Microfinance in India

By: Suruchi Chaudhury, MBA I

Microfinance, Micro credit, Self Help Groups, SHG-Bank Linkage Program, Partnership Model, On Tap Securitization Model, Farmer Service Centers, Social Initiatives Group etc. - these terms have come into sharp focus in the present day India and more so after Dr. Muhammad Yunus won the Nobel this October for his pioneering work in the field of Microfinance which began in 1970’s and the subsequent setting up of the Grameen Bank in 1976 in Bangladesh.

“A lot of directed lending is indeed wasteful and hugely inefficient. But microfinance is a form of directed lending that greatly improves efficiency. This is hard-nosed economics, not the bleeding heart variety.” - Swaminathan S Anklesaria Aiyar, Consulting Editor, Economic Times in 2004

According to Dr. Yunus, “Microfinance leads to poverty reduction through a virtuous cycle comprising: ‘low income, credit, investment, more income, more credit, more investment and thus growing income”. He further adds that the impoverished have skills that are underutilized and that they are creditworthy borrowers and hence their financing needs should be adequately taken care of.

The above mentioned benefits as well as inputs from various research studies show that in many cases microfinance has reduced poverty through increasing income levels. It is also believed to result in improved healthcare and nutrition, child education and women empowerment. And so in the recent past it has become a promising way to use already scarce development oriented funds to achieve the objective of “Poverty Alleviation”.

In the context of this increased activity in the arena, it becomes interesting to know more about the state of Microfinance in India, the industry setup, the challenges and roadblocks ahead and the way to handle them best.

Current Scenario

India has 400 million people spread across more than six million villages who are in need of micro-financing. The organized financial sector caters to the need of only 20 million people. Because of the lack of statistical validity of data sets, there are few reliable indications on the reach and demand of microfinance. The UN, in collaboration with the World Bank and the IMF is working on constructing a headline indicator for access to microfinance. However as per industry experts, the demand for microfinance in India is estimated to be around Rs.300 billion. All this suggests that there is a huge unmet gap between demand and supply. This happened because in the past big commercial banks considered small loans as a statutory obligation rather than a business opportunity. These loans were considered as the ones that were difficult to recover, unprofitable and involving high transaction costs.

Industry Setup

With so many Microfinance Institutions (MFI) around, the Indian Microfinance Industry is no longer “micro” in scale. As the Economy is growing this sector is also becoming more organized in comparison to the scattered system of individual moneylenders and loan sharks in the villages.

A case in point is that of an MFI named Spandana. Today it operates with 2,000 employees and serves 800,000 loan recipients at interest rates of 10 to 15 percent a year.

It lends to small Self Help Groups (SHG’s) of 5 to 10 people rather than to individuals and also insists on regular payments to be made weekly so that the borrowing family manages the debt and financial responsibility properly. When a SHG comes together, they save small sums on a regular basis. This serves to aggregate small funds into a sizeable and more importantly- “serviceable” amount. They also learn to handle resources of a size beyond their individual capacities, and get motivated to save more.

In India, there exists a variety of micro finance organisations in the government as well as in non-government sectors. Leading national financial institutions like SIDBI and NABARD have played a significant role in making micro credit a real movement.

India has also witnessed phenomenal development of SHGs in the past two to three years. These are better known as SHG Bank Linkages, as they are credit-linked to banks. The SHGs have remarkable rates of recovery of 98%-99% showing that their credit rating and ability to absorb credit and repay has increased.


New Entries

In the middle of all this, what is interesting about India is that its biggest commercial lenders such as ICICI, HDFC, SBI, UTI etc. to name a few have diverted their funds and attention to this sector in a big way. MNCs like ABN Amro, Standard Chartered, HSBC and the Citigroup are also moving into this sector.

Clearly what drives these institutions is not social responsibility alone. There is a bigger gain involved. What attracts them is a huge market opportunity here with 30% of India’s 1 Billion+ population still living below the Poverty Line and these banks realize that lending to credit worthy rural borrowers is a lucrative business proposition.

As per Ranjan Ghosh, who heads Financial Institutions for India and South Asia at Standard Chartered Bank, "With fewer defaulters in this sector, clearly the risk return rate is acceptable to the banks. We look at it as an investment."

And may be that is why Nachiket Mor of ICICI spends so much of time in India's economically depressed rural hinterland looking for prospective borrowers.
So all in all it’s a good business for Indian banks, given the diminishing market for lending to companies and consumers in cities.

ICICI Bank is one bank that has developed a very clear strategy to expand the provision of financial products and services to the poor in India as a profitable activity.

ICICI Bank's micro credit initiatives involve provision of basic banking services like savings and withdrawal along with micro-investment products like mutual funds and insurance. This provides poor people with safer avenues for saving with little volatility or risk.

Its structures also include buying the microfinance portfolios of MFIs either on a selective basis or buying the complete loans of a branch or a particular area along with partnership arrangements with MFIs. This helps leveraging the operational strength of NGO/MFI with the financial strength of ICICI Bank. In the world's largest securitization deal, ICICI Bank purchased a portfolio of 42500 loans worth US$ 4.3 million from Share Microfin Limited in 2004.

In the Public Sector SBI is doing a commendable job in this area with its innovative products like Project Uptech, SBI Life ‘Shakti’, Sahayog Niwas, Agri SBU, Contract Farming and Kisan Credit Cards.

As has been mentioned earlier Indian Microfinance Industry is increasingly attracting the global attention. Unitus is a case in point. Started in early 2000 by a group of friends with a common mission of poverty alleviation, it is based in Redmond, Washington, with an office in Bangalore. Unitus works in Latin America and Southern Africa, but with one third of the world's population in India, its focus has naturally turned to India.

The structure that Unitus is using is based on what it calls its "accelerator" model, which basically implies acceleration of outreach. To address gaps, Unitus uses three different capital instruments, namely Grant, Debt and finally Equity. Working typically with MFIs, which are NGOs or have originally been NGOs, Unitus first uses grant funds to build the infrastructure in the MFI.

Unitus Equity Fund, along with SIDBI, Vinod Khosla and other social venture capitalists made a Rs 11 crore (Rs 110 million) investment in SKS Microfinance in India. The money would be used to access commercial debt and scale outreach from SKS's current 200,000 clients to 700,000 clients by 2006-07.

In short what the bigger institutions do is partner with microfinance specialists across India who have knowledge of the local villages and can identify worthy borrowers.

Another very interesting phenomenon that is associated with this industry is the creation of a secondary market over time. Under this the Micro loans would be bundled together into larger Bond issues which will be tradable among the Indian and the Global Investors taking Micro lending to a higher level.
The Challenges

All this sounds like a nice combination of corporate interests, fulfillment of social needs and a panacea for India’s balanced development. But this system is not free of complications and challenges.

There have been allegations time and again that microlenders structure their loans with hidden costs to exploit borrowers. The suicides of about a dozen women caught in this kind of a debt trap in Andhra Pradesh illustrates this point. The Government Inspectors had also pointed out four Organizations namely Spandana, Asmita, Umdama Pottu Pedatha and Share Microfin of charging interest rates as high as 40% to 50 %.

On the one hand, the industry is trying to grapple with problems of sudden growth, while, on the other, global social venture funds think that impact needs to be maximized and that institutions with the right professional leadership, governance, and systems need to be supported.

The biggest challenge is to develop a systematic growth mode which can cater to the accelerating demand. In this scenario the two main hindrances to the growth of MFIs are ‘lack of capital’ and ‘lack of capacity’.

Most MFIs are unregulated non-profit organisations, which prevents them from building an equity base. Through a combination of grants, equity and debt, it is possible to transform them into regulated financial institutions with an equity base that then allows MFIs to bolster their balance sheet and access local capital markets. Lack of capacity can be attributed to a variety of factors such as weak corporate governance, lack of management depth, absence of management and strategic planning systems and insufficient business infrastructure.

Another very inherent issue is that the focus of bigger funding organizations is always on mature MFIs, forcing young and mid-tier MFIs to look for capital from local sources, primarily grants. This focus on mature MFIs may be stalling industry growth as only a small percentage (1-2%) of MFIs is sustainable. So provisions have to be made to absorb some initial risk while the MFI develops a track record, relationships and credibility. Along with this what is required is upfront, longer-term involvement. And finally, there is a need for MFIs to work with policymakers on current regulations that limit options for MFIs and investors. Like in India, most MFIs are still NGOs and so they can accept local debt but not equity, and at the same time foreign investors have limited opportunities for investment in the sector.


The Path Ahead

Successful microfinance can be defined by three main characteristics: sustainability, outreach, and impact. Sustainability refers to the ability of a program to continue over time, preferably without ongoing subsidies. Outreach refers to the number of clients reached and targeting of the poor. Impact refers to the ability of a program to assist poor households and individuals to move out and remain out of poverty, and that is the ultimate objective of microfinance provision.

Enterprise growth is much more than just providing credit, it is also about financing a viable business idea. The importance of partnerships between the public and the private sector, as well as between social entrepreneurship groups and microfinance institutions thus becomes critical.

Care has to be taken that borrowed funds feed into a new business. No matter how the loan is described on paper, many families use the money to finance the purchase of a new motorbike or to pay the family doctor.

At the same time MFIs can help to facilitate capacity building consultancy projects to improve MIS/Accounting, technology and human resources. This emphasis on Management Information Systems (MIS) as well as the innovative use of technology (virtual branches, ATMs, credit and debit cards) is extremely crucial.

All this will lead to reduction in costs to clients and the institutions, building new distribution channels, helping clients build assets (not just debt), as well asmobilizing banks and capital markets for microfinance.