Table of Contents

Table of Contents ............................................................................................................................ 1 Introduction ............................................................................................................................................. 2 Origin and Development ..................................................................................................................... 3 Status Quo ............................................................................................................................................... 6 Why Bankers have so far heisted in offering microfinance? .............................................................. 6 The rise of MFIs in India .................................................................................................................... 8 The Capital of Microfinance: Andhra Pradesh ............................................................................... 8 The fall of MFIs in India ................................................................................................................... 11 Commercial Banks and Microfinance................................................................................................... 14 Comparative Advantages/ Incentives of Commercial Banks In Microfinance ................................. 14 Disincentives of Commercial Banks in Microfinance ...................................................................... 17 ICICI Bank: Case Study........................................................................................................................ 19 Model 1: The self-help group (SHG)--bank linkage model .............................................................. 20 Model 2: Financial intermediation by the microfinance institution .................................................. 20 Model 3: The partnership model -- MFI as the servicer ................................................................... 21 Conclusion ............................................................................................................................................ 22 Works Cited .......................................................................................................................................... 24

Introduction The term microfinance (MF) refers to the provision of banking services to lower-income people, especially the poor.1 These services include small loans for microenterprises and individuals, savings, money transfer services, means of payment and insurance. Given their nature, micro entrepreneurs tend to operate on the margins of the formal economy, often without permits and commercial documentation, and usually lacking fixed assets that could serve as collateral. Formal expense and income records are generally scarce. Income is often on the lower end of the scale, although operating margins for microenterprises in percentage terms can be significant.2 In the history of microfinance, MFIs3 have been the first to identify the vast un-served demand for microcredit in developing countries, develop methodologies for delivering and recovering small loans, and begin credit programs for the poor. Successful programs have reached high loan repayment rates. One of the obstacles that even successful programs had to overcome were the severe capital constraints faced by lending institutions. Unregulated and unable to access substantial amounts of commercial finance and usually to provide voluntary savings services these institutions can normally meet only a small fraction of microcredit demand in the regions they serve. Some MFIs have been able to overcome this situation by gradually turning themselves into commercial banks specialized in MF (upgrading). The demand for microfinance services has rarely been met by the formal financial sector, and this may be due to several reasons, including the following: 1. failure to perceive the poor households demand for financial services; 2. belief that microfinance cannot be profitable for banking institutions; 3. existence of public, legal and regulatory policies that ignore MF; 4. high operating costs; 5. lack of specific experience in the provision of microfinance services; 6. lack of adequate platforms for the provision of microloans.

Banerjee, Abhijit, Esher Duflo, Rachel Glennerster, and Cynthin Kinnan, The Miracle of Microfinance? Evidence from a Randomized Evaluation,NBER Working Paper, 2009. 2 R. Rosenberg, Unknown, 1996. 3 In the context of this project the term MFI is reserved for non-regulated organizations that provide microfinance services, typically in the form of non-profit NGOs.

However, it has been proven that this demand can be met profitably and on a large scale,4 and many commercial banks have already identified the business opportunities of MF.5 Commercial banks6 have now ventured into microfinance in many countries, where microfinance is at different stages of development.7 In its most advanced form, in banks and other formal financial institutions, all microloans are fully financed by savings, commercial debt and retained earnings. However, in most developing countries, the formal financial sector still does not serve microfinance clients on a massive scale. Origin and Development In 1976, an entirely new model of development finance emerged not from Delhis halls of power but from the forgotten back streets of Jobra, an impoverished village in Bangladesh. Abandoning his classroom, Muhammad Yunus, a professor of economics, ventured out to meet directly with the poor and learn exactly what factors kept them from earning their way out of poverty. By 1983, Yunus had founded Grameen Bank as a formal financial institution. It offered small loans to the poor with no collateral required. The bank successfully employed a group lending model, which holds borrowers accountable to their neighbors for repayment performance. Grameen proved that the poor were indeed creditworthy; in fact, the bank boasts that its loan recovery rate is 97.66 percent. It has enjoyed phenomenal growth: It works in almost 85,000 villages, has served almost 8 million borrowers, and has disbursed US$8.4 billion since its inception. Grameen is 95 percent owned by its borrowers, most of whom are poor women, and is now completely self-sustaining through the deposits of its customers.8 Grameens success inspired a host of other organizations to try microlendingand soon the model expanded beyond the provision of small loans to become microfinance, which encompasses a whole range of financial services for the underprivileged. These include savings accounts, investment products, money transfers and remittances, bill payment services, home loans, education and consumer loans, agricultural and leasing loans, life insurance, property and crop insurance, health insurance and even pension products
4 5

M. S. Robinson, CGAP, 2001. Banks Can Reach Out to the Poor, The Banker, 2nd February,2005. 6 Throughout this document, the terms commercial banks and financial institutions are used synonymously unless otherwise specified. 7 Graham Baydas and Valenzuela, Commercial Banks in Microfinance: New Actors in the Microfinance World, 1998, www.cgap.org/publications/focus_notes.html 8 Data retrieved from Grameen Bank website, At a Glance, http://www.grameeninfo.org/index.php?option=com_content&task=view&id=26&Itemid=175.

services that were once completely out of reach for disadvantaged populations.9 It is difficult to get an accurate read on the size of the industry worldwide, but it is estimated that anywhere from 1,000 to 2,500 microfinance institutions (MFIs) serve some 67.6 million clients in over 100 different countries.10

The industry has finally achieved a scale that is large enough to permit the pooling of loans and the data capacity is now available to make structured transactions a reality. In 2002, Mexicos Compartamos became the first MFI to tap the bond market, with an offering that S&P rated the equivalent of AA. (Subsequent offerings have added credit enhancements for even higher ratings, and have been oversubscribed, with heavy interest from institutional investors.) As a result, Compartamos has enjoyed a lower cost of funds.11 Another seminal debt offering was put together by Blue Orchard Finance in 2004; this $40 million deal brought 90 investors into nine international MFIs. Two years later the field saw its first securitization, structured by RSA Capital, Citigroup, the Netherlands Financing Company, and Germanys KfW Bank for the Bangaladesh Rural Advancement Committee (BRAC). The $180 million deal, which was recognized by International Financing Review Asia as the best securitization of 2006 in the Asia Pacific region, securitized a pool of more than 3 million small loans, most for less than US$100.12 More recently, in November 2009, a microloan securitization completed by IFMR Capital and Equitas Micro Finance marked the first-ever mutual fund investment into the Indian microfinance sector.13 The $10.4 million transaction, backed by more than 55,000 microloans originated by Equitas Micro Finance, was structured by IFMR Capital into three separately rated tranches to match investor risk-return profiles, thus expanding the range of institutions that can invest in the asset class. ICICI Prudential Asset Management, Indias third-largest mutual fund, subscribed to a majority of the securities.14 Despite the success of microfinance, it does not appear to be the magic bullet that will eradicate global poverty. Not only does it have limited penetration, but the typical microcredit loan creates an income-generating activity for just one individualand not

Elisabeth Rhyne and Maria Otero, Microfinance Through the Next Decade: Visioning the Who, What, Where, When and How, Global Microcredit Summit, 2006. 10 Estimates from Microfinance Information Exchange and the Microcredit Summit Campaign, Data retrieved from http://www.worldfinancialreview.com/?p=781 on 30 October 2011. 11 Ibid at 10. 12 Ibid at 10. 13 Rajdeep Sungupta, and Craig P. Aubuchon, The Microfinance Revolution: An Overview. 14 IFMR Capital, press release, November 20, 2009.

everyone is an entrepreneur by nature. It has a role to play, but microfinance alone cannot sufficiently impact job creation and capital formation.15 To achieve broad-based and sustainable growth, financial innovation needs to turn its attention to the small- and mediumsized firms that have long been ignored by development finance. This project aims at exploring the main aspects related to commercial banks provision of microfinance services and the future prospects for this activity. Chapter 2 which discusses Status Quo, begins by analyzing the relationship between commercial banks and MF. First, it discusses the dearth of capital faced by MFIs, due to less involvement of commercial banks in micro lending. Afterwards, a trend that is gaining growing consensus is analyzed. According to this trend, commercial banks can adequately meet the massive demand for microfinance services sustainably and on a large scale. A review is made of the incentives and disincentives for financial institutions to venture into the MF sector, and their specific advantages and disadvantages when competing in this market.

15

Abhijit Banerjee, Esher Duflo, Rachel Glennerster, and Cynthin Kinnan, The Miracle of Microfinance? Evidence from a Randomized Evaluation, NBER Working Paper, May 30, 2009.

Status Quo Why Bankers have so far hesitated in offering microfinance? From the 1950s through the 1970s, financial systems in many developing countries were predominantly composed of state-owned banks and of branches of foreign-owned commercial banks that provided short-term commercial and trade credit, for example in India itself Banks were nationalized in 1969, which covered private players like Birla group. The state-owned banks promoted economic development priorities through a network of financial institutions such as agricultural banks, development banks, and export banks, while borrowing heavily from multilateral and foreign private banks to support these efforts.16 The private local banks that did exist were typically small, and often served a closed set of business groups. Until the 1980s, the regulatory repression of formal financial markets in most developing countries interest rate ceilings, high reserve requirements, and directed credit lines largely precluded established banks from servicing a higher-cost and riskier microenterprise clientele. With the advent of structural adjustment and financial liberalization in the late 1980s, private domestic commercial banking expanded rapidly. Many new private banks were founded by large business groups to access funds for their own businesses and corporations, in India the case was different as the policy still precludes established business houses to enter into banking space, albeit NBFC root remains open which have been exploited partially. With the exponential growth that Indian economy was witnessing post liberalization era, banks that were present at a small scale started growing at double digit growth, many time more than public sector banks could ever dreamed off. Private sector banks received further boost in their growth momentum due dot com bubble burst, as trillion $ investment done by American companies came to use for Indian IT and banking companies as they started investing in technological advancement, providing credit facilities at a faster rate, also the concept of easy money developed in Indian during this very period only. No matter how much lead was taken by these banks there ultimate aim remained profit making, so they naturally favoured the large accounts of an established clientele. When granting loans to less familiar clients, banks protected themselves with asset (mostly real estate) collateral two to three times the value of the loans. Although the new regulatory

16

World Development Report, Gonzalez-Vega and Graham, World Bank Series, 1989, 1995, Indian banks for say pledged gold to Japan Central Bank and Bank of England.

environment was more favorable,17 these new commercial bankers were unlikely providers of loans to small businesses, small farmers, and micro-entrepreneurs. Competition was growing, however, as new banks enter the market under banking laws that allow more freedom of entry and a less repressed regulatory environment. For example, Honduras has 18 commercial banks for an economically active population of 1.7 million people; most of these institutions were licensed in the last decade and are still small, Indias case is little better as still ratio is very wide, but the core issue still remains accessibility to such facilities. The struggle to survive is forcing many of these banks to look at new markets, including the microfinance market, and the deregulation of financial markets is creating an environment in which these opportunities can now be explored for the first time. Most bankers have not regarded microfinance as a genuine option, however, because they have believed it unprofitable. When asked through various surveys,18 why they do not pursue microfinance, traditional commercial bankers have typically expressed three basic concerns:

1. Too Risky: Bankers perceive small businesses and microenterprises as bad credit risks. Many insolvent state-owned agricultural banks seemed to prove that small farmer clients could not or would not repay their loans. The perception is that small clients do not have stable, viable businesses for which to borrow and from which to generate repayment.19

2. Too Expensive: Bankers also believe that because microloans are small and have short terms, bank operations will be inefficient and costly.20 It takes the same amount of time and effort (if not more) to make a Rs. 1,000 loan as a Rs. 100,000 loan, but the return on the larger loan is much greater. So why make a small loan?

3. Socio-economic and Cultural Barriers: According to bankers, micro and small enterprise clients have difficulty approaching a bank because they lack education and do not possess business records to demonstrate cash flow.21 In many developing countries, social, cultural, and language barriers do not allow for an easy relationship with a modern banking institution. It is hoped, however, that with a more widespread diffusion of innovations in financial
17 18

Finance Bill 2010 provided for around 40% of Credit reserved for weaker sections and agricultural sector. H. Jenkins, Commercial Bank Behavior and Performance in Micro and Small Enterprise Finance, Harvard Institute for International Development, Discussion Paper No. 741, 2000. 19 Ibid at 18. 20 Ibid at 18. 21 Ibid at 18.

methodologies, reducing the risks and costs of micro lending, more banks will begin to incorporate micro-entrepreneurs into their portfolios.

The rise of MFIs in India By the 1990s economic reforms in India opened up space for the private sector to play a larger role in the banking system. Amid these reforms a new breed of private microfinance provider emerged: microfinance institutions (MFIs), which originally operated as nonprofits (societies and other ownerless legal forms), but soon transferred their operations into forprofit nonbank finance companies (NBFCs). Most often influence was concentrated in the hands of the original founders.22 In more recent years the dominant practice has been to form start-up MFIs as NBFCs from the outset, obviating the need for transformations. By 2010 there were at least 30 MFIs operating as NBFCs, many with substantial growth trajectories. This new breed of NBFC MFI has been supported by government policies and direct investment. The state-owned Small Industries Development Bank of India (SIDBI) has steadily increased its lending to MFIs as a part of its mission to support small enterprises. Loans by commercial banks to MFIs also count toward priority sector lending quotas. In the last few years MFIs were also capitalized by equity investments from specialized microfinance investment vehicles (MIVs) and, more recently, mainstream private equity funds. By 2010 these new MFIs were expanding at an annual rate of 80 percent, and had reached 27 million borrowers across India,23 nearly all this outreach achieved through a standard group-based loan product common to South Asia. Importantly, these MFIs are effectively barred by regulation from taking any deposits and instead rely heavily on debt with commercial banks to fuel their growth. The Capital of Microfinance: Andhra Pradesh Andhra Pradesh in southeast India is the fifth most populous of Indias 28 states, with 75 million inhabitants. Recent state governments in Andhra Pradesh have invested in progressive policies and programmes focused on growth and building a sizeable information technology industry around the city of Hyderabad. Andhra Pradesh has also undertaken a series of largescale projects to fight poverty, the most prominent being the Society to Eliminate Rural
22

M. S. Sriram, Commercialization of Microfinance In India: A Discussion of the Emperors Apparel, Economic & Political Weekly, 12 June, 2010. 23 N. Srinivasan, Microfinance State of the Sector in India, Access Development Services, Sage Publications, New Delhi, October,2010.

Poverty (SERP). SERP is a service delivery program under the Rural Development arm of the state government that offers far reaching livelihood promotion programs, including employment generation, vocational training, and access to savings and credit through SHGs. SHGs have a long and important history in Andhra Pradesh and have deeper penetration there than in any other state, with a total of 1.47 million SHGs reaching 17.1 million clients statewide,24 that is the reason why we have opted Andhra Pradesh as a case study among all the other states. Within the broader SHG approach in Andhra Pradesh, SERP (and other Andhra Pradesh government programs) has a significant presence, directly working with 9.5 million of these SHG clients.25 The central government is looking to expand this approach to other states, most notably to Bihar, a state with a less developed microfinance market than the one in Andhra Pradesh and significantly less outreach.26 One reason households have large amounts of credit from the SHGbank linkage program supported by SERP is the total financial inclusion program the Andhra Pradesh Government began three years ago. Traditionally SHGs were based on member savings, and rules generally capped bank loans to the SHGs at three to four times this savings base, effectively limiting borrowings to Rs. 1,00,000 or less. But under the new program, banks began to lend up to Rs. 5,00,000 to targeted SHGs. Additionally some loans to SHGs had a five year repayment period, up from one year, and any amount of interest paid by SHGs above 3 percent would be reimbursed to the SHG by the Andhra Pradesh Government if the group did not default on its bank loan.27 SERP encouraged SHG members to repay moneylender and MFI loans, but evidence suggests that instead members kept multiple loans from multiple sources. In the late 1990s some of Indias first MFIs got their start in Andhra Pradesh. Today, five of Indias largest NBFC MFIs are headquartered in Andhra Pradesh making it the epicenter of the microfinance industry in India.28 Over the last five years MFIs in Andhra Pradesh were among the first to attract significant investment from specialized MIVs as well as mainstream private equity players. These capital injections proved to be steroids as they provided the equity capital for growth but they have also created strong incentives for continued levels of high growth and profitability to drive higher valuations. All of this has fostered a perception
24 25

Ibid at 10. MFI Registration Data November 2010, Rural Development Department, Government of Andhra Pradesh. 26 Andhra Pradesh 2010: Global Implications of the Crisis in Indian Microfinance, CGAP, No. 67, 2010. 27 Ibid at 13. 28 Ibid at 12.

of MFIs as being primarily profit-oriented organizations. While most MFIs have acted responsibly, a few have generated unusually high returns on assets, compensated executives lavishly, and remained nontransparent in ways that only furthered a negative stereotype of MFIs. In recent years MFIs across India have diversified geographic coverage, and Andhra Pradeshs share of the total national MFI outreach has dropped to less than one-third. Nevertheless, a few of the largest MFIs remain heavily focused in Andhra Pradesh where growth has been rapid. The combined presence of the large and well-funded state-backed SHG program and five of Indias largest and fastest growing MFIs has resulted in a rapid proliferation of credit across Andhra Pradesh and wide use of multiple loans by borrowers. And levels of household debt are high. In Andhra Pradesh, the average debt outstanding per household is Rs. 65,000 as compared to a national average of Rs. 7,700 of outstanding microfinance debt per poor household.29 The parallel growth of two approaches to delivering credit has expanded the reach of credit substantially over the past several years, as has competition between the state-supported SHGs and private MFIs. SHG lending reaches 17.1 million SHG members with Rs. 117 billion outstanding.30 By November 2010, MFIs were reaching 9.7 million borrowers with Rs. 72 billion outstanding, according to the government. But MFIs, while still somewhat smaller in total outreach than SHGs, had been growing more rapidly over the past 18 to 24 months as SHG disbursements were slowing. Also, the repayment tenor of many SHG loans is considerably longer and often more flexible than those of MFIs, reducing the size of repayment installments and thereby the debt servicing burdens on borrowers. Nonetheless, the combined outreach and continued growth has meant that the borrower accounts of SHGs and MFIs together on a per capita basis is over four times the median of Indian states. Srinivasan,31 compares five Indian states with high levels of microfinance penetration and finds that the average loan amounts per poor household in Andhra Pradesh is triple the size for the next largest state. By any of these measures the provision of credit in Andhra Pradesh has reached much greater proportions than in any other state in India. Reports also suggest that many households have multiple loans significantly increasing their overall debt. This current supply side penetration data are partly corroborated by a demand side survey conducted nearly a year and a half ago by IFMRs Center for
29

Ibid at 10. (Srinivasan estimates the total number of microfinance clients in Andhra Pradesh at 25.36 million (19.11 million SHG members and 6.25 million MFI customers), with a total debt of Rs. 165 billion.) 30 Ibid at 10. 31 Ibid at 10.

Microfinance. Johnson and Meka,32 show that 83 percent of households had loans from more than one source, including from moneylenders, with many households managing as many as four loans at a time.33 The study found high levels of penetration of SHGs into rural households, with just 11 percent of households borrowing from MFIs. However, sampling covered all rural households (rather than just poor households) in Andhra Pradesh. With the growth since the time of the survey and some sampling distortion, it is likely that the 11 percent figure significantly understates the level of penetration of MFI loans, though no current demand side survey data exist to offer an exact figure. In sum, there is much higher penetration of microfinance in Andhra Pradesh than in any other state in India. Household debt comes from several sources, not just MFIs.34 The picture that emerges from the data suggests that households in Andhra Pradesh have too many loans and too much debt than seem to be supportable considering their income levels and ability to repay, this situation no doubt can be equated to American subprime crisis, though this is a very small one. The fall of MFIs in India In 20052006 one of Andhra Pradeshs 23 administrative districts experienced a crisis when the district government closed 50 branches of four MFIs following allegations of unethical collections, illegal operational practices (such as taking savings),35 poor governance, high interest rates, and profiteering.36 On that occasion, the dispute was calmed by the MFIs agreeing to abide by a Code of Conduct alongside support from the national government and the Reserve Bank of India (RBI), which recognized the useful role MFIs played in providing credit for low-income households, albeit the nodal organization started work on an act which could help to regulate MFIs. But a rivalry between competing MFI and SHG models for serving the poor, often reaching into the same villages, has been simmering ever since, this is where commercial banks can come into play. The SKS initial public offering (IPO) earlier this year highlighted both the enormous scale potential of the MFI model and the considerable opportunity it provides to improve financial inclusion, while at the same time

32 33

Doug Johnson and Sushmita Meka, Access to Finance in Andhra Pradesh, IFMR Research, October 2010. Data from a study conducted by the Centre for Microfinance in 2009. The study, which included 1,922 rural households, gathered information on use of informal and formal financial products within these households. Data sets can be found under Access to Finance Data at http://ifmr.ac.in/cmf/resources.html. See also, CGAP Microfinance Blog at http://microfinance.cgap.org/2010/11/11/who%e2%80%99sthe-culprit-accessing-financein-andhra-pradesh. 34 Ibid at 13. 35 Thomas Dichter and Malcolm Harper, Whats Wrong with Microfinance?, Rugby 2009. 36 Prabhu Ghate, Learning from the Andhra Pradesh crisis, 2007

highlighting potential high profits and lavish executive compensation.37 Reports over the summer cited links between MFI practices and some suicides in Andhra Pradesh. The situation came to a head in early October when Andhra Pradeshs chief minister passed An Ordinance to protect the women Self Help Groups from exploitation by the Micro Finance Institutions in the State of Andhra Pradesh, which sought to place a range of new conditions on MFIs, including district-by-district registration, requirements to make collections near local government premises, a shift to monthly repayment schedules, and other measures that affect how MFIs operate.38 This ordinance has contributed to a general environment where MFI ground-level operations are impeded, and loan collections for MFIs in Andhra Pradesh dropped dramatically. In the face of low loan collections, MFIs with proportionally larger exposures in Andhra Pradesh could find it difficult to refinance their loans with commercial banks or to raise new equity.39 MFIs unable to effectively negotiate their financing could become illiquid and insolvent. Even MFIs that are well capitalized and have a geographically diversified portfolio beyond Andhra Pradesh might have to absorb large losses in Andhra Pradesh, impacting their growth elsewhere. It is possible that a few MFIs might have to close or dramatically downscale their operations in Andhra Pradesh. And the result could be the removal of a credit service that poor people have come to view as reliable in their otherwise uncertain lives. The nonrepayment of loans by clients has gained momentum as politicians at the state level have seized upon the opportunity to make populist pronouncements, while MFI staff are still intimidated and are not resuming normal operations in many parts of Andhra Pradesh. 40 This environment is encouraging clients to question their obligations to repay, with potentially far reaching consequences for both MFI and SHG repayment rates. Stakeholders outside Andhra Pradesh have also reacted to the conflict between the state government and MFIs, and the intense media coverage. Though it has not made any public statements to date, RBI, the regulator of NBFC MFIs, has formed a subcommittee tasked with looking into a wide range of microfinance issues nationally, including a re-examination of MFI loans classification as

37

Greg Chen, Stephen Rasmussen, Xavier Reille,and Daniel Rozas, Indian Microfinance Goes Public: The SKS Initial Public Offering. Focus Note 65., Washington, D.C., September 2010, Data retrieved from CGAP, http://www.cgap.org/gm/document-1.9.47613/FN65_Rev.pdf. 38 Andhra Pradesh 2010: Global Implications of the Crisis in Indian Microfinance, CGAP Focus Note, No. 67, 2010. 39 Ibid at 13. 40 According to Sa-Dhan, Andhra Pradesh accounts for more than a quarter of the total loans outstanding of MFIs in the country, with Rs. 52351.4 million, DNA India (2010) reports that the unrecovered loans are anywhere between Rs. 500 million and Rs. 750 million.

priority sector lending.41 The Ministry of Finance has supported the continued presence and value of MFIs while at the same time it has pushed for improved MFI practices, lower interest rates, and stricter regulation. The financial markets have taken notice, SKSs share price dropped steeply, and it is unlikely there will be follow-on MFI IPOs very soon in the current environment.42 In recent years, the levels of profitability and private gain have caused political concerns and have exposed issues of reputation management for an industry whose very existence is based on doing good by serving poor people. The potential for large returns made by the promoters of MFIs and their investors vividly illustrated by the headlines about the SKS IPO from late July onwardshas served to exacerbate the issue of interest rate levels, which are a chronic political and public relations flashpoint.43 The following chapter will try to discuss the incentives and disincentives that a commercial bank has over other means of micro-credit, it also discusses the current market situation, i.e. what is the approximate market worth available that a commercial bank can hope to tap and competition it faces, if it decides to enter the market, albeit all the figures are approximate and need some authority to verify, but still it is able to provide us with near about figures which at present times seem very lucrative.

41 42

Ibid at 25. Deccan Chronicle, MFIs face music, banks stop loans, 22 October 2010. According to the Deccan Chronicle (2010) banks have already stopped the disbursal of around Rs. 1750 million to Rs. 2000 million to around 44 MFIs. 43 The Economist, Microfinance in India: Discredited, 4 November 2010.

Commercial Banks and Microfinance

In a number of countries, banks have been compelled by their governments to provide financial services, especially credit, to sectors such as small or agricultural enterprises that are considered social priorities.44 Using moral or legal compulsion generally has not led to sustainable models of service provision. However, increasingly, commercial banks are investigating for themselves, and some are entering the microfinance market because they see sustainable profit and growth opportunities. Commercial banks face increasing competition in their traditional retail markets. This is causing margin squeeze. It is also leading forwardthinking banks to explore new potential markets that can generate growth in client numbers at acceptable profit margins. CGAP estimates that there are up to 3 billion potential clients in the microfinance market.45 Some 500 million people are currently being served by socially-oriented financial institutions, ranging from cooperatives to postal savings banks that extend financial services beyond the traditional clients of commercial banks. Nonetheless, a significant number of potential clients remain un-served.46 A recent CGAP survey identified over 225 commercial banks and other formal financial institutions that are engaged in microfinance. 47 For some, microfinance has been highly profitable. Certain microfinance- specialized banks are now more profitable than the banking sector average in their country.48 Success is not guaranteed, however, as some banks have attempted to serve this market and failed because they did not understand the market or tried to move too quickly, but still it remains a very lucrative untapped market for commercial banks. Comparative Advantages/ Incentives of Commercial Banks In Microfinance At first glance, banks appear well positioned to offer financial services to ever-increasing numbers of microfinance clients and to earn a profit. Banks have several advantages over non-bank, micro-lending NGOs, SHGs, or even Microfinance Institutions:

44

Jennifer Isern, Commercial Banks And Microfinance: Evolving Models Of Success, CGAP Focus Note, No. 28, 2005. 45 Rosenberg Christen, and Jayadeva, Financial Institutions with a Double Bottom Line, 2004. 46 Microfinance Joins the Mainstream, The Banker, 2nd February, 2005. 47 Ritchie Isern, Crenn, and Brown, Review of Commercial Bank and Other Formal Financial Institution Participation in Microfinance, November, 2003. 48 Bankscope, 2003.

 They are regulated institutions fulfilling the conditions of ownership, financial disclosure, and capital adequacies that help ensure prudent management. Many have physical infrastructure, including a large network of branches, from which to expand and reach out to a substantial number of microfinance clients. They have well-established internal controls and administrative and accounting systems to keep track of a large number of transactions. Their ownership structures of private capital tend to encourage sound governance structures, cost-effectiveness, and profitability, all of which lead to sustainability. Because they have their own sources of funds (deposits and equity capital), they do not have to depend on scarce and volatile donor resources (as do NGOs). They offer loans, deposits, and other financial products that are, in principle, attractive to a microfinance clientele. All of these advantages could give banks a special edge over micro-lending NGOs in providing microfinance services. These factors are related both to the banks internal organization and to the market in which this bank operates. However, the main incentive is basically related to the fact that profits are in line with the risks incurred. Growing competition in markets traditionally served by banks e.g., loans to big companies, small and medium-sized businesses and consumers along with the resulting fall in banks returns has encouraged the search for new market niches. In countries with no experience in MF, there exists an unattended market segment which may be viewed by banks as a potential source of rapid growth and positive returns. The first products generally developed by institutions entering MF are microloans. However, as the business progresses, institutions start offering a broader range of products. The possibility of cross-selling is another positive aspect that commercial banks take into account when deciding to enter this sector. Commercial banks can offer their clients a range of products, including banking services, means of payment, money transfer services and insurance. Major banks have adapted their structure (contacts with insurance providers, branches abroad for fund transfers, ATM networks across the country) precisely for the delivery of these products.

Entering a new sector enables banks to diversify their loan portfolio, focusing on a population segment previously unattended by them. By making loans to thousands of small borrowers, the micro-lending portfolio itself achieves substantial diversification in terms of number of clients served. Commercial banks can overcome this obstacle thanks to their branch networks across the major cities in the country. In addition, the performance of the micro-lending portfolio may have low correlations with traditional bank business lines due to the very different nature of the clients and activities. Similarly, having a sector specialized in MF may help commercial banks improve their public image, as caring for the most disadvantaged social sectors is welcomed by clients and society in general. The IADB,49 points to the existence of underutilized capacity in some banks as one of the reasons for them to enter MF: excess liquidity or underutilized branches or information systems can reduce costs and encourage banks to get into micro-lending. Another reason for entering this field is the availability of free or cheap donor technical assistance. Many case studies50 show cooperation agreements between banks and international MF support networks, in which the latter provide training to institutions that have recently begun to operate in the field of MF.51 On the following page, Table 1 and 2 are provided, which is an output of the survey conducted by Harvard University, it reveals the reasons and incentives respectively which are driving Commercial Banks towards Microfinance.52 Table 1: Drivers for bank entry into microfinance Internal Factors Profit External Factors Large microenterpise or low-income market

Risk diversification

Competition

Excess liquidity

Trend or fad

49

G. D. Westley, Strategies and structures for micro-finance employed by commercial bank, Inter-American Development Bank, 2006. 50 Ibid at 36. 51 Miguel Delfiner and Silvana Pern, Commercial Banks and Microfinance, Regulatory Planning and Research Department, Central Bank of Argentina (BCRA), June, 2007. 52 H. Jenkins, Commercial Bank Behavior and Performance in Micro and Small Enterprise Finance, Harvard Institute for International Development, Discussion Paper No. 741, 2000.

Image

Regulations

Cross-selling opportunities

Government or donor initiative

Bank leadership

Market pressure on margins

Social responsibility

Desertion of traditional clients

Public relations Compatibility with bank strategy Data taken from Survey Conducted by Harvard University

Regardless of the commercial reasons encouraging banks to enter MF, policies imposed by some governments, aimed at contributing to the development of the MF sector, have driven or even compelled the financial system to provide loans to low-income sectors. Table 2: Reasons why banks make micro and small enterprise loans Reasons Profitability of micro and small loans Increasing market competition in lending to large/medium enterprises Social objectives Regulations imposed by the government Number of banks 72 64 29 25 % of total 49% 44% 20% 17%

Data in above table retrieved from Survey Conducted by Harvard University

Disincentives of Commercial Banks in Microfinance Table 3: Disincentives for making micro and small enterprise loans Disincentives Higher administrative costs Lack of network and personnel to serve this market Interest rate controls Number of banks 29 23 21 % of total 40% 32% 29%

Other Risky borrowers Not interested in microenterprises

18 12 5

25% 17% 7%

Data in above table retrieved from Survey Conducted by Harvard University

Higher administrative costs seem to be the main discouraging factor that prevents banks from entering microfinance.53 Administrative costs are high due to the nature of the business, which involves charging high interest rates for making successful micro and small enterprise loans that are commercially sustainable. The implementation of interest rate controls in some countries has been one of the major factors that discouraged banks from entering MF, although the situation is changing as governments are gradually lifting these controls. 54

53 54

Table 3, indicates the observation. Ibid at 38.

ICICI Bank: Case Study

Capital constraint is an issue impeding scaling up of microfinance in India. Based on an analysis of traditional financing models and ICICI Bank's experience in India, it analyses the `partnership model' of financing microfinance institutions (MFIs). This model is unique in that it combines both debt as well as mezzanine finance to the MFI in a manner that lets it increase outreach rapidly, while unlocking large amounts of wholesale funds available in the commercial banking sector in India, this is the very reason that efforts by Commercial Banks to enter into Micro Finance space are promoted, as otherwise funds released/provided by government are not accountable as there generally is no recognized institution; on the other hand commercial banks enjoy statutory recognition and in general do not have any dearth of funds.55 In India, high performing MFIs grow at suboptimal rates simply because of a capital constraint.56 Owing to priority sector targets for banks, which require banks to lend at least 40 per cent of their net bank credit in any given year to agriculture and weaker sections, including lending to historically disadvantaged communities and microcredit, there has been logic for the flow of wholesale funds to this sector, however limited it has actually been. However, there are no `natural providers' of risk capital for microfinance and this has constrained the growth of several MFIs. (In fact, risk capital or equity is a constraint, not just for microfinance in India, but also for the small scale enterprise and infrastructure sectors).57 Models of microfinance that have prevailed tend to use risk capital inefficiently. 58 The few MFIs in India which have raised commercial equity have delivered return on equity figures of less than 5 per cent, primarily because of low levels of leverage. The fact that several MFIs have chosen to establish themselves legally as nonbanking finance companies (NBFC) also imposes a demand for regulatory capital. (In order to register as an NBFC, an MFI needs entry level capital of Rs20,00,000).59 The preference for an NBFC format may be largely explained by the desire of MFIs to provide savings facilities for clients.

55 56

Dilin Lim, Practical Challenges of Microfinance Institutions, Instituto De Empresa, December, 2009. Observation made by ICICI Banks in, ICICI Research 2006 Report. 57 Colin Sloand and Mecene Investment, Supporting Growth and Stability of the Microfinance Industry in SubSaharan Africa: A Shifting Role for Development Agencies, Lehigh University - College of Business & Economics, 22 January, 2010. 58 According to ICICI Research Report 2006. 59 Ibid at 58.

In this section, the project briefly discusses how savings may be facilitated without the MFI adopting an NBFC format. Following are provided existing models, which have been employed by various Micro Finance Institutions and Banks, and also the model pursued by ICICI Bank. Model 1: The self-help group (SHG)--bank linkage model The predominant model in the Indian microfinance context continues to be the SHG--bank linkage model that accounts for nearly 20 million clients. Under this model, the selfhelp promoting institution (SHPI), usually a nongovernmental organization (NGO), helps groups of 15--20 individuals through an incubation period after which time they are linked to banks.60 The bank lends to the groups after the incubation period, and this linkage may be single or multi-period. The SHPI typically receives no, or below cost, consideration either from the bank or the clients for the function of group promotion. Weakness: Owing to the limited number of rural branches, the SHG--Bank Linkage model is not considered a scalable route for any Commercial Banks, as even after 60 years of independence banking penetration in rural areas remains abnormally low.61

Model 2: Financial intermediation by the microfinance institution In this model, the MFI borrows from commercial sources and lends to clients (groups/individuals). This is a recent shift that has been facilitated in part by the participation of commercial banks in the microfinance sector and in part by the lack of resource options for growing MFIs, given that they cannot take deposits and face limited availability of grant funds.62 Most MFIs in India started operations with grants and concessional loans and gradually made the transition to commercial funding. For instance, Bharatiya Samruddhi Finance Ltd (BSFL), one of India's leading MFIs, financed much of its growth in the initial years with concessional loans from funding agencies.63 Weakness: The disincentives of the MFI to maintain supervision levels are high in this case, as it bears 100 per cent credit risk on the portfolio, as any default by any client adds on to the burden of MFI.64

60 61

N. Tejmani Singh, Micro Finance Practices In India: An Overview, Manipur University,Canchipur. Data retrieved from, info.worldbank.org/etools/docs/ICICI%20Resource_Bindu.doc. 62 Ibid at 60. 63 Ibid at 60. 64 Ibid at 61.

Above two models are quite popular, but Commercial Banks for minimizing their risks, increasing profits, and enlarging their market presence are trying to come up with new ways to tap the micro-credit market, one such model employed by Indias largest private sector bank, has been discussed below. Model 3: The partnership model -- MFI as the servicer Loan contracts directly between bank and borrower. This feature is similar to the SHG--bank linkage model, and means that the loans are not reflected on the balance sheet of the MFI. The MFI continues to service the loans until maturity, however, so the bank relies on the MFI's field operations for collection and supervision.65 The key difference, then, between this and the financial intermediation model is the manner in which the financing structure has been designed. This structure primarily attempts to separate the risk of the MFI from the risk of the underlying portfolio.66 When the bank lends to the MFI, it has no recourse to the underlying borrowers. On the other hand, if the bank lends directly to the borrowers without the funds entering the MFI's balance sheet, it has recourse to the borrowers. So, if the particular MFI goes bankrupt or closes down for any other reason, the bank can appoint another agency to recover the dues from borrowers.67 In addition, since the loans are not reflected on the balance sheet of the MFI, its own requirement for regulatory capital ceases to exist. In order to preserve MFI incentives for portfolio quality in the new scenario where its role is closer to that of an agent, the structure requires the MFI to provide a guarantee (typically a `firstloss default guarantee') through which it shares with the bank the risk of the portfolio, up to a certain defined limit.68 The MFI collects a `service charge' from the borrowers to cover its transaction costs and margins. The lower the defaults, the better the earnings of the MFI as it will not incur any penalty charges vis--vis the guarantee it provides.69 ICICI bank, is one of the first private sector banks to step into Micro Finance, and so far its experience have been encouraging, which has resulted banks of equal stature like HDFC Bank, Axis Bank, etc., to participate in the rural economy.
65

Data retrieved from, http/www.rbidocs.rbi.org.in/rdocs/PublicationReport/docs/63448.doc on 6 November, 2011. 66 Observation made by ICICI Banks in, ICICI Research 2006 Report. 67 Ibid. 68 Ananth, Bindu, Financing microfinance the ICICI Bank partnership Model, Small Enterprise Development, Vol 16 No.1, March 2005. 69 ADB Project Number: 43158, Proposed Loan and Partial Credit Guarantee India: Micro, Small, and Medium Enterprise Development Project, January 2010. Data retrieved from, http://www.adb.org/documents/rrps/ind/43158-ind-rrp.pdf on 6 November, 2011.

Conclusion

A decade ago, the central preoccupation of the microfinance industry was the search for scalable and financially sustainable models for delivering financial services to low-income people. Today, we see huge progress on that front. Across the globe, including in India, the microcredit movement has proved that it is possible to deliver financial services to poor people living in rural areas at a large scale, free from any reliance on subsidies. As a result, millions of poor households today have access to credit, and also increasingly to savings, insurance, and money transfer services that they use to manage household finances more effectively. And yet there are still 2.7 billion people in the world without access to formal financial services that are less expensive and safer than informal alternatives. It remains a priority to ensure that previously unreached low-income population segments gain access to these services, including in large swathes of India. The problem that arose in Andhra Pradesh can be easily addressed, provided regulatory authorities stop easing regulations, and lowering key rates for such institutions, as they have done for Commercial Banks in the last one and a half year. We all acknowledge that there is a need of spreading basic banking facilities to the masses, as that would result in lifting up their economic conditions, but it should not come at a cost where people develop a habit of not paying their dues, otherwise we are not far away from replicating another sub-prime crisis. Banks should also realize that short term profits will not help them to grow; they should concentrate on macro view of the situation and care for their long term interest. And regarding illegal procedures adopted by MFIs, government should take initiative and should clamp down on all the illegal practices that MFIs are involved in, albeit we are witnessing some steps, such as ordinances by Andhra Government or the bill proposed by central government in the Parliament, which is now seen as one of the first steps by government to regulate the sector. Banks can play a very important role in extending financial facilities to rural masses, but the greed should not take over the philanthropist aim, as it becomes very dangerous as what we have witnessed in the SKS case, there remains immense possibilities for banks and concern to India there is enough space to accommodate all the major banks, but one thing they should remember, as nicely put by our former RBI Governor Reddy, that banks should not fall for

short term profits, the problem in financial sector is that short term goals of a company out runs the long terms one, so it is upon Banks to realize their actual profit. It may not be a panacea, but it has brought a sea of change in the lives of many. Only spreading the outreach of micro finance will bring down the cost of capital and the operating cost and to strengthen the bonding between micro finance and the formal financial system. However, for sustainable development the poor rural economy, focus must be on development of rural infrastructure and rural economy, to ensure that there exist activities that require finance. Some valuable lessons can be drawn from the following experience of successful microfinance operations. India is to stand among the country of developed nation and there is no denying the fact that poverty alleviation and reduction of income inequalities has to be the top most priority. In this backdrop impressive gain made by SHG-Bank Linkage Programme in coverage of rural population with financial services offers a ray of hope, further we have studied upcoming models that could really help to change the face of rural economy of India.

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