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A Primer on Microfinance

U. B. Desai
SPANN Lab. Dept. of EE IIT-Bombay www.ee.iitb.ac.in/~ubdesai

Some Basic Question

Why do we need finance?

Why the special need for finance for the underserved communities? Why do poor still go to unorganized financial institutions (money lenders, shaukars, ...)?

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Why is the spread of microfinance so slow?

Why are commercial banks hesitant to enter microfinance?

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Some Basic Question


Why do we need finance?

Why the special need for finance for the underserved communities?

credit is an instrument for investment and growth.

Why do poor still go to unorganized financial institutions (money lenders, shaukars, ...)?

Same as above Shift in Perspective: From poverty alleviation to wealth generation --microfinance will enable wealth generation We will look at this during the talk

Why is the spread of microfinance so slow?

Why are commercial banks hesitant to enter microfinance?

Commercial financial institutions are not ready to enter this arena

We will explore this in the talk

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General Belief

Poor are too difficult to reach. Small loans to poor is not a financially viable proposition Financial institutions will loose money when they give microcredit to the poor Microcredit or microloans will only increase the debt burden for the poor Do you agree? What is your opinion?

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Microfinance (mFI)

A clever scheme for small-savings and smallloan for the underserved community A financial service for the poor A financial approach empowering the poor Microfinance brings in incremental changes

Microfinance may also be considered a tool to give poor people the opportunity to participate fully in economic life Will improve the village economy

It does not bring in dramatic changes like the ones that occur when a company goes in for an IPO

Help generate trade thru micro-enterprises

Facilitate increase in cash flow Bring more villages into the market; monetize more villages

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Microfinance: Interplay Among ..

Institutions:

Access points for the poor to get financial services (e.g. SEWA, Grameen Bank, etc.) These could be bank branches (could be virtual branches), socially oriented financial institutions, or a partnership between the two

Funding Sources: Domestic savings (~70%),

private socially responsible citizens (~30%) Infrastructure: Here ICT can play a major role

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Unorganized mFI Institutions (mFI)


Exorbitant interest rates On the low end 3% per month (36% per annum)

Still the poor approach UmFI --- Why?


can be much more

Often collateral, like cattle, jewelry, etc not returned Often the poor get into a debt cycle for life! UmFI does not give loans for sustainability (for e.g. starting a micro-enterprise!)

Always available (always on!) You get it when you really need it Quick disbursement Negligible transaction time

Poor go for micro-loans just before they really need it

Loans without collateral

Dependence of low-income households on informal sources for loans is nearly 78 per cent.

The poor not only has low income but irregular cycle of payments and withdrawals. The informal financial institutions (money lenders) satisfy this need to the tee
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UmFI: Case of Solapur District


Collateral based lending

Gold is typically the collateral Borrowers: small time office clerks, peons, people who have permanent jobs Collateral amount is 1.5 times the loan value Loans taken for illness, family function, etc. Interest is 3% per month Default rate 80% -- most of the time gold is confiscated About 100 lenders each lending about a Rs.10 lakhs; totaling Rs.10 crs.

Lending without collateral

Interest rates are around 3% per month Repayment is on a daily basis Hawker, vegetable vendors will go for such loans Often, most of the income goes in loan payment About 200 to 300 lenders in this category Each loaning about 5 to 10 lakhs Totaling about 20 crs

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Some Facts

There are an estimated 3,000 microfinance initiatives serving the world's poor

Only 30 microfinance initiatives have grown to serve more than 100,000 poor borrowers.

scarcity of money and participation by commercial financial institutions has limited their expansion. More than 70 percent of them serve fewer than 2,500 borrowers each.

The largest mFI, Grameen Bank in Bangladesh, reaches more than 3 to 4 million borrowers. A total of $4 billion has been disbursed since Grameen started giving loans in 1976 with seed loans starting as small as $35.
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India

Earliest Initiative

Shri Mahila SEWA (Self Employed Womens Association) Sahakari Bank was set up in 1974 Since then, the bank is providing banking services to the poor self-employed women working as hawkers, vendors, domestic servant etc. SEWA bank has 1,75,000 depositors; about 70% from urban area, 30% from rural areas The deposit and loan portfolio stood at Rs 623.9 million ($13.86 million) and Rs133.6 million ($2.97 million) respectively. Though SEWA mFI is making profit, yet the SEWA bank model of mFI has not been replicated elsewhere in the country Very low default rate

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India

Today, there are about 60,000 retail credit outlets of the formal banking sector in the rural areas comprising

While there is no published data on private mFIs operating in India,


On an average, there is at least one retail credit outlet for about 5,000 rural people

12,000 branches of district level cooperative banks over 14,000 branches of the Regional Rural Banks (RRBs) over 30,000 rural and semiurban branches of commercial banks besides almost 90,000 cooperatives credit societies at the village level

the number of mFIs is estimated to be around 800. Not more than 10 mFIs are reported to have an outreach of 100,000 microfinance clients. An overwhelming majority of mFIs are operating on a smaller scale with clients ranging between 500 to 1500 per mFI.

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Target Populace for muF

Rural Poor Women Asset value less than Rs. 20,000/Per capita income is less than Rs. 350/per month Live in poor housing conditions

(from SHARE Microfinance Ltd.)


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Different type of Microfinance Institutions

Institutions that offers financial services to low income people at the prevailing market rates.

Most of these provide microcredit and accept small payments for saving and repayment of loans. They do not take saving from the general public. They take savings from their cliental mainly the low income group.

NGOs which are wholly involved in this or partly. The ones partly involved do several other work that is done by an NGO. Credit Unions Private commercial banks Non-bank financial institutions
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Often one classifies financial institutions like

National Bank for Agriculture and Rural Development (NABARD) Small Industries Development Bank of India (SIDBI) Rashtriya Mahila Kosh (RMK)

as mFIs; But, I feel ,they do not fit the bill, because they do not cater to the kind of income talked about earlier

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Appropriateness of mF

mF works best for those who have identified an opportunity and the credit can be used to exploit this opportunity to develop a sustainable source of income. Microfinance is not appropriate for

Extremely poor, destitutes There has to be some viable way of micro-loan repayment People who are extremely poor may get into debt trap with microfinance Numbers vary, but some feel that one has to have 98% loan repayments rate for an MFI to succeed.
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Some Data on Financial Sector in Rural Areas (2002)


For 630,000 villages we have 32,443 bank branches Of the ~67,000 bank branches in India, ~32,500 or ~48 per cent are in rural India The average population served by a rural bank is approx. 15,000 Overall, 18 per cent of the rural population has bank accounts. The comparative figure in urban India is almost 100 per cent

The per capita deposit in rural areas is Rs 2,000 Dependence of low-income households on informal sources for loans is nearly 78 per cent.

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Share of Different Sectors in GDP (GDP at factor cost, 1993-94 Prices) Rs. In crores

Agri.

Industry

Services

Total

Services%

1970-71

137320

46151

113438

296278

38%

1980-81

159293

70687

171148

401128

43%

1990-91

223114

150383

319374

692871

46%

2000-01

285877

263797

649011

1198685

54%

2001-02

302054

272359

691016

1265429

55%

2002-03

292625

288266

739842

1320733

56%

-- RBI, Handbook of Statistics on the Indian Economy

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Breakup of Indian GDP

GDP for India: $1000 billion

Rural GDP: ~$250 billion (25%)

12th largest in the word Approx. 4000 billion base dpn PPP

Compare this with IT industry, which is ~ $ 20 billion

22%

56%

22%

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Credit to Deposit (CD) Ratio for banks in India

Rural CD ratio needs to brought upto 60% Low CD ~ a lot of cash is idling, or cash collected in rural areas is used to give credit to urbanICT4SED IT 625: areas Oct 2008

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Different Financial Services under Microfinance

Deposit services Credit lines Term loans Money transfers Micro-Crop and life insurance Micro health insurance

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Innovation in Microfinance

Development of finance products for the underserved Management of credit risk (minimization losses in giving credit) Scalability: how to reach a vast, diverse, not easy to reach and geographically scattered populace

Efficient delivery of microcredit

exploit technology
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Gautum Ivatury: Focus Notes, Jan 2006, CGAP (Consultative Group to Assists the Poor) www.cgap.org Oct 2008 IT 625: ICT4SED 23

Microcredit

Delivery of microcredit has to be done more and


more efficiently

Determination of a borrower's willingness and ability to repay a loan is critical if a microlender is to minimize credit risk

Here ICT can play a major role

Willingness to repay a loan are complex and

determined by economic, legal and moral incentives

Ability refers to a borrower having the financial


resources to make a scheduled loan payment.

Legal systems and community pressure (for rural areas) contribute to a borrower's willingness to repay a loan

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Three operational areas on which a microlender should focus to minimize credit risk:
loan design underwriting loan servicing

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Micro-Loan Design

Balance between affordability needs of borrowers and costs to micro-lenders

Revolves on the design of interest rates (must cover operating costs, credit risk and funding costs) mFI interest are not very low at present 15% to 36% per annum (SEWA charges 15% to 18%) Note: RBI interest ceiling is 21%

Interest are very critical to microfinance institution


On the other hand, for rural poor, it has been observed that the amount of monthly payment is much more important than interest

As long as they are comfortable with the scheduled payment amount they do not worry too much about interest rates
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Micro-loan Underwriting

The process of determining a borrower's credit worthiness

ability and willingness to repay a loan

Most important from the microlenders point of view

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Micro-Loan Servicing

Loan servicing is the act of collecting payments and maintaining the balance of a loan

Things are not easy in the world of microfinance.


In commercial banking, loan payments are made by bank draft or by directly debiting payroll or a bank account.

The typical borrower does not have access to a bank account and often does not receive a formal salary. This means that for many customers of microlenders making loan payments can be difficult and put them in the position of making the choice to take time off from work (and possibly get fired) in order to deliver a loan payment or choose not to make a payment. Successful lenders will set up payment kiosks in communities. The kiosks are typically open before the typical work day starts and after it ends. Another effective method, albeit more labor intensive is door-to-door collections.

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Micro-Loan Servicing

Provide positive incentives for payment.


Be proactive in dealing with delinquencies.

Borrowers respond well to positive incentives for good payment history. Microlenders and mortgage lenders have successfully used incentives such as payment rebates, small appliances and food to achieve very high levels of repayment. For example, one Mexican lender offered a free bag of corn meal if a borrower made timely payments for six months. The result was a delinquency rate of less than 1% Rather than wait until a loan goes into default, a microlender should investigate a loan within weeks of it first becoming delinquent. Often, the cause of a delinquency is due to illness or unemployment. If caught early enough a lender can give the borrower assistance as well as workout a equitable repayment plan.
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Challenges

Establishing the idea of access to financial services as human right; just like health care, education etc. are basic rights (Mathew Bishop, Business Editor of The Economist)

Managing credit risks in microlending operations

Convincing, for profit organizations like established banks, non-bank financial institutions, that microfinance is a good business opportunity and they should commit large capital to establish this business.

Developing a market driven interest rate schedule for the poor

Also convincing them that charity (funds donated by established organization) is not a sustainable way for growth

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Challenges

Reaching people in sparsely populated, diverse, not easy to reach, and geographically scattered areas

Most important challenge is to exploit technology to reduce transaction costs so that financial institutions will indeed take up microfinance as one of their major service. Reaching the poorest of the poor the destitute:

Last mile problem of reaching the rural poor.

Make microfinance part of main stream financial market Data Collection need to collect data that can indicate

Many ignore this segment Very difficult for a commercial institution to recover micro-credit given to this segment Here Government will have to step n develop a scheme for micro-grants

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One Approach exploiting ICT

Rural ATM Providing ICT based Rural Banking


Developed by the TeNet group of IIT-Madras To be deployed in village kiosks in collaboration with ICICI bank Low cost rural bank Deposits, withdrawal, and loans Cost of rural ATM: Rs40,000/= Conventional ATM costs: Rs.7,50,000/= Uses extremely low cost finger print authentication system (Rs.50/=) Use of plastic ID cards smart or otherwise not viable in rural areas

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Another Approach exploiting ICT


Growing at a phenomenal pace 300 mil cell phones Cost of deployment in urban areas:

Exploit Cell-phone, Smart-Phone Platform

Landlines Rs.20K per line Cellular --- Rs. 3K to 3.5K per line

Annual business of handset reaching Rs.10,000 crore ($220 mil), comparable to color televisions indicating affordability. 7-9 mil new connections across the country every month Only ~20 mil PCs in India

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Microfinance is a necessary input for rural wealth generation but by no means sufficient

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