India’s Microfinance Industry: An Anatomy of Risk for April 2012

With around 20 million borrower accounts estimated for March 2012, India still has one of the largest microfinance industries in the world – even though the number is much lower than 32 million in October 2010 when the microfinance crisis began.  However, in March 2012 it also had the dubious distinction of having perhaps the worst portfolio quality in the world (at the national level).  Since October 2010 commercial bank lending to MFIs, which made up over 70% of their funding, has been consistently drying up mainly because of perceived political risk.  

Over the past 18 months since the crisis began, stakeholders in the microfinance industry – policymakers, commercial banks, academic institutions, investors and MFIs – have debated and introspected, conducted studies, assessments and yatras, reaching out to clients and analyzing the issues and problems of the industry.  

In December 2011, M-CRIL released a report on the industry, the findings of which were amongst the topics discussed on 4 April 2012 at a Seminar on Risk in Indian Microfinance at the College of Agricultural Banking, in Pune, India.   The college is a training and research unit of the Reserve Bank of India (RBI), the country’s central bank.  The seminar took stock of the condition of MFIs in India since the AP intervention and the actual and potential future impact on the industry of the regulatory measures announced by the RBI over the past few months.  A number of issues emerged.  

In March 2010, banks provided 71.3% of the average Indian MFI’s funds and this is estimated to have risen to over 75% by October of that year.  While over 75% of MFI funds were invested in portfolio when the crisis broke in October, the decline in bank funding since then has meant that MFIs have had to shift their fund use increasingly into portfolio resulting in the deployment of 88% of funds in portfolio as early as March 2011.  In spite of this shift, overall portfolios have been declining and, by March 2012 were down to half the October 2010 level as shown by M-CRIL’s index (see graph 1).

With banks now lending to MFIs at much higher interest rates than before (14-16% instead of 10-12%), and the limitation of the MFI onlending rate at 26% by the RBI,  MFIs now have much smaller margins to cover their operating costs and provisioning expenses. In this context, the M-CRIL Review shows that organizations with lower staff turnovers, implying better staff pay and working conditions have lower average operating costs. Also those with a higher proportion of women loan officers have lower operating costs. M-CRIL is planning some qualitative case studies to explore this aspect further.

At the risk seminar earlier this month, the main message was that MFIs are an integral part of the financial inclusion architecture and have a role to play in providing financial services to low income families.  Yet, due to the high growth of 2008-10 and the events surrounding the SKS IPO and the subsequent action of the AP government,  MFIs are perceived as being risky propositions for banks and investors.  Amongst the risks discussed were:

Leadership risk: One major perception of participants was that the problems of the industry stem largely from a failure of leadership with the wide range of financial sector risks having become subservient to individual egos and the pursuit of short term monetary gain.  There was concern that the lessons of the crisis have not been adequately learned and that some of the leading MFIs had not yet done enough to strengthen internal controls and inculcate a commitment to client protection in all aspects of their operations.

Reputational risk: The public perception that MFIs have experienced mission drift and do not have adequate social motivation has affected commercial bank lending to them.  All MFIs are painted with a single brush without consideration of the diverse performance and motivations of organizations in the industry.

Regulatory risk: The regulatory framework announced by the RBI so far has significant costs of compliance.  This includes the cost of (i) assessing borrower incomes to ensure that clients fall within the limits set by the RBI, (ii) verifying indebtedness levels through credit bureau checks, (iii) checking loan use to ensure that the money is actually invested in productive assets, and (iv) verifying compliance with codes of conduct through independent assessments.  

How does the MFI bear such costs with shrinking margins, and what are the features of compliance that are working and those which are impractical? For example, the regulation says that no family that has an outstanding loan of Rs 50,000 (US$1,000) should be provided with additional loans. How does the MFI monitor and capture this information when many loans are through informal sources including borrowings from friends and relatives of which there is no record?  The point was made that this regulatory approach entailed such a degree of micro-management that it could lead to the exclusion of measures such as varying prudential capital requirements based on degrees of geographical saturation in relation to levels of financial inclusion.

An inverse relationship can be established between levels of inclusion in a region and the amount of capital required to under-pin lending in that region.  A more nuanced approach to various aspects of regulation would result in a more practical application of client protection than is possible at present.

Risk of developing a “herd mentality” or monoculture: The MFI industry has suffered from a culture that promoted the development of a single “plain vanilla” product and working in what became key hotspots leading to saturation of outreach and excessive lending to individual families. There is a need to develop a wider (if still limited) range of credit products along with the measures to introduce greater transparency, indicated above.

At the end of March 2011, the number of MFI borrower accounts was 20% higher than the previous year. This was considerably lower than the growth of 43% in 2009-10 but indicates the continuing demand for door-to door financial services amongst the poor. This graph shows that out of the total number of micro-credit accounts in India, MFIs have the second largest number, and three times more than those of the rural banks.  Only self help groups have facilitated more loans than MFIs. Thus MFI outreach is high and could play an important role in financial inclusion. At the seminar, where leading commercial banks, regulators and MFIs were present, another message was clear: the microfinance industry in India has learned many lessons from the past. To enhance its contribution to financial inclusion, restrictive regulation that limits its freedom to innovate needs to be modified to establish a broader framework that encourages MFIs to experiment and provide a wider range of services to low income clients in a reliable, responsible, and sustainable manner.