The macrocosm and microcosm of microfinance Commentary: Ayan Banerjee1

As microfinance becomes the flavour of discussion with abounding literature being presented earlier that applauded the poverty alleviation that microfinance has catalysed, there is also this growing body of evidence that criticises the dark side to the extent of almost overlooking the benefits that the sector has brought about. Though microfinance, in large part, has transformed from a social business to a (social) business, it is still unequivocally acknowledged that microfinance is additionally endowed with keeping societal impact in consideration catering to those who are not only underserved but also economically and socially underprivileged (and may thus need state protection). The macro-picture: Market risk is very little understood, credit risk even less. Long Term Capital Management, arguably the most famous hedge fund, which had two Nobel laureates on board collapsed despite having, supposedly a 15 sigma, implying probability of default an infinitesimal fraction of a percent. Hedge funds, being leveraged businesses, and with little and no regulation then, caught greater focus. While there is no rational comparison between microfinance and hedge funds, leverage as a creator of financial crises as pointed out by Hyman Minsky, the surrounding paranoia in the macroperspective is understandable. The existing 99%+ repayment rate is of little consequence while assessing risks; anyway, these numbers will soon be revised downwards as Microfinance Institutions (MFIs) have observed in Latin America. The fear of any of the big four MFIs failing, as has lurked in the minds of many industry observers, will create a massive impact on perspectives on financial inclusion and beyond. And, they cant be bailed out! The current popular press bashing Non-Banking Finance Companies (NBFC) microfinance operators, as exploitative, should not overlook the tremendous positive macro-economic impact that microfinance in the last 3-4 years has created; special contribution of the resounding positive impact

TheauthorisDirectorCorporateDevelopmentatAadhaar,anotforprofitentityestablishedwiththeobjectiveofcontributingtoand driving social change in India through social enterprises. Aadhaar aims to assist socially relevant organizations achieve sustainability withoutdilutingtheirmultiplebottomlineobjectives.
This article is based on a sanitized case vignette prepared by Aadhaars research and implementation of microfinance through its consultingexperienceinthefield.
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Electronic copy available at: http://ssrn.com/abstract=1701662

created by the NBFC-MFIs: Rural employment opportunities, access to affordable finance (compared to interest rates of 300-500% charged by moneylenders), propensity towards a (Gandhian-type) selfsufficiency at the village level and deepening the financial infrastructure. Greed and fear create the bullish and bearish runs and concerns loom large in the minds of the investor (valuations being driven downwards). Think tanks have now begun to assess several questions from a policy and regulatory perspective, with a greater sense of urgency. For instance, should proliferating for-profit but more transparent NBFCs be unleashed? Would this, essentially, entail deepening the financial divide or facilitate bridging it? Given that the original reason of microfinance to come away from loan sharks and usurious money lenders, should there be a cap on interest rate spreads? There a trade-off between outreach and efficiency of MFIs in India: should the economic benefits be shared with the clients? Are the operational costs of MFIs really that high; or, can interest rates be brought down? Should we have a fragmented, localised large number of local suppliers who are more emotionally rooted to poverty alleviation or should we have a few large NBFC-MFIs consolidated through rapid organic or inorganic growth, who are well positioned to be suppliers for most of the microcredit supply and, thereby creating an efficient sector? Should the lending be secured or unsecured? Should NBFC-MFIs be allowed to mobilise deposits? Will the consolidation of NBFC-MFIs through M&A create value or destroy value, since they will have an effectively eroded client base due to multiplicity of loans? Depending on the policy view, if should there be a distinction between the rural marketing of bottled cola and microfinance delivery? We understand that the outcome of these debates will have important implications for the potential direction for regulation of the sector. There is a serious implication of these on macroeconomic indicators: obviously, inflation levels; employment rate (yes, the sunrise sector has generated a huge employment opportunity in the rural areas, a path to poverty eradication; GDP as soon these microenterprises become formalised institutions as Micro and Small Enterprises through various credit cycles; as well as various social and human development indicators.) At the micro-level: With a lot of policy level, thirty thousand feet above the ground, discussions and opinions are being liberally churned out in the press, the view is less likely to help unless one understands the basics of the current concerns in microfinance. We begin by outlining the microperspective.

Electronic copy available at: http://ssrn.com/abstract=1701662

Any loan by any entrepreneur results in having fixed cash outflows mapped against variable cash inflows. The excess of all costs, including debt obligations is the surplus that is available to the household as profit. As it accumulates over time, the profits saved form as cushion for taking more credit and against credit defaults. However, when the same erodes - ceteris paribus - because of rising (debt) costs bankruptcy begins to envelope the household. Few MFIs are doing their credit checks diligently. Application of debt: Many micro-entrepreneurs have been blessed in recent times with ample access to microfinance. While the loans were intended for enhancing income generation, in a large number of cases they are used for consumption purposes. Any loan purpose-utilisation check cant verify it. Even when they are used for income purposes, it must be noted that the relationship between financing and returns to scale is not elastic. There are indeed myriad other ingredients that would be necessary (marketing and business development for one) for success of the enterprise. Thus, a higher supply of credit, if availed, is only likely to only create a debt burden without the proper application of the finance. So what is the optimum supply of credit to the entrepreneur and how does one ascertain it? This necessitates financial literacy, which is alarmingly poor in all socio-economic segments, more so here. Its not that easy to reason: When and how much should you take a loan? Financial literacy needs to be imparted at the grassroots level to make micro-entrepreneurs more discerning, since debt can be a double edged sword! Micro-enterprise development is critical. Without loss in generality, let us take the case of Lalitha, a vegetable vendor in Chennai. She takes a loan of Rs 20,000 from an MFI. Availing of
Figure:Whythefamousrepaymentratesof99%arenot sustainableinMicrofinance
? Application ofDebt N Has increas ed income ? Income Expenditure Savings DebtTrap! Savingserosion.Theexpenditurewould includeconsumptionand/oralsorepaying previousloans.Tomaintainliving standard,takefurtherdebt..

Assumingthatexpenses arenotincreasing,the accumulatedsavings Y shouldincrease implyingageneral increaseinwealthand welfareofthe household

the debt she prospers, when cash flow rises beyond what is needed to pay off debt and consumption; soon thereafter a speculative euphoria develops. Then two other MFIs offer her loans of Rs 15,000 each. Underestimating the entrepreneurial skill in an individual is a missed opportunity (as Prof. Yunus highlights) but overestimating it is a risk! Nine women cant deliver a baby in one month: Lalitha assumes a constant (or even increasing) return to scale for the vegetable business i.e. the more money she pumps in, the more successful she will get. Alas, she subsequently realises that it may not be that simple to run three outlets in the same neighbourhood. As she shuts one shop, suffering losses, she is reminded of the loans she has to repay. Ever-greening is rampant; one loan has already been sized up. Unable to repay, she takes yet another loan from another new age MFI. This slow movement from stability to crisis (somewhat similar to Minsky moment at the macro-economic level) leads to household bankruptcy. As these repayments continue to pile up, coupled with malpractices by recovery agents, she either contemplates suicide to avoid humiliation or forms a group with other similar defaulters and tries to get the debt waived by approaching the local government. Cutting corners: The creation and formation of a group and training them to appreciate microfinance costs Rs 4,000- 5,000. It is tempting for any MFI to cut costs and time by acquiring entire groups of other MFIs and enrol them. The shortcuts inflate client numbers and portfolio, with limited incremental cost of acquisition. Balance sheet analysis will wrong herald them as efficient with the valuations looking shinier. This encourages field operators to overlook multiple lending. Yet, another case of competition not driving in best; over-indebtedness in saturated places; first mover disadvantage is in virgin areas which nobody finds attractive (microfinanceable) due to genuinely higher operational costs as well as costs of explaining microfinance. Thereby the existing scenario defeats the financial inclusion promises that MFIs make recurrently. The tip of the iceberg is coming into view; the perils of everyone picking up the same low hanging fruit. The Innovation buzz: Enthusiasts talk about customisation and innovation as soon as a mass market product is rolled out. Its the obvious thing to do. In todays microfinance scenario, innovation and customisation are far outcries; the T-model type microcredit delivery needs radical uplifting. The quest for positioning a financial institution as service provider of blind spots is chronic (new age banks have been doing). The need to deliver the same, though mesmerizing, is

not acute. As has been comprehensively argued in leading scholarly circles, this is neither the time for innovation (e.g. securitisation, being one such attempt to free capital; were not talking about bilateral portfolio sales here) nor customisation but to damage control the potential miscarriage of the vanilla product. The crux of the issue today: The real concern in microfinance today is not interest rates. The average rate of interest on credit cards is 34 percent is acceptable. Interest rates, even if brought down by 2-4% from 20-30% today, would bring down the weekly instalment to only about Rs 510, quite an inconsequential amount even for the end borrower. A second loan doubles the weekly burden. In many villages, borrowers have taken loans from as many as 10-12 MFIs! And there is no way to do this credit check, yet. Its like having ten loans from ten banks on the same vehicle! Should even a single borrower default or the loan be waived at the local level, there is likely to be multiple delinquencies for the sector. The gravest concern today is that there is no mechanism being implemented to sort out multiple lending. Fortunately, thoughts are on. Need for Regulation: The National Bank for Agriculture and Rural Development (NABARD) initiated Self Help Groups (SHGs) linked to banks is by far is the largest microfinance programme in the world. Given that NABARD is uniquely positioned to understand microfinance nuances at the operational level, right now microfinance needs more than light and careful regulation for it to survive as a sector and to continue to achieve social and commercial benefits. NGO-MFIs, which usually are dealing with Bank-SHG linkage, have a smaller share of the total microcredit portfolio. Their significantly lower repayment rates of ~80-85%, shows their weak mechanism to collect the repayments. It is important to regulate the NBFC-MFIs, big and small, old and new. Unless government steps in to control the operational deficiencies, we could be staring at a massive Corporate Social Conflict: A social issue at hand in direct loggerheads with the commercial interests of the MFIs. With a large microfinance client base and potential credit defaults and competition only intensifying by the day, the target on getting 99%+ repayment, as expected by some private capital investors does put undue pressure on the MFI management. The backlash of indulging in coercive techniques has begun in Andhra Pradesh and is likely to percolate to in Tamilnadu, Karnataka and West Bengal unless some speedy but well-thought out action is taken.