Diagnosis.” Economic and Political Weekly 20 May 2006 <http://www.microfinancegateway.org/gm/document-1.9.27434/33479_file_EPW.pdf>

Microfinance in India Part 1

I read an article in The Hindu last week about the state of Tamil Nadu shielding its women from exploitative practices of Microfinance institutions. I found the content of the article thought provoking. While, I understand the economics of microfinance, I am only learning about India’s microfinance sector, thus the following post is heavily sourced. At the end of the post you will find sources which I used for this post.

Introduction and History

 

Some of you may have read about the microfinance credit crisis in India’s state of Andhra Pradesh in 2010 as well as the recent retirement of Mohammad Yunus, a Bangladeshi financier that created one of Asia’s most prominent micro lending institutions – the Grammeen Bank. India’s regulatory authorities, both state and national are working on instituting a package of new regulation which is supposed to both protect the consumers seeking micro loans and create a regulatory environment within which the micro lending industry will thrive.

I felt that to learn more about microfinance in India, I first needed to delve into the modern history of India’s financial institutions and regulatory framework. India’s experiences with establishing and regulating its financial sector created the environment within which social entrepreneurs established India’s micro-lending institutions in the late 1980s.  To understand India’s banking and regulatory legacy, I looked at the Economist Intelligencer Unit, IMF reports and Elizabeth Rhyne’s illuminating article on Huffington Post. Elizabeth Rhyne is the Managing Director at the Center for Financial Inclusion, Vaneet Rai of the Harvard Review Blog and others. 

Background 

Since India’s independence in 1947, the country carried out three major initiatives that shaped the country’s banking sector. The first took place in 1955 when India moved towards greater public ownership of banks, when the Imperial Bank of India was taken over by the government and renamed into the State Bank of India. The State Bank of India took over seven banks and its subsidiaries in 1959. In 1969 the Indian government nationalized 14 more private banks. The idea behind nationalizations was prevention of concentration of the financial sector within a few private hands and promotion of a balance of financial development. 

Following in Ghandi’s goal of self sufficiency, the government took steps to ensure that the financial sector provided enough credit to agriculture (especially in underdeveloped rural areas), export and small scale industries. While in 1974 the Reserve Bank of India issued guidelines indicating that both private and public banks must allocate at least one third of its credits to priority sectors indicated above, this requirement was increased to 40% in 1980. Heavy regulation of the banking sector lasted until the liberalization of the 1990s. Liberalizations of the 1990s removed controls on interest rates, liquidity ratios, entry barriers, relaxation of credit controls, and more. 

Microfinance: Background

The idea of micro-lending comes from the broader idea of financial inclusion. In other words, all people rich or poor need access to affordable financial services to conduct daily activities. When we think of banks we think of the types services they provide to customers; such as opening checking and savings accounts, obtaining credit cards, as well as loans to go to university, buy a house or a car. All banking services come at costs which are split between the bank and its customers. To issue a loan, the bank will need a lot of paperwork, including but not limited to establishing the customer’s identity, collateral, creditworthiness and the ability to repay the lent amount. Based on available background on the customer and health of the credit market, the bank will decide how much interest to charge. The amount of charged interest will bring the bank some profit, cover the risk of lending capital and cover the cost of administering the loan.

However, there are customers that both need tiny loans and are high risk borrowers. These potential customers are not likely to be part of the traditional financial system, may not have a credit history, collateral, and may not look like good candidates for a regular bank loan. Additionally, if the loan is small enough a regular bank may have no interest in processing it as administrative costs may turn out to be higher than the return on the loan. 

As a result, these customers tend to obtain loans from informal sources, such as the local moneylender. Micro-lending institutions come in to fill this gap and extend financial services to those customers.  In issuing loans, micro finance institutions use traditional social structures and higher interest rates to mitigate risk from such customers. These institutions lend to groups, which means that both administrative costs are lower per capita and overall loans tend to be larger overall. Microfinance institutions’ interest rates are higher than traditional banks to mitigate higher risk customers who often lack collateral. The majority of beneficiaries are in rural areas, where traditional banking services are far from villages and are part of close knit communities. Lending to a group within a close knit community provides social pressure on individual members of the debtor group to pay on time. Groups that fail to repay communal micro-loans do not get new loans, thus hurting the long-term prosperity of the group. As in the case of Grameen Bank, groups applying for loans go through months of financial planning courses, mitigating non-repayment risk further. 

While this is not the case in India, in some parts of the world, microfinance institutions take bank deposits, thus giving poor communities a way to buy into the success of the micro-lending institution. If groups that borrow from a micro-lending institution also have savings accounts, they give themselves a strong incentive to pay back their loans. Failure to repay a loan will not only mean a denial on the next loan, but also a higher chance that their lender will go out of business. If a micro-lender goes out of business, the community’s savings held at the same bank disappear with the lending institution. From a business development perspective, providing financial services to a group of people previously not part of the financial system, not only gives more income flexibility to this group, but brings a previously untapped source of customers for micro-lending institution – in other words more customers is good for business. This leads to a question, are MFIs in this line of work for the good of the people or business? 

Microfinance: India

After a number of nationalizations of India’s banks, the Bank Penetration and SHG-Bank Linkage Program was created in order to both maximize the increase of the reach of banking services to remote areas and incentivize people to use state banking services instead of more informal traditional financial sources – moneylenders.  The program succeeded in bringing financial services to remote areas and in fostering economic development. 

Andhra Pradesh of the late 1980s emerged as the poster child of success of this government program. This state worked together with the Indian government through SGH-Bank Linkage Program and the National Bank of Agriculture and Rural Development, NGOs, as well as the World Bank towards economic growth. As a result of this success Andhra Pradesh became birthplace of India’s robust microfinance sector. Ultimately, nationalizations and banking policy prior to the reforms of the 1990s resulted in preferential treatment of public sector banks and SHGs. 

In my next post, I plan to cover the development and growth of India’s micro-lending sector and how India’s regulatory framework promoted lending and growth within this sector.

Sources:

1. 1.      Gupta, Poonam, Kochhar, Kalpana, and Panth, Sunjaya. “Bank Ownership and the Effects of Financial Liberalization: Evidence in India.” IMF Working Paper. 3 March 2011 <http://www.imf.org/external/pubs/cat/longres.aspx?sk=24695>
2. “India: Demand for Financial Services.” Economist Intelligencer Unit. Main Report: Finance 2010. <http://www.eiu.com.proxy1.library.jhu.edu/index.asp?layout=displayIssueTOC&issue_id=187333003&publication_id=690002069> 
3. Kannan, Ramya. “State to Shield Women From Microfinance Institutions,” The Hindu. 8 March 2011 <http://www.thehindu.com/news/states/tamil-nadu/article1518093.ece> 
4.  Pankaj Kumar and Ramesh Golait, “Bank Penetration and SHG-Bank Linkage Programme: A Critique” Reserve Bank of India. 19 June 2007. <http://www.rbi.org.in/Scripts/bs_viewcontent.aspx?Id=2029> 
5. Rai, Vineet “India's Microfinance Crisis is a Battle to Monopolize the Poor” Harvard Business Review Blog , 4 November 2010. <http://blogs.hbr.org/cs/2010/11/indias_microfinance_crisis_is.html> 
6. Rhyne, Elizabeth. “On Microfinance: Who's to Blame for the Crisis in Andhra Pradesh?” Huffington Post. 2 November 2010 <http://www.huffingtonpost.com/elisabeth-rhyne/on-microfinance-whos-to-b_b_777911.html >

Nayagan: The Godfather Tamil-style

I recently discovered that love of the Godfather I spans oceans and continents and in fact, imitation is the highest form of compliment. A. and I saw the movie Nayakan recently. Nayagan, written and directed by Mani Ratnam in 1987, tells the real life story of a Bombay don named Varada. Varada hails from Tamil Nadu and sympathetically depicts the struggle of South Indians living in Bombay. Narayan gained rave reviews and was wildly popular in India and won an Oscar for Best Foreign Language Film in 1987. 

For a Tamilwood movie, the plot line comes across as fairly realistic, dance numbers are kept to a minimum, and the film clocks in at around 2.5 hours; a fairly short movie. A. and I watched it for three reasons, cultural exposure, Tamil language comprehension, and last but not least entertainment. I did not understand a thing, except when the dialogue switched into Hindi and I picked out an odd Arabic word or two. Believe me when I say, picking up one or two Arabic words which made it into Hindi, probably came out to about five words during the span of 2.5 hours.

I did however discover that as the movie progressed, the main character grew to resemble Marlon Brando in the Godfather. As Varada, the main character, got older he adopted Don Corleone’s mannerisms, speech patterns and even pitch of the protagonist of the 1972 American hit. Varada moved his arms and head in the same way that the Godfather. As Varada got older, his cheeks acquired the same puffiness as did his American predecessor. I read somewhere that Marlon Brando stuffed his cheeks full of cotton balls to affect his tone and speech as his character in the Godfather got older. The pattern of Varada’s speech grew to mimic Don Corleone’s, especially in scenes where he helped members of his community or met with other Indian gangsters. As Varada took on mannerisms of Don Corleone, the music changed as well – traditional South Asian background music took on Southern Italian themes. I found the transformation most intriguing and fun. Unfortunately for the couple that shared the viewing pleasure of the movie with us,  I started calling out references to the Godfather in the last third of the movie – not sure they appreciated my enthusiasm. 

If you are interested in watching this movie, it is available via Netflix, subtitled in English. Happy watching!