The Curious Case of Microfinance - a Boon or a Bane

The recent series of suicides by committed by the poor borrowers from Microfinance Institution (MFI) in Andhra Pradesh, the state where it all began in India, brings the fundamental question of whether the MFIs are really a boon to the poor that are underserviced by the banking system or merely vultures that are replacing the moneylenders that were already charging usurious interest rates.

Let us begin by looking at the cost structure of the industry. There are three main cost components: cost of capital (11-12% for the top ones, 1-2% more for others), loan loss provisions (2%) and transaction costs (SKS reported 12.66% for fiscal 2009 in its prospectus). The transaction costs are high because of the mode of collection of repayments which is usually done on a weekly basis and the personnel costs. The sum total of these works out to be roughly around 26-30%.

In the wake of the spate of suicides, there is a call for the interest rates to be capped. But, the MFIs defend by saying that the interest rates they charge are probably what the credit card or a personal loan from a bank would cost, may be even a little lesser than them. (Average interest rate charged on credit cards in India-hold your breath, is a whopping 34%). They argue that though the proposed cap of 24% offers client protection, the needy might find excluded from this institutional credit system altogether! The logic is that the start-up MFIs and other smaller ones in remote areas will make losses for many years before breaking even. This also would mean that MFIs would avoid remote areas where process of delivering loans and collecting repayments is people intensive and quite expensive. Also, small ticket loans might not be issued because of the huge transaction costs involved. Hence, needy people cannot be brought into the ambit of Microfinance. Thus, it appears as if there is a trade-off between the availability of institutional finance and the reduction in interest rates.

Further, the argument is that as MFIs establish their business model in each market and start competing for customers, capital, employees and banking relationships, the economies of scale kick in and as they adopt new technologies, they would innovate in products and means of delivery/repayment to reduce the transaction costs and hence, the interest rates. Another thing that is used to oppose interest rate cap is the Raghuram Rajan Committee on financial sector reforms which says that liberalizing interest rates would allow the formal sector to lend to the poor and not the interest rate ceilings.

The proponents of a need for regulatory system for MFIs including a cap on the interest rate spread argue that the MFIs are making hyper profits at the expense of the poor robbing them of the meager surplus. Also, they point out various irregularities in the current MFI system, which include usurious interest rates, lack of transparency, cheating and using coercive mechanisms to recover loans like moneylenders.

They allege MFIs of indulging in multiple lending without due diligence exercise on the capacity to repay, purpose for the loan and its end use which is in direct violation of prudential norms. This raises the possibility of large scale defaults leading to a large chunk of Non Performing Assets (NPAs) which could have cascading effects on the balance sheets of the banks. They are also worried about the lack of transparency on effective interest rates and explain that because of weekly recoveries, poor unable to understand the usurious rates and that they are being taken for a ride by the MFIs.

The high transaction costs could also be because of the exorbitant sums of compensation the CEOs pay themselves in the large MFIs as pointed in the literature (Sriram, 2010). There is a total lack of transparency in this regard.

In the case of AP, critics point out that the state has had a community based SHGs existing more than 10 million women organized and federated at the village, mandal (an equivalent of Taluka) and the district levels. Further, Society for elimination of rural poverty (SERP) has achieved financial inclusion by linking SHGs with the banks. It holds more than 20,000 crores of outstanding loans on its books. MFIs are merely piggybacking on this system by showing them as Joint liability groups (JLG) formed by them. They are resorting to inducing SHG members to join the JLG by wooing the group leaders through freebies. Unlike SHGs MFIs getting hyper profits In case of non-payment or default, coercion and unethical means of recovery ranging from confiscating household articles using goondas, to forcing defaulters to take further loans for repayment and so on, which leads to distress and an increasing number of suicides.

They argue that currently there is a regulatory vacuum and the RBI needs to step in with a framework. The AP government itself is in the process of issuing an ordinance to regulate the activities of the MFIs.

The regulators must focus on improving MFIs’ lending practices, make them more transparent, ensure the clients understand the terms of loans and make sure that measures are in place to reduce multiple lending to segments like agricultural labourers for personal purposes rather than merely putting a cap on the interest rate spread.

In all, it is pretty clear that all is not well with the way MFIs are conducting themselves in the guise of NBFCs. It is definitely not working the way one leading MFI put its purpose as- Our purpose is to eradicate poverty. We do that by providing financial services to the poor and by using our channel to provide goods and services that the poor need. However, one positive to emerge out of this discussion is that these excesses by MFIs are being debated in the public domain is because of them being in organized space. The faceless moneylender who might’ve caused much more grief to the poor was never in such a spotlight.

Reference: "Commercialisation of Microfinance in India: A Discussion on the Emperor’s Apparel" by M S Sriram, March 2010