Microfinance in India: Searching for New Ground

Attention around the world in recent weeks has been focused on microfinance and its untapped potential in developing countries like India, triggered by the 2006 Nobel Peace Prize that went last month to Muhammad Yunus and Grameen Bank, the microfinance organization he founded in Bangladesh three decades ago. The prize helped reemphasize the appeal of microfinance as not just a viable but also profitable financing vehicle that traditional lenders like banks had previously underestimated. It also promises to reduce resistance from governments and banks that perceive competitive threats from microfinance institutions (MFIs) operating in under-banked areas.

Adding to the appeal are interest rates of 25% to 35% that microfinance lenders are able to charge borrowers; they justify such rates by claiming high costs in the delivery of their loans to largely untested customers. As a result, in India today both international and Indian banks are striking partnerships with MFIs. In addition, some foreign venture funds have also entered the microfinance field, hoping to maximize their returns and also benefit from the relatively low default rate that Yunus perfected for others to emulate.

Geoff Davis, president and CEO of Unitus, a microfinance investment non-profit based in Redmond, Wash., has long been an admirer of Grameen Bank. Unitus was founded after a group of friends from the U.S. met with Yunus in Bangladesh in January 2001. The trip changed their lives. They went on to create the Unitus Acceleration Model through which Unitus partners with high-potential MFIs and helps them reach poor clients across Asia, Latin America and Africa. In India, Unitus works through seven MFIs including Swadhaar in Mumbai and Grameen Koota in Bangalore.

Half-Empty Cup

Yunus himself believes that India’s microfinance cup is half-empty, with more room for demonstrable participation by the public sector and foreign funds. He told India Knowledge@Wharton that state-owned financial institutions such as the National Bank for Agriculture and Rural Development (NABARD) and the Small Industries Development Bank of India (SIDBI) could play a more active role in providing risk capital to new MFIs. “A mental block on their part is encouraging foreign funds to take advantage of the opportunity,” Yunus notes. “India does not need the small change that [foreign] venture funds are bringing in. Changes in regulation are needed to create an environment conducive to tap the huge domestic resources that are available.”

In India, the history of rural finance is typified by the image of a nationalized banking system which has failed to deliver credit and, if it has, not been able to recover it. Microfinance, by contrast, is increasingly being seen as an innovation in lending and the panacea for rural India’s indebtedness to money lenders.

The recent focus on microfinance in India marks a paradigm shift in orientation. The recipients of state-sponsored subsidized loans in the early 1980’s, 75 million poor households today have become the driver of new assets. While no accurate estimate of the size of the Indian microfinance market exists, M-CRIL (Micro-Credit Ratings International), a leading micro credit rating agency based in Gurgaon, puts the estimated demand at Rs. 480 billion ($10.7 billion). That is calculated for 60-70 million households at an average household credit demand of Rs. 8,000 (less than $200).

Indian banks may soon saturate high- and middle-income customers with retail loans and home loans, and are under pressure to move to low-income and even poor households. To do this, they are choosing to partner with MFIs, most of which have current recovery rates of over 96%. Foreign banks with little or no presence outside India’s major metros are also looking to work with MFIs to secure their micro-lending market shares.

Insurance companies too are busy wooing MFIs to link insurance with their loan schemes. In fact, the country’s public sector Life Insurance Corporation (LIC) launched a micro insurance program, where the premium is collected once every week or every two weeks for the assured minimum sum of Rs. 5,000 ($110). “That is sold through NGOs and MFIs,” says Hemant Bhargava, LIC’s chief of micro insurance, as a confidence vote for his new distribution channels.

Among banks, the most aggressive move into microfinance has come from ICICI, India’s largest private sector bank. Of the total estimated Rs. 30 billion ($650 million) that all MFIs have loaned to their small borrowers, about $225 million, or nearly 30%, has come from ICICI alone. At the other end of the spectrum is ABN Amro, a foreign bank with no presence outside large Indian cities. “We have a target of reaching 1 million poor households by 2008,” says Moumita Sen Sarma, ABN Amro’s vice president of microfinance for India. Sen Sarma already has an exposure of $30 million and has reached 250,000 households, or a quarter of her target. This is in contrast to ABN Amro’s experience in Brazil, where despite being one of the mainstream banks and focusing on microfinance over the last five years, the bank has only about 10,000 borrowers. Between the two ends of the spectrum are banks like HDFC and UTI, and now even some public sector banks that have exposure in all the large MFIs.

The MFI Nexus

To further its microfinance reach, ICICI has gone beyond conventional lending to MFIs; it has signed two securitization deals with Share Microfin and Bhartiya Samruddhi Finance. “Raising bank finance has become so much easier today, compared to six years ago when we started,” says Chandra Shekhar Ghosh, executive director of Bandhan, the fastest-growing MFI in eastern India.

Ghosh’s comment underscores the fact that banks aren’t able to find enough MFIs to work with, although about 800 to 1,000 NGOs provide micro-loan services to poor borrowers. But not all NGOs make the grade as full fledged MFIs, and industry watchers say barely 25 of them that qualify are capable of scale.

That gap between what the bankers want and what they get is being plugged. A handful of venture funds exclusively funding microfinance companies (including Bellwether Microfinance Fund in Hyderabad, Avishkar-Goodwell Fund in Mumbai and Lok Capital Fund in New Delhi) have been set up over the past year. Also helping the existing MFIs accelerate their outreach are organizations like Unitus and Accion International, a micro-lending organization based in Boston, Mass. “With one-third of the world’s population living in India, the focus has naturally turned to India,” says Unitus India head Sandeep Farias, who is based in Bangalore.

To be sure, lending to the rural poor is not new in India. Even before microfinance became a global movement with a name — in fact, from the government’s early Five Year Plans (beginning 1951) — the Indian government has emphasized the importance of access to financial markets in reducing poverty. Taking into account the public sector banks, the regional rural banks, cooperative societies and non-bank finance companies, there are a total of 140,000 institutional outlets serving the rural poor, implying one outlet for every 5,600 persons — a pretty good ratio.

In the 1980s and 1990s, this network was used by the government for what is described as the world’s largest microfinance program, the Integrated Rural Development Programme, or IRDP. Loans of less than Rs. 15,000 ($330) were given to the rural poor, resulting in financial assistance of Rs. 250 billion ($5.5 billion) over 20 years to 55 million families. But because the loans were subsidized and the bank managers saw them as political handouts, follow-up on recovery was a casualty. These gave the unsuspecting borrowers a bad name and hampered their ability to access financial services.

The Rise of Self-Help Groups

Parallel to the IRDP, India saw the growth of “self help groups,” much like local savings and loan associations. Such groups keep their reserves at the bank and take bulk loans which are further lent to members at a premium, thereby covering costs and rewarding savers. The self help group (SHG) movement was started in the 1980s by NGOs, but it was only in 1992 that they managed to persuade the government to launch a pilot project promoting 500 SHGs and linking them to bank branches. In 1996, the Reserve Bank of India, India’s central bank, instructed the banks to cover SHG financing as a mainstream activity under banks’ priority sector portfolio (directed credit amounting to 40% of assets). That movement took on huge proportions, and by March 2006, a total of 2.2 million SHGs had been “linked” to banks with an average loan size of Rs. 50,917 ($1,100) per SHG and cumulative bank loans of Rs. 114 billion ($2.5 billion).

Deep Joshi, executive director at Pradan, one of India’s most respected NGOs, offered an explanation for this rapid growth at a recent roundtable discussion on microfinance in New Delhi. “The image of the NGO is led by the exceptional few that are mission-focused and strategic,” he said. “The majority tends to take on current ideas, and funding for current ideas often spawns new NGOs. Microfinance is the current flavor.”

Canvassing by various organizations like NABARD, SIDBI, Rashtriya Mahila Kosh, international funding agencies including the United Nations Development Program and the World Bank, and lately commercial banks have propelled NGOs to promote SHGs in a big way. “Most NGO-led microfinance is with poor women, for whom access to small loans to meet dire emergencies is a valued outcome,” said Joshi. “Thus, quick and high ‘customer satisfaction’ is the USP that has attracted NGOs to this trade,” he concludes.

But the SHG model puts the responsibility of book-keeping and accounts on poor and often illiterate women. In a 2003 paper titled “Mircofinance: Analytical Issues for India,” New York University professor of public policy and economics Jonathan Morduch and Stuart Rutherford, a visiting fellow at the Institute for Public Policy and Management at the University of Manchester in the U.K., point out, “The prospects for the SHG movement are far from clear…. This is because the present system is unsustainable, for lack of clarity about who is to play the key role of maintaining quality, and how the costs of doing so are to be met.”

Morduch and Rutherford felt that if NGOs remain involved as promoters and ‘minders’ of the groups, they will need to be paid to do so. “Yet in the long run, with their social-development perspective, NGOs are not ideal candidates for this role, and nor is it clear who are to be their long term paymasters,” they said in their paper. “But the banks themselves, whose business is financial services, are unlikely to want to do more than ensure that their loans are safe, and will not take on the time consuming task of helping groups manage the book keeping of their internal savings and loan accounts.”

Need for a sustainable model

Microfinance delivery models have made bigger strides in some developing countries that India could take cues from. In Indonesia, the Bank Rakyat Indonesia works closely with the Badan Kredit Desa Network, an MFI. In Bangladesh, MFIs are supervised by an NGO bureau rather than the central bank. India clearly needs to find a structure that can, over the long term, mainstream the movement.

The MFIs in India (who actually take on the task of book keeping themselves) are therefore adopting models that are successful elsewhere in the world and also are innovating as they go long. Many of the MFIs are Grameen Bank replicators, which implies that all borrowers are members of a five-member joint liability group which in turn get together 7-10 groups from the neighborhood to form a center. Others follow variants that are pretty similar, and some lend to SHGs as well.

The recent increase in MFI outreach in India, however, has not pleased everybody. The public sector banks that have nurtured the SHG movement, or government officials who have access to soft loans from international donors, have been critical of the rates being charged by the MFIs, terming them “usurious.” They want MFIs to reduce interest rates that currently range from 25% to 35% (inclusive of loan-linked insurance premiums at times).

The interest-rate justification

The MFIs argue that high administrative costs of door-step credit delivery of unsecured loans and recovery follow-up determine the interest rates. “In our country the government-run postal department charges 5% for domestic remittances,” says Vijay Mahajan, chairman if Basix, an MFI in Hyderabad with a current outstanding of about $25 million. “That is indicative of the cost of door-step delivery,” he says.

The Reserve Bank of India has been silent on the interest rate debate, perhaps because it has deregulated interest rates as part of financial sector reforms. Says Nachiket Mor, executive director at ICICI Bank, “With biometric identification and building of credit histories, interest rates can be structured in favor of good borrowers,” adding that work has started on these fronts.

Despite a few occasional hiccups, new-age microfinance practitioners have been able to create enough of a buzz for the government to consider new microfinance legislation in the coming winter session of Parliament. There are two major expectations from the new legislation. Firstly, greater clarity on regulation. Currently, the microfinance industry comprises five organizational forms — trusts, societies, cooperative societies, not-for-profit companies and non-bank finance companies. What complicates things is they are governed variously by state legislation, central legislation or the central bank, or a combination thereof.

Secondly, the new legislation may address a longstanding demand of the MFIs: to allow them to act as thrift organizations capable of collecting the small savings of only their borrowers. “This does not amount to public deposits, nor will it be able to meet the MFIs’ funding requirements,” says Achala Savyasachi of Sa-Dhan, an association for MFIs. “It is purely in the nature of providing a service to the MFI clients.”

Malcolm Harper, a veteran microfinance practitioner across the globe and a long-time India watcher, sums up the last two decades of microfinance in India in a recent interview with a journal of the Chennai-based Institute for Financial Management and Research: “People used to say — and I also used to say — that Indians should learn from elsewhere. And I am hearing lots of people from elsewhere saying now that they can learn from India, which is great.”

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