From Gospel to Heresy: The Crisis in Microfinance

(A guest post by Malavika Raghavan. Malavika graduated from NALSAR, Hyderabad in 2008. She currently works at Allen & Overy LLP in London, and is an active member of their Microfinance Group.)

In the beginning was the Word: The Genesis of “Microfinance”

Microfinance, the love child of social engineering and financial strategy, has grown from an avant garde experiment to a buzz word over the last forty years.

While several claims are now made to its birth, it is widely acknowledged that the approach was pioneered by Mohammed Yunus, now known globally as the founder of the Grameen Bank, in 1976 with his first loan of USD 27 to 42 women in a Bangladeshi village. Since then, microfinance has exploded across the world as a scalable model of offering financial services to the poor.

And the light shineth in darkness: So what is Microfinance, exactly?

Microfinance essentially involves advancing financial services (predominantly credit) to the working poor. The loans are of small denominations, and usually made towards income generating purposes to those who are unable to secure loans from mainstream banking institutions. A key point to note is that these loans are normally advanced without any collateral, and to groups of borrowers. In the absence of collateral, it is social pressure that is used to ensure repayment. This has also, till date, been one of the key successes of microfinance – across jurisdictions, repayments have been consistently high with a global average of 97% (See the Microfinance Information eXchange’s website).

With the growth of microfinance from fringe effort to a mainstream financial strategy, there has been a diversification of the models used by various microfinance institutions (MFIs). Yunus’ initial vision saw microcredit as the lending of loans to poor women for income generating purposes. The emphasis is on poverty alleviation and agency building, and the banks forming the network are owned by the borrowers i.e. made up of their deposits, with all profit being funnelled back into the system. The sector has since seen the rise of commercialized for-profit MFIs, twinning profit and service motives with investments from capital markets and private investors seeking returns. While several moral questions have been raised about the ethics of profiting from the poor, until recently the real world success of these MFIs effectively silenced their critics, or at the very least, muted their disapproval.

I am not the Christ: India, Microfinance, and the Eruption of a Crisis

The growth of microfinance in India in the last ten years has been prodigious. Between 31 March 2007 and 31 March 2010, the number of outstanding loan accounts i.e. borrowers serviced by MFIs is reported to have increased from 10.04 million to 26.7 million and outstanding loans from about Rs. 3800 crores to Rs. 18,344 crores (See “The Report of the Sub-Committee of the Central Board of Directors of Reserve Bank of India to Study Issues and Concerns in the MFI Sector” (the Malegam Committee Report), Reserve Bank of India; available here).

Classified as “NBFCs” for the purposes of regulation by the RBI, MFIs qualify for priority sector lending from mainstream banking institutions i.e. the requirement that at least 40% of Bank funds be lent to worthy “priority sector” borrowers. In addition, private donors also contribute to fund MFIs. While, interest rates that appear high at first glance (between 28% to 32% typically), they factor in branch costs, the fact that MFI officers service the loans at the borrowers’ door step, and the cost of financing. Indian MFIs ironically, are even recognized to have the lowest rates of microfinance globally (See the Intellecap Paper, available here). The State of Andhra Pradesh (AP) has been the focal point for this growth, home to headlining MFIs like SKS Microfinance (SKS), Spandana Spoorthy and BASIX, with more than 12 million borrowers being added between 2005 and 2008 in the state alone. The fever pitch of expansion reached its climax, for some, when SKS went public on 28 July 2010, backed by Private Equity investors including George Soros and Sequoia Capital, raising USD 358 million. Hotly debated, Yunus and Akula (the founder of SKS) faced off in an iconic conversation, at the Clinton Global Initiative in September 2010, on microfinance IPOs, and “profiting from the poor” (available here). In hindsight, the timing of the debate was morbidly poetic.

Between September and October 2010, the media in AP had boiled over with the public outrage at a spate of suicides – reports of the actual number of deaths ranging between 20 and 80. The story of Prabhakar, a fruit seller, who hung himself after failing two weekly repayments, and being struck by an illness which stopped him from selling his remaining stock, hit the headlines. Other stories of borrowers being harassed by MFIs for repayment mushroomed in the media. By 15 October 2010, the AP government had passed an ordinance severely restricting the operation of MFIS, arrests of MFI employees had been made and the borrower defaults on outstanding loans began to have a domino effect. The world of microfinance watched in disbelief.

Art thou that Prophet? No! – A Post-mortem of the Tragedy

An outside observer may be forgiven for surmising that India has only recently woken up to the microfinance paradigm. However, India’s microfinance story goes back several decades with the Self Help Group (SHG) strategy.  Backed by the Reserve Bank of India (RBI) and the National Bank for Agriculture and Rural Development (NABARD), the programmes began around 1990, involving groups of 15-20 women developing credit and savings discipline, operating joint bank accounts and accessing loans. The long term aim of the programme was to help the women to build credit histories and ultimately access financial services individually. However, the model has not gained the momentum expected, and the phenomenal growth in the sector was largely kick-started by the entry of the “commercialized” MFIs using their more streamlined model, with smaller borrower Joint Liability Groups (JLGs), door-step collection and reduced bureaucracy.

The can of worms that had been opened by the tragedy in AP showed a more complex picture of the tension between advocates of the SHG model and the newer MFIS. Intellecap’s incisive white paper titled “Indian Microfinance Crisis of 2010: Turf War or a Battle of Intentions” (the Intellecap Paper, available here) provides this telling analogy, before launching into quality analysis of the situation:

“If we may be permitted a whimsical moment, the Indian microfinance story offers an irresistible parallel to a familiar Bollywood plot: in the Indian microfinance potboiler, the SHG model is the elder brother in an Indian joint family while the MFIs play the part of an aggressive younger brother. The elder brother struggles to uphold tradition and retain his leadership position, while the maverick younger brother tries to break free (using new financial and technology tools), often overenthusiastically, and sometimes recklessly, in pursuit of the same goals.”

Reports that several of the suicides involved individuals who also had loans outstanding with SHGs, and traditional money lenders emerged. In to the mix were thrown politicians with sympathies aligned with various groups, and hostility between state and MFI employees. The waters muddied quickly.

What sayest thou of thyself?: The Malegam Committee Report

In January, the committee headed by Y. H. Malegam released its report – a comprehensive review of sector commissioned by the RBI as the primary regulatory authority for banking and financial institutions.

Key recommendations of the report include the creation of a separate category of “NBFC-MFIs”, with a prohibition on entities not falling within the definition from lending to the poor. Proactively, the report also rejects the need for state governments to regulate MFIs, so as to avoid a conflict with the authority of the RBI. Regulation on interest rates has been recommended, with “margin caps” i.e. restricting the margin that can be built in to their interest rates by MFIs to recover costs and factor in profit. Restrictions on multiple-lending to borrowers with existing loans, penalizing of coercive recovery methods and increased corporate governance are called for.

The most controversial parts of the report come from recommendations that set down thresholds to apply on the ground. MFIs are required to have a net worth of Rs. 15 crores (up from the Rs. 2 crore limit presently). Loans can only be advanced to borrowers with incomes below Rs. 50,000 per annum. The maximum amount of loans themselves must be Rs. 25,000. Crucially, the report reviewed the Andhra Pradesh Micro Finance Institutions (Regulation of Money Lending) Act passed on 14 December 2010 and called for its repeal on the basis that an independent regulator free from political pressure is best placed to regulate these entities.

What sayest thou of thyself? I am the voice of one crying in the wilderness: Finding the way, Post-crisis

1 April 2011 is the deadline set for the acceptance of the recommendations of the Malegam Committee. The RBI is currently in consultation with stakeholders on various parts of the report, but it has announced last week, that the cap on interest rates at 24% will apply from 1 April 2011. Meanwhile, the clouds of a storm are gathering in AP, where the state government refuses to repeal the law in force, stating that under List II of the Constitution, it has the preeminent authority to legislate on the matter. In the face of the tangle of regulation, SKS has recently stated that it may consider stopping operations in AP in the current scenario where new lending is very limited, and defaults have become de rigueur.

Microfinance continues to work around the world positively as an agent to bring change, for financial inclusion, and as a means to help the poor out of poverty. However, the events of the last few months have brought to light the failure to regulate on the part of the Indian authorities, and self-regulate by certain MFIs until tragedy struck. The next few weeks therefore are definitive in terms of setting the new regulatory landscape for microfinance in India, after an agonizing six months. The choice that lies ahead is between using this as a cathartic moment to transcend failings, or throw the baby out with the bath water in a knee jerk reaction.