Big concerns over small loans

Microfinance is an effective tool for financial inclusion. Here are

some elements of the recently embattled sector
The recent controversy surrounding the microfinance sector has entirely eclipsed the fact that it is the first effort in
India to have delivered financial services to remote corners of the country in a self-sustaining manner. The stakes
are high for India’s poor, and we have to pave the way for orderly growth in the sector. Here is our view on some
key issues that have featured in the current debate.

• High interest rates: The effective interest rate charged by microfinance institutions (MFIs) to their clients has
varied between 24% and 40% per annum. Given that default rates on microfinance loans are extremely low, these
rates seem “usurious”. MFIs justify them, citing high operating costs involved in serving remote areas with small
loans. However, recent equity market valuations suggest that in reality, stable return on assets are 8-10% for an
efficient MFI charging 28%—much higher than that of banks and other non-banking financial companies. So, even
while it is true that these rates are lower than those charged by informal lenders and within the envelope of returns
earned by clients from micro-enterprises, there is clearly massive room for lower rates. But the big question is: How
will these lower rates come about?

If economic history is anything to go by, definitely not through regulation that caps rates and shrinks supply. One
alternative could have been a benevolent public sector that charges “fair price” for the same service and puts pressure on the
private sector. Let’s examine the self-help group (SHG) programme. Banks lend to an SHG typically at 12%. This is,
according to the Rangarajan committee, 10-20% lower than the true total costs of a bank even after fully accounting for
implicit subsidies from the government by way of cheap refinance and privileged access to low-cost current account and
savings account funding. SHGs acting as quasi-banks, in turn, lend this money (and internally raise deposits from a few
members) to the end client at around 24-48% per annum. These rates are comparable to those charged by MFIs and mean
that there is no pressure on rates from public sector alternatives.

Therefore, the only way out is to aggressively promote competition between entities and facilitate entry of disruptive
new models. However, any mention of competition is met with grave concerns regarding multiple borrowing and
evergreening.

• Multiple borrowing and excessive client leverage: Talk of unfettered competition prompts images of
borrowers collapsing under a mountain of credit card debt in South Korea. When educated and disciplined South
Koreans could not escape this debt trap, how can we expect the hapless illiterate rural Indian borrower to do so?
Facile comparison, we think. The low-income borrower is in fact a careful money manager and is not easily enticed
by promises of more “easy” money— more so when she knows that it needs to be compulsorily repaid. In addition,
the group structure and the threat of credit denial upon default puts enormous pressure on members to be
conservative on amounts and purposes. Researchers, on the contrary, rue that microfinance does not help
entrepreneurship, given the small amounts and extreme risk aversion created by the group model.

• Evergreening: A related concern with competition is that new loans service old loans. From our experience, the
near-zero default rates are a fact. The Grameen Bank methodology requires people to borrow in groups, guarantee
each other and make repayments of principal and interest in weekly instalments. Eligibility limits start at Rs. 5,000,
rise gradually, and cap out at Rs25,000 per member. These limits have remained intact in nominal terms for over
two decades, and have thus halved in real terms. This approach results in clients borrowing conservatively and
relying on current income for repayments. Research shows that the closest parallel to a microloan is a
mandatory/disciplined savings programme. Clients view the loan as a disciplining device to create assets for the
household, rather than leverage in the commonly understood sense. The weekly instalments, combined with low
default experienced by all players, make evergreening a technical impossibility and fit more neatly with the desired
savings patterns of rural households.
• Excessive credit discipline and coercion: When times are good in microfinance, the coercion by groups to
repay is applauded as the beneficial power of “social capital”. Maintaining a high degree of credit discipline is at the
heart of the microfinance success. However, in the case of group-based microfinance, this credit discipline is
principally enforced by members of the group on each other because they are desirous of maintaining a good track
record with the lender. The key here would be to not weaken overall credit discipline, but to protect clients in events
where there is genuine inability to pay; emphasize process discipline at the time that the loan is made; and not rely
on high-powered incentives for loan officers linked to collections. Industry participants such as Basix chairman Vijay
Mahajan have repeatedly emphasized the role of insurance in providing a safety net to clients during bad times.
These are useful directions for MFIs to pursue without losing focus on credit discipline.

It is critical that we don’t let years of hard work and innovation come to naught over imagined concerns or
organization-specific episodes. The large, systemically important MFIs are routinely audited by the Reserve Bank of
India (RBI). Boards, top management and investors have to be stewards of orderly growth and market discipline in
any financial institution. Microfinance is no different. MFIs and lenders to these entities urgently need the certainty
and the reassurance from RBI that they will be held accountable to the same standards.

Rajan makes a case for small banks

Says well-managed NBFCs, MFIs should be allowed to set up banks; worried
about entry of large industrial houses .

The honorary economic adviser to Prime Minister Manmohan Singh, Raghuram Rajan, is against industrial houses
being allowed to run banks as the central bank is engaged in the process of drawing up the guidelines for allowing
more entrants into the industry.

According to Rajan, the Indian central bank should allow about 20 new, professionally managed, small banks with a
minimum capital of Rs. 50 crore. Well-managed, small non-banking financial companies (NBFCs) as well as
microfinance institutions (MFIs) that are in the business of giving tiny loans to poor people should be allowed to
convert their firms into banks, he has recommended. Finally, while the majority of the new entrants should have
local promoters, foreign players should also be allowed to set up banks, provided they meet the fitness criteria.

Rajan, the Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago’s Booth School of
Business, made the confidential comments to the Prime Minister on the Reserve Bank of India (RBI) discussion paper
that deals with the proposal to allow more private sector banks.

The note, a copy of which was reviewed by Mint, was written by Rajan in his capacity as Singh’s honorary adviser.
He declined to comment to Mint on this issue, saying, “Any reports I send are meant to be confidential.”

Finance minister Pranab Mukherjee in his February budget had said the banking regulator will allow more new
entrants to allow Indians greater access to banking services. About 40% of the country’s 1.2 billion people don’t
have such access now. RBI in August released a discussion paper on new bank licences and asked for feedback by
30 September. It is expected to release draft guidelines at the end of January for public comments.

The August discussion paper focused on capital, ownership structure, foreign shareholding norms and the business
model of new private banks, but stayed away from taking any position on the profile of the new entities that will be
given licences to run such banks. It also said all applications will be examined by an external group and “a limited
number of licences” will be given, based on the group’s recommendations.
The RBI paper has proposed that the minimum capital requirement could be anything between Rs. 300 crore and Rs.
1,000 crore, and a higher minimum capital norm will ensure “banks operate on a strong capital base”, and such
banks would be able to take part more meaningfully in the financial inclusion drive through their ability to invest in
technology.

Licences to industrial houses, according to the paper, ensure important sources of capital, management expertise
and strategic direction, but a conflict of interest could arise as the firms may misuse the bank for their own needs
and restrict credit flow to competitors.

RBI has explored the option of allowing industrial houses to take over regional rural banks (RRBs) before setting up
banks. RRBs are currently 50% owned by the Union government, 15% by the respective state governments and
35% by sponsored commercial banks.

Among other things, the RBI paper discussed at length the issue of converting NBFCs into full-fledged banks.

Rajan, a former chief economist of the International Monetary Fund, who now has the rank of secretary, government
of India, in his capacity as adviser, said, “RBI could allow the entry of small banks, but not restrict their growth or
geographical spread.” In the past, India has experimented with a concept known as local area banks that operated
with small capital and a tiny geographical area.

The 20 new entrants Rajan is in favour of should have a capital to asset ratio of not less than 15%, he has
suggested.

“Restrict their activities in initial years to more traditional banking activities…and maintain close supervision,” the
note said. “Remove restrictions as supervisors gain confidence in the banks and allow a full-fledged banking licence
not less than three years after commencing operations and once certain criteria are met.”

According to him, a minimum entry requirement of Rs. 1,000 crore would ensure that only large corporate houses
can get a banking licence and with the capital to asset ratio at 10%, such banks will have an asset base of Rs.
10,000 crore at the outset. “A bank of such size is unlikely to be effective at local lending or at promoting financial
inclusion… Finally, untried management handling Rs. 10,000 crore in assets is a risk RBI should worry about.”

A sound track record on financial services and higher capital to asset ratio should be the focus rather than higher
capital as the cost of information technology systems is not prohibitive. “There are very few well-managed small
NBFCs and MFIs that could well be entrusted with a banking licence,” he said.

Pandora’s box

Rajan is worried about the risks posed by the entry of large industrial groups as such banks could tend towards
lending to related entities, with such loans increasing when a house runs into trouble. “India already has a
concentrated wealth structure, which influences political decisions. Allowing industrial houses to own banks will
exacerbate the concentration of economic power and political influence. We should not open this Pandora’s box,” he
said.

On the other hand, Rajan has suggested an experiment with a dual-licensing structure. For instance, a few industrial
houses whose integrity is above reproach could be given restricted small bank licences that can be upgraded
depending on their performance and “supervisory comfort”. Based on this experience, RBI can open the doors to big
industrial houses in phases.

Foreign financial firms, according to him, have expertise and hence “while most of the approved licences will be for
more domestic promoters, there is no reason why foreign promoters should have very different requirements
imposed on them”.
Finally, Rajan does not see much merit in branch expansion. With the growth of mobile banking, the advent of the
unique ID programme, and a liberalized business correspondence rule, he sees no reason in linking inclusion to
branch expansion. “We should write our regulations such that branchless banks are also possible.”

Rajan’s suggestions could influence RBI’s thinking when it frames the draft guidelines for new bank licences in
January.

Earlier, a Planning Commission panel on financial sector reforms, and headed by him, had suggested the separation
of debt management from RBI’s mandate and sowed the seeds for the Financial Stability and Development Council
that the government has set up.

Size does matter when it comes to microfinance

Smaller MFIs made losses in fiscal 2009 due to high operating costs; new study
pegs loan recovery at 99%

Size does matter when it comes to microfinance. That and the pace of expansion mark the difference between
success and failure, according to a study into the industry.

One out of three microfinance institutions (MFI) in India made losses in fiscal 2009, says a study of some 230
lenders conducted by ACCESS Development Services, a not-for-profit organization that offers consulting services to
MFIs.

The study also shows that a higher proportion, 42%, of small microfinance lenders, or those that have a loan
portfolio of up to Rs5 crore, posted losses.

“Small does not seem to be the right size for viability,” says the study, which was led by N. Srinivasan, an expert on
MFIs.

In fiscal 2009, MFIs recovered 99% of their loans, according to the report, which is way above the recovery of
commercial banks. While MFIs lend at rates going up to 30%, the smaller ones make losses because of high
operating costs, according to industry experts.

For large MFIs, the cost of distributing and recovering loans are typically 40-45% of the total. The rest is the cost of
funds—MFIs typically borrow from banks and other institutions at around 12% interest. But for smaller players,
operating expenses, or the proportion expended in distribution and recovery, could be as high as 60% of the total.

“If a new lender tries to expand fast and spends a lot of money on manpower, technology and market penetration, it
could face losses,” says Chandra Shekhar Ghosh, managing director of Bandhan Financial Services Pvt. Ltd, one of
the biggest and most profitable MFIs in India. “Operations should be scaled up gradually after building a certain
amount of business.”

However, operations are sustainable only if a lender can raise its loan portfolio to at least Rs10 crore and that should
take around two years from inception, according to Manoj K. Sharma, director of MicroSave, a consulting firm that
advises MFIs. “Scale is very important in microfinance. A lot also depends on lending practices as well,” says
Sharma.
The ACCESS report says “unbridled expansion tactics”, and competition in some cases result in lenders offering more
loans than borrowers could service, and this, in turn, leads to delinquency. For illustration, Srinivasan cites
largescale defaults in Kolar district of Karnataka, where non-performing assets (NPAs) are as high as Rs60 crore,
almost half of the total NPAs of the industry.

Paring transaction costs is the biggest challenge facing microfinance lenders. “It isn’t easy making finance available
to the last man in the queue,” says J.P. Dua, chairman of Allahabad Bank, which funds MFIs such as Bandhan. “It
also costs quite a bit.”

MFIs in India had nearly doubled their outstanding loan portfolio to Rs11,734 crore in fiscal 2009, according to the
ACCESS report. They added 8.5 million borrowers during the year and had 22.6 million borrowers as on 31 March.

The bigger players were better off—in fiscal 2009, 84% of the large MFIs, or those that have a loan book of more
than Rs50 crore, were profitable, and of those that have a loan portfolio of up to 50 crore, 80% were profitable.

Meanwhile, on Wednesday, D. Subbarao, governor of the Reserve Bank of India (RBI), said MFIs were lending at
very high rates, while acknowledging that they had made finance available to a large section of the society “left
behind by the formal financial sector”.

Competition should eventually force MFIs to pare lending rates, Subbarao told Mint on Thursday.

The Union government could introduce a Bill to regulate microfinance lenders, finance secretary Ashok Chawla said.
The legislation had been put on ice because one of the former allies of the Congress-led government wanted the Bill
to put a ceiling on lending rates.

Chawla said the Bill “would be discussed by the standing committee” and it could “look at issues such as lending
rates”.