Microfinance institutions (commonly known as MFIs) were created with the socio-commercial objective to provide access to credit low-income people and thereby aid in poverty alleviation. Their loans serve the low-income population in multiple ways: providing working capital to build businesses, infusing credit to smooth cash flows and cushioning against the economic impact of shocks such as illness, theft, or natural disasters. Moreover, these loans were meant to rescue the borrower from the high lending rates imposed by traditional moneylenders. However, the industry has recently come under scrutiny in India for reasons varying from alleged suicide cases induced by high interest rates to coercive collection methods and corrupt and unethical practices amongst the head honchos of some of the largest MFIs. In response, the Andhra state government (Andhra Pradesh has the largest concentration of microcredit borrowers) has published an ordinance attempting to exercise greater control over the activities of MFIs. As media frenzy and speculation among government, investors and other stakeholder groups on the latest microfinance scandal, it is worth examining the key characteristics and principles that will help define and assess the long-term sustainability of Indian microfinance companies.There seems to be an uncanny resemblance between some of the business models that have developed in microfinance lending and that of sub prime lending. The main differentiator between the two though is that a sub prime loan charges a high rate of interest assuming a high probability of default by the borrower. In the case of MFIs, higher rates of interest have been justified by high operational costs due to smaller sized loans. The success of the MFI scheme is largely dependent on its ability to assess the repayment capacity of the borrower as many do not have a so-called “credit history” to begin with. However, the Indian microfinance sector is noted to have one of the smallest loan sizes of around $150 as well as the lowest yield on portfolio of 21.2%. Despite the global recession and subsequent liquidity crunch, the Indian microfinance industry grew steadily in the second half of 2009. As of March 2009, MFIs in India reported a client base of 22.6 million borrowers with an outstanding portfolio of more than $2 billion in loans. Since 2005, the sector has delivered a compound annual growth rate of 86% in the number of borrowers and 96% in that value of the loans portfolio.
But while measuring the metrics, it appears that we have lost sight of equating progress or ‘growth’ with poverty alleviation. In the Indian context, the achievement of the
commercial component within the “socio-commercial” objective is clearly evident. Apart from lending, MFIs have broader responsibilities of limiting credit dependence. Moreover, microcredit is meaningful only if it is a part of a range of offerings including microinsurance, financial literacy, and entrepreneurship skills training. Over the last five years, as MFIs chased growth, the nature of microfinance delivery changed. The job of income generation and social capital building was left for others to tackle. As competition intensified and markets reached saturation, MFIs took on the additional risk of lending to households with uncertain cash flows. If this trend persists, there is a huge likelihood that the industry will follow some of the flawed practices of the sub primelending models, resulting in huge collective losses over a period of time.
Since self-regulation within the industry has not been completely successful, government imposed regulations have become unavoidable. This does not necessarily mean the death of the micro finance industry as we know it. But it will have certain implications on the workings of these institutions including the shelving of IPO plans by some MFIs and more state level regulations similar to that of Andhra. This could negatively impact some of the smaller MFIs and push them into bankruptcy. From an investor perspective, growth in the future is likely to be much more muted than it has been in the past.
Priyanka Joseph is a senior sustainability analyst and project manager with Solaron Sustainability Service (www.solaron.in).