Indian microfinance industry

Over the last few months there has been a strong movement, especially in the state of Andhra Pradesh, against the microfinance industry; more so fuelled by the political interests backed by petty money lenders who again come in with strong political connections and support. With the drop in collections, the viability of the ‘microfinance’ model is now being questioned, and commercial banks have now stopped giving loans to microfinance companies. So now, the question is who is authorised to regulate microfinance industry? Read on…

Dr Suresh Srinivasan

Several years ago, one evening, when I was on an official visit to the interiors of Andhra Pradesh, appraising a commercial bank, I overheard an elderly woman at the market place. She was thanking a gentleman, virtually falling in his feet, and returning a hundred rupee note. I tried to understand their conversation and figured out that the gentleman is part of a Non Government Organization (NGO) and provides, on a daily basis, loans to people in the village. In this specific case, he gives the elderly women Rs 96 in the morning with which she buys vegetables in the ‘whole sale’ market, and sells the same during the day in the ‘retail market’ earning around Rs 115. Out of her sale proceeds, she repays back the Rs 96 she had borrowed from the gentleman, and in addition she also pays Rs 4 as interest on the Rs 96 she has borrowed without any security, leaving her with Rs 15 as her profit for the day. The NGO has virtually breathed life by providing a livelihood for the elderly women; well, this typically seems to be ‘financial inclusion’ we are all talking about; this seems to be noblest of the gestures that will go to elevate poverty and empower the poor, in our country!

Cynics could however have completely different perspective on this issue. One can argue that, the elderly women is being exploited; she pays Rs 4 as interest for every Rs 96 borrowed; ie, 4.17 percent (4 divided by 96) interest, on a daily basis, which translates into 1,521 percent (4.17 percent multiplied by 365 days) on an annual basis, and thereby allege that the gentlemen from the NGO is charging exorbitant rates of interest and taking advantage of the vulnerable position of the elderly women! This situation typically summarises the recent crisis that has hit the microfinance industry.

What is microfinance?
Microfinance can be loosely defined as the process of extending loans to low income households. Unlike borrowers with financial capability, the low income households would not be able to provide any security or collaterals to the lenders. Banks and financial institutions, generally take collateral security like hypothecation of property or personal guarantees from financially established individuals, before extending loans. But low income households, which form the majority in our country, do not have any collaterals or assets to offer as security and hence they do not fall under the purview of the Indian banking system. Microfinance institutions specialise in having created a model to address this issue. They create ‘one on one’ contact with the borrowers and a systematic follow up through an extensive network of ‘front line’ staff that is in regular contact with the borrowing community and its society. Although the interest rate seems high, it is justified to cover the above costs that are required to reach the ‘bottom of the pyramid’. This is achieved through loans being provided in small denominations without physical security, though an emotional commitment is secured. Repayment happens with the lender collecting the dues at the door-steps of the borrower on a weekly basis. Since no security or collaterals are available, repayment is ensured through a process of ‘social commitment’, the borrowers and their community commit to repay the loans together with other borrowers in their neighborhood. Such social commitment that has been embedded into this model ensures that the repayment rate in the microfinance industry is more or less close to 100 percent. However, critics argue that such social commitments exert undue pressure on the borrowers.

All said, microfinance has already grown to be a significantly large industry, in our country; it is a Rs 30,000 crore industry. Andhra Pradesh accounts for around 30 percent of the country’s total microfinance exposure. Around 80 percent of the total exposure of the microfinance institutions are funded by the commercial banks through loans to microfinance institutions.

Off late there has been a public hue and cry that microfinance institutions are charging exorbitant interest rates and exploiting the poor. It is also being widely reported that the lenders are employing coercive recovery mechanisms to recover dues. Recovery at door-steps of the borrower also exerts enormous pressure, that when done on a weekly basis, which is the current practice in the industry.

But, definitely, the question is if there weren’t any microfinance, how would the rural poor emerge out of their poverty? At least microfinance seems to provide a hope!

Initial signs of trouble with the microfinance industry: The Andhra Pradesh ordinance
Over the last few months there has been a strong movement, especially in the state of Andhra Pradesh, against the microfinance industry; more so fuelled by the political interests backed by petty money lenders who again come in with strong political connections and support. It has also been widely reported that local politicians and the district authorities are openly asking borrowers not to repay the monies borrowed from microfinance companies; as a result, collections have dropped from the prevailing 99 percent to less than 50 percent in the state of Andhra Pradesh. With the drop in collections, the viability of the ‘microfinance’ model is now being questioned; the commercial banks have now stopped giving loans to microfinance companies.

During Mid October 2010, the government of Andhra Pradesh has passed an ordinance against the microfinance institutions operating within the state of Andhra Pradesh; reacting to which, SKS microfinance limited, the only Indian microfinance company to be publically listed in stock exchanges, saw its share price dwindling by more than 25 percent. Credit rating agencies like CRISIL have also immediately downgraded all the key companies in the microfinance industry.

The following are the key contents of the ordinance, which have impacted the microfinance industry:

Microfinance companies are prohibited from recovering interest that exceeds the principal amount, thereby curbing the rate of interest charged to microfinance borrowers. This is a serious blow to the viability of the industry. Microfinance companies have started to cut their lending rates to 24 percent in Andhra Pradesh.
Collections will have to be on a monthly basis and not on a weekly basis, as per the current practices. Collections should no more take place in ‘door steps’ of the borrowers, but all recoveries should take place at the government premises.
Lending limit of Rs 50,000 per borrower has been stipulated. Further, individual borrowers should not borrow from more than three microfinance companies. Registration of microfinance companies with district level registering authority is mandatory.

The way forward
The damage has already been done to the industry by the AP ordinance; the question is whether the state government is correct in passing this ordinance or should it have come from the RBI? Who is authorised to regulate microfinance industry? All banking and non banking financial institutions (NBFCs) come under the purview of the Reserve Bank of India (RBI) and as per protocol it is the RBI that needs to take what ever steps, if there is a case. On these lines, a panel constituted by RBI under the leadership of Y H Malegam, the seasoned banker, is already preparing a report and will soon come up with a recommendation. The Finance Minister has confirmed that the government will finalise a regulatory architecture for the microfinance institutions once RBI submits its report; he however confirms that it should not curb interest rates which should be freely agreed between the borrower and the lender, based on the lenders risk perception. This will decide the fate of the future outlook of the microfinance industry!