Sucharita Mukherjee and Kirthi Rao talk about the importance of quality of underwriting standards in microfinance institutions.

This is the first in a series of articles by the authors on the topic Unearthing the real issues in microfinance. Recently, the media coverage on the evolution of microfinance has taken on a worried tone about the future of the sector. Forthcoming IPOs from large Indian microfinance institutions (MFIs) after a period of runaway growth fuelled by the irrational exuberance of private equity and the declining asset quality in some countries such as Nicaragua and Pakistan seems to have raised grave concerns. Also pointed out are political risk, lack of regulation and the nascent level of self-regulation in the industry with the inference that a tightening of standards will bring about a meltdown. IFMR Capital, with its deep understanding and involvement in the sector, has reason to believe that these worries are misplaced. Indeed, the microfinance sector has grown tremendously (portfolio outstanding of Indian MFIs grew at 102% between 2008 and 2009), this can be attributed to two reasons: the strength of the underlying Grameen model of uncollateralised lending, and the vast unmet demand for credit within low income households in India. Vast unmet demand A variety of public policy measures such as the promotion of cooperative banks, regional rural banks and local area banks, bank nationalisation, loan waivers, recapitalisation of failing cooperative banks and regulation directing lending to priority sectors by commercial banks, have been aimed at providing access to finance more broadly in India. However, financial inclusion still remains a distant dream. This is illustrated by the fact that only 2.9% of the lowest income quartile has a loan from a formal institution. As per the CRISIL Top 50 MFIs report, India still represents the largest microfinance market, with only about 10% of the demand being met by existing MFIs. CRISILs report estimates the figure for credit demand by low income households at least INR 1.2 trillion, a small fraction of which is the current size of the microfinance sector. Multiple asset evaluation criteria

The Grameen model is a pioneering development, in that it enables good selection of

borrowers by leveraging on rich information possessed by the members of the group that cross guarantees each other. Most microfinance institutions (MFIs) in India today follow the Grameen model. The strength of the Grameen model has been amply demonstrated by strong equity investor appetite, bank funding and very low defaults despite no subsidies. This model, with a standard structure of lending to joint liability groups has the twin features of being both strong and replicable. Rapid growth is possible, provided MFIs follow the operational framework of this model with rigour. This implies that these MFIs must not only have robust financials, but also invest in a strong second line of management, training of field staff and a system to track and monitor the performance of their loan portfolio. These are some of the factors that debt investors consider when evaluating MFI asset quality. These criteria have been synthesised into Underwriting Standards, by CRISIL and IFMR Capital. The performance of MFIs can be tracked not only by rating agencies but also is publicly available on the IFMR Capital Deal Portal. While political risk in this asset class can certainly not be ruled out, the performance of MFIs till date has been driven by how well each MFI follows the Underwriting Standards. The CRISIL report states MFI asset quality indicated by their portfolio at risk (PAR) greater than 30 days, is healthier than those of other financial service players in India. MFIs have maintained relatively healthy asset quality mainly because of strong group pressure and efficient collection mechanisms, which have ensured high repayment rates. The asset quality is expected to remain superior to asset classes such as vehicle loans, credit card receivables and small ticket personal loans. Strong underwriting standards is the key Concerns about an impending collapse a la the US sub-prime crisis in the media seem to emanate largely from opinion rather than fact. The sub-prime crisis was characterised by poor underwriting standards, lack of incentives for mortgage finance companies to originate high quality portfolios as most loans originated were sold down immediately, and overly aggressive rating models assuming very low loss rates, correlations and an unstated assumption of house prices cannot fall! The microfinance sector has demonstrated default rates under 2% for more

than five years, is financed largely by on-balance sheet loans, and MFIs retain a strong incentive for good due diligence and follow up as they hold first loss equity positions in rated off balance sheet securitisations that are several multiples of their historical default rates. What we must learn from the sub-prime crisis is the importance of monitoring the quality of underwriting standards of originators, and the need to invest in systems that have such monitoring and supervision capability such that credit flows most reliably and at the best price to the MFIs that are less risky, as measured by their quality of underwriting. The microfinance sector can then deliver on financial inclusion built on a solid, sustainable platform of high quality underwriting and supervision. The media, we believe, would do well to focus on criteria that truly drive asset quality, such as quality of systems, group loan origination processes, cash management, second line of management and governance practices of MFIs. These institutions are clearly critical for equitable growth in our country, and in order to strengthen them, we need a debate focusing on the real questions raised here. [Sucharita Mukherjee is the CEO and Kirthi Rao is a team member of IFMR Capital Finance Private Limited.] Trackback URL

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This Time Is Different (in India)? | David Roodman's Microfinance Open Book Blog 07/07/2010 02:33 AM [...] spirited case against the proposition that the Indian microcredit is overheating, from Sucharita Mukherjee and [...]

This Time Is Different (in India)? | David Roodman's Microfinance Open Book Blog 07/07/2010 02:33 AM [...] spirited case against the proposition that the Indian microcredit is overheating, from Sucharita Mukherjee and [...]

Assorted Links Mostly Economics 07/07/2010 12:25 PM [...] IFMR Blog on unearthing the real issues in microfinance: quality [...]

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Vijay Mahajan on the Risk of a Microfinance Bubble

Joy Bolli, Online Publications
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11.02.2010Microfinance has been praised as a tool to pull people out of poverty. But in the light of the global recession and recent developments in the microfinance business, some analysts are concerned about the next bubble.

Joy Bolli: Mr. Mahajan, you founded an organization called BASIX India in 1996. What exactly does your company do in the field of microfinance?
Vijay Mahajan: Basix is actually the name of a group of companies and together we try to promote livelihood, that is, create jobs for poor people, mostly rural households in India. We do that by using microcredit but also a range of other financial services of which microinsurance is the most important. In addition to financial services we provide specific technical services like agriculture extention, life stock development, market linkages and so on.

Why is microinsurance so important?

The lives of poor peole are full of risks and the same risk that may be rather small to us can wipe out their full net worth, so risk management through insurance is very important. Whether it is the death of a life stock, or the failure of a crop, the death of a bread winner or the incidence of being in a hospital for a long time, fire in the shop or in the house all these things can wipe out a poor household. And therefore having insurance is very important for them.

What motivated you to establish BASIX did you want to help others, or was it simply a good business opportunity?
Actually, I have been doing this kind of development work since I was a student, so I guess the primary motivation was helping. I ran BASIX for almost ten years as an NGO. But as an NGO you have a lot of limitations in terms of how much money you can raise, what scale you can achieve - and banks dont lend to NGOs easily. And so we decided to run BASIX as a company and be financially sustainable and indeed, then we also applied for a banking license and part of BASIX is also a bank now. So, it all evolved in pursuit of the goal. But the goal remains to help poor people to achieve a life of dignity and a higher quality of life.

Is there an educational program at BASIX that teaches borrowers how to control their finances?
It is in the process of how we originate a loan. We have a long dialogue with the household about their current livelihood activities and we work out cash flows for those activities and then only we consider giving a loan. Additionally, before disbursing the loan, a customer has to pass a kind of oral test: Do they understand what amount they are borrowing, what is the interst rate, what is the installment they have to pay, what is the full loan tenor of the loan and any other conditions. Only if they answer these questions properly they receive the check. If they fail that, we send them back to our field staff in our premisses for a few more hours of discussion and then they can come back. Eventually, while they are waiting for the loan disbursement, we show them videos which indicate what economic activities they can do, what is the benefit of insuring their crops or their animals, personal life insurance, health insurance, etc. By the time they walk off from our office with the check, they not only understand what we are giving them but also what their obligations are.

Critics of microfinance often claim that microfinance offers limited benefits, if at all, for the poor. What is the percentage of people who really make it out of poverty with the help of microcredit, and how long does it take on average?
Well, I am one of the critics myself and I am widely cited as saying that. But the full story is that microcredit does help a certain type of poor people: Those who are entrepreneurial and who live in regions where there is enough of a density of transactions so there is a market. But if you are very poor, or if you are living in remote regions then credit by itself is not enough. You need other services: You need links to markets, sometimes training and skill building and all of that toghether only can make a difference. So, when you are dealing with non-entrepreneurial poor people which is the vast majority of the poor then you certainly need to have microcredit but you need credit plus. Therefore, the critism is not that microcredit is of no use but that by itself it is inadequate.

So what is the percentage of people who really make it out of poverty?

Its hard to cite a single number like that but in general, in those areas where there is reasonable presence of a market, anywhere between maybe a quarter to a third of the borrowers of MFIs in about three to five years will overcome poverty. So, 25 to 33 percent. But it takes three to five years because the loans are rather small and the incremental income that you get from those loans is not that great that in one year you can overcome poverty.

Returns for investors can be very high. Just how social are social entrepreneurs?
We need to distinguish between investors and microfinance entrepreneurs. And in both categories, there are those who are doing it for a social motivation and those who are doing it because its a good business proposition. So, the sector is a mixture of these two. You will simultaneouly have MFIs which barely make a small profit and their investors make no return. And youll have other MFIs which are making a lot of profits and therefore are able to reward their investors. But the sector will settle down to a middle path because if you make too little profits, you cannot grow and will have a problem with capital and attracting loans. If you make too much profit, almost usurious, then eventually someone will raise their voice against you and you will have to stop that.

What other soft spots do current microfinance developments reveal?

There are several other issues. One of them is consumer protection. Poor people dont necessarily know the full cost they are paying in terms of interests and other transaction services. Then there are issues of being too insistent on getting the repayment. One of the USPs of MFIs is that they have a very high repayment rate, 99 percent and above. So, you must repay under any condition becomes a kind of a norm and that sometimes leads to practices which are not desirable. So, there are one or two issues, but they can be handled.

Credit Suisse runs a special microfinance initiative, which aims to enhance capabilities and provide staff training for microfinance institutions. Why is such financial training needed?
It is centrally important. MFIs do well because there is a lot of unmet demand among poor people and some whole sale supply of capital is beginning to be available. But as it grows, these institutions can become large and complex and unless the capability of people running those institutions on all levels is enhanced, it can be a very big risk factor. So, it is important that the amount of money in the sector is matched with the amount of capability in the sector.

The effects of the financial crisis on the real economy of countries in the emerging markets have made it difficult for certain borrowers to repay debt as agreed. What is your take on this development with regard to India and Africa?

For a vast majority of microfinance customers the financial melt down and the economic recession that followed was not that serious. It was only for the people who are working in the export business, like diamond polishers or people who are producing commodities which are largely exported. There you certainly had a high correlated risk, and therefore, those loans would have to be significantly restructured. For that the respective MFIs will have to be given secondary support. But the good news is that the micro-economy in general is doing better than the macro-economy. Therefore, microfinance as long as the overall capital flows to it are protected will actually be part of the solution rather than part of the problem of the current global financial crisis.

Analysts are now talking about the risks of a microfinance bubble. What exactly are the dangers here? Are these risks real, or exaggerated?
There have been some very real incidents. In India and some other countries, there have been a couple of cases where there was first a high growth that led to multiple lending and over-indebtedness. That again led to crash in the portfolio quality. However, if you see these incidents as a proportion of the total, its very very small. But because these incidents have got publicized, both among the media as well as the lenders and in the sector, everybody has learned their lessons from it. I think its like a vaccination: you get a little shot and after that youre okay. The sector will be fine. I dont think that the bubble will go the way it went, lets say, in the credit derivatives.

What are (your) suggested solutions to avert a bubble?

To avert a bubble, lenders and equity investors should be careful not to ask for growth rates which are unrealistically high. Demand is very large. But the supply should be limited to the institutional capability to do it well. You cant increase that capability by 150 or 200 percent per annum. You can do that in the early years but you cant do it later. So, investors have a role in saying okay, cool it. Whatever the locally appropriate growth rates are, just stay with that. Then regulators have a role. And then the managers in those MFIs have a role in ensuring that the incentive structures for the field staff are designed in such a way that they engage in prudential lending and are not just throwing the money away. They should be incentivized under recovery rate and not just on how much they disburse. Through all these means together, the chances of a bubble can be significantly avoided.

How do you see the future of the microfinance business?

The micro-economy is doing better than the macro-economy in most cases in the country. It is the time that the lower end, the bottom of the pyramid, will grow faster and microcredit and other microfinance services are badly needed and should be provided. This is the growth sector. And it is part of the solution, not part of the problem.

About Vijay Mahajan

Vijay Mahajan originally studied electrical engineering. During his studies, he became involved in improving living conditions in rural India. In 1996, he founded BASIX India, which provides microentrepreneurs with financial services.

BASIX

About Traverse

As part of its Traverse series, the Swiss Agency for Development and Cooperation (SDC) in Berne regularly hosts podium discussions on contemporary issues related to international cooperation. On February 2, 2010, the Traverse series invited participants to a discussion entitled The Financial Crisis and Banking for the Poor. The speakers were Vijay Mahajan (BASIX India) and Dr. Arthur Vayloyan (Credit Suisse). The event was moderated by author and columnist Roger de Weck. Discussion focused on critical aspects of capitalism and new paradigms for the future.

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Part 1: Current State of Microfinance in India

9 February 2011 at 12:00 TC 2 comments

In the past few months, the Indian microfinance industry has been in the spotlight for the wrong reasons. A few Kiva Fellows wanted to learn what the issues were, and what can be done to prevent them in the future. We will present our findings in a series of posts over the coming days. Given the inherent complexities, the multiple viewpoints and an ever changing political and legal landscape, our work is only intended to provide a top-level summary of the situation as it stands now. If you are interested in learning more about microfinance in India, we encourage you to explore these issues beyond what is presented, and to draw your own conclusion. The series of posts will be: 1. Current state of microfinance in India 2. The issues, players and outcomes 3. Borrower protection practices at Kiva partners 4. What is the industry doing to protect borrowers? Without doing any reading or research on the topic, I am willing to bet that the average American has heard through the media that microfinance is having problems in India. On one hand, microfinance has been heralded as an innovative solution which reaches the impoverished in third world nations. On the other hand, microfinance has been criticized for reckless lending that harmed the impoverished more than it helped. Articles in The New York Times, The Wall Street Journal, and The Washington Post have recently focused on the negative impacts of microfinance in India. Let us take a closer look at the current state of the industry, the governments response to the issues at hand, and the media coverage. The Current State of the Industry It is interesting to note that there is extreme concentration in the Indian microfinance industry approximately one-third of all outstanding microloans and borrowers are from the state of Andhra Pradesh. It is also interesting to note that despite the recent growth of the industry, around 90% of the Indian population remains without access to financial services. Microfinance in India is funded by private and public capital. Private capital comes in the form of private equity investments and funds from the capital markets. Loans from private equity firms and the recent initial public offering of SKS microfinance are examples of private capital. Public capital is known in India as priority sector lending. The Indian government mandates all banks in India to lend to the priority sector. The priority sector includes agriculture, small enterprise, retail trade, education, and housing finance. The intent behind this policy was to make sure that under-served markets are not ignored by commercial banks. Microfinance falls into this definition of the priority sector, and this capital has been the primary driver of the recent growth in microfinance. From 2003 to 2009, the number of microloans extended to the poor in India grew from 1.0 million to 26.7 million. For additional information on priority capital, please click here.

The Andhra Pradesh Governments Response In recent years, Indian microfinance has been a lucrative business for investors, evidenced by SKS Microfinances $358 million initial public offering in August 2010. Following in the footsteps of SKS, other microlenders found that it was easier to disperse loans to borrowers who already knew how the game was played than to disperse loans to borrowers who needed to be educated about the rules. What occurred was similar to the way that college students in the U.S. rack up credit card debt; villagers in India were offered easy access to capital, which piled on top of prior debts from village lenders, family members, friends, etc.). Eventually, the debt repayments became too high and families began to have trouble meeting repayments. As reports of investors becoming wealthy from microfinance reached villages and microlenders relentlessly sought repayments, villagers began to feel that they were being taken advantage of. Last fall, encouraged by political leaders belonging to the opposing party to the one in power, these villagers began to stop repaying their loans. To further complicate matters, the Andhra Pradesh government issued an Ordinance on October 14, 2010. This Ordinance required MFIs to halt operations, register with the government, and wait for those registrations to be processed before resuming operations. In addition, the Indian government began to fear that it would not recoup its loans to microfinance institutions, and it halted loans to MFIs. The government backstops nearly all the priority capital lent to the microfinance industry, exposure valued at approximately $4 billion. With their main line of credit turned off and the number of clients defaulting on loans climbing, MFIs faced the threat of bankruptcy. The Media Coverage In response to the state of microfinance in India, Western media outlets such as The New York Times and BBC News ran articles covering the developments. In articles such as these, the authors present stories of women and men who are negatively impacted by microfinance. The stories range from a man who dropped dead from a stress induced heart attack at the age of 40, to a woman who abandoned her family to escape the pressure from lenders, to a woman with financial difficulties who hung herself in her home. These articles implied that microfinance destroyed families and was the cause of suicides. Though over-indebtedness adds to social pressure, it is difficult to suggest that microfinance causes suicides. Reports suggest that over 90% of Andhra Pradeshs rural population have some sort of loan. Therefore, there is an obvious correlation between those who are committing suicide with those with microloans. However, the initial claim that one caused the other has gone through much scrutiny in recent months. Studies done across Europe and Asia have tried to look deeper on whether one could really accuse MFIs of being the reason behind the suicides. Turns out, most of the rural population in Andhra Pradesh get their debt from numerous sources, most of which are informal (money lenders, family members, and friends). To imply that people killed themselves due to MFIs is a push since they were expected to pay back all the debt they had from different sources. Furthermore, some smaller development organizations had since gone back and interviewed the families of those cases which the Western media picked up on.

Most of the family members have tried to better explain their position and have admitted that the loan sharks had created the majority of the problems and repayment pressures. While a (weak) correlation is obvious, it is a stretch to link the growth of MFIs to a rise in suicide rates. More likely, it is the high level of overall debt and the lack of regulatory oversight that results in putting borrowers at a point of despair where they feel they have no other option. In the series of posts to follow, we will discuss the issues with microfinance in India in greater detail, what the MFI partners Kiva works with do to protect their clients, and how the broader microfinance industry is addressing these issues. For additional information on the matter, please check out Kivas official response to these issues here.

2 Comments Add your own

1. David Roodman | 14 February 2011 at 18:43 Tran, I agree with a lot of what you wrote, but I think your dismissal of the microcreditsuicide link is too facile. First of all your studies link points to only one study and it is based on cross-country datathose kinds of studies are now in disrepute in economics and should not be relied upon. I have followed blogged events in Andhra Pradesh extensively. Here is a quote from one early post that I think is relevant: [At the World Bank in Delhi,] I spoke with Parmesh Shah, a rurual development specialist who is centrally involved in the Banks support for SHGs [self-help groups, an alternative microfinance model]. Naturally that role colors his perspective. But he told me something that sheds light on the charges of suicide that been leveled at MFIs. He told me about confidential research the Bank commissioned after smaller microcredit crises in Andhra Pradhesh about the causes of suicide. Apparently 300 cases were studied in depth. At least among debt-related suicides, the typical pattern was that the loan troubles would build up over years, as the people borrowed from whomever they could. Then, typically, some traumatic event would trigger the suicidea public shaming by a creditor, a beating, a threat of rape. Thus when people end their lives they may owe only a small share of their debts to MFIs. Yet I can imagine that MFIs, because they insist on on-time repayment and because hypergrowth may have outrun the inculcation of appropriate procedures and norms, have been more prone than SHGs to provide these triggering events. Thus even when microcredit may represent the minority of a persons debt it may well be more apt than other forms of credit to generate the stressful, shameful triggering event that leads to suicide. I am skeptical of the Andhra Pradesh governments official list of microcredit-induced suicides because it is cleraly biased (kind of like this post); but at the same time, I cant dismiss the basic concern outright.
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2. Gareth, KF14, Benin | 9 February 2011 at 23:32