With an ordinance issued by the government of the state of Andhra Pradesh being replaced by legislation, the era of regulation of microfinance institutions (MFIs) has arrived. The law among other things seeks to cap interest rates and regulate the functioning of the MFIs because of evidence that the credit provision strategies, the interest rates and the collection practices of these institutions trap the poor into debt and makes it so difficult for some to escape that they even resort to suicide.
Thus the new law marks a transition away from the view that microfinance is a benign and progressive instrument for development with equity. That perception constituted an important cornerstone of the institutional redesign adopted as part of financial sector liberalization and “reform”. Implicit in that view was the position that MFIs were better means for delivery of credit to small borrowers engaged in agriculture and petty or small scale production. Thus, a group of academics (of Indian and foreign origin) resident in the US, which includes many who have advocated microfinance as an important developmental instrument and (implicitly) as an option to formal lending, have come out against the effort to regulate the MFIs and limit their reach.
It is to be expected that lending to a large number of remotely located borrowers, each of whom borrows a small sum of money increases transaction costs substantially. In addition, the precarious economic conditions of at least some of these borrowers increases the probability of default, requiring a significant risk premium, besides expenses on more stringent monitoring and well organized collection systems. In the event, even if intermediation costs are kept under control, the interest rate on debt of this kind is bound to be high. To ensure that costs are covered and interest rates are not too high for productive purposes, a special kind of “relationship” banking is called for.
In the past, nationalized banks were pressured by policy into providing such services. This led to an expansion of the branch network, including in backward rural areas, and some degree of cross-subsidization in which low (or even negative) returns resulting from higher costs and reasonable lending rates on small borrower lending, were covered with margins earned from lending to bigger borrowers and more lucrative markets. But cross-subsidization implies that the average return earned by the institution concerned was lower than it would have been had small borrowers been excluded from the lending net.
Not surprisingly, private banks, whose role has been increasing since liberalization, have not been keen on directly involving themselves in such lending. The government has accommodated their interests by insisting less on the realization of priority targets and, more importantly, by permitting a wide range of substitutes for priority sector credit, varying from rural infrastructure bonds to lending to input providing agencies and firms. Since liberalization results in the comparison of the profits and performance of the public sector banks with that of private banks, the nationalized banking system too has been seeking to exit from such lending. The consequence has been withdrawal from branching in rural and remote areas, a reduction in the number small borrower accounts and diversion of credit to priority sector “substitutes”.
This has provided the space for the hitherto unregulated MFI sector. Able to adopt flexible recruitment practices, relying on group lending that permits peer-monitoring and peer-pressure to meet repayment commitments and under no pressure to abjure interest rates that are excessively high, these institutions are not only occupying the space vacated by the formal banking system but have been able to cover costs and earn reasonable returns. However, the interest rates they are charging are known to be in the 35 to 50 per cent range and even higher and often opaque being folded into the equated installments in which loan commitments are met by the borrowers concerned.
In the initial spurt of MFI lending they were presented as a better means of credit delivery to small borrowers and a better way of reducing dependence on usurious money lenders than the formal banking system. The real success of the MFIs, it now transpires, was their ability to ensure high recovery rates, through a combination of local peer pressure and unsavoury collection practices. The net result was that what started as a social movement spearheaded by Non-Governmental Organisations soon appeared to be a lucrative commercial activity. This ability to earn profits while keeping default rates low made the MFIs an obvious intermediary for banks and other financial institutions which saw an opportunity in the large market for credit to small-scale clients and wanted to share in the profit that could be earned in that market. Not surprisingly, MFIs were soon able to obtain funds from banks and other financial institutions to on lend to their small-borrower clientele. In fact, as the NABARD Chief General Manager in Karnataka has pointed out, banks now favour lending to MFIs rather than directly to self-help groups (SHGs) and individuals. Thus, banks in Karnataka have reportedly lent Rs. 2600 crore to MFIs in 2009-10 as compared with Rs. 1,000 crore to the SHGs. Though this difference has not been replicated across India the numbers are still indicative of the emerging trend. At the all-India level, while bank lending to SHGs stood at Rs. 14,450 crore, that to MFIs was a substantial Rs. 10,700 crore. Microfinance has been turned into a form of agency banking. With access to such resources, the scale of microfinance lending had to increase hugely, through an expansion in the universe of clients serviced. MFIs have therefore been canvassing and attracting borrowers who are bound to find it difficult to repay. That led to even harsher collection and recovery practices.
This attracted into the microfinance sector for-profit institutions that operated on purely commercial terms and sometimes adopted rapacious practices. But since these activities were undertaken behind claims of being socially committed development institutions, these for-profit players were presented as examples of institutions that combined economic sustainability with the pursuit of social objectives.
It was from here a short step for successful MFIs promoted by private interests to approach the market for direct finance by resorting to equity issues, often at inflated valuations. This had two consequences. It delivered even more funds to the MFIs which were offering themselves as agents for other profit-seeking financial interests. It, therefore, led to a further extension of the reach of the MFIs. It also made the promoters of these institutions wealthy because the rush for MFI equity resulted in speculative increases in their valuations. Needless to say, if such valuations had to be sustained, profits and interest rates had to be raised further. So we witnessed the further expansion of the universe of small borrowers at extremely high interest rates. Since these rates were too high to be covered by margins that could be earned in most productive activities and livelihood options the loans went in substantial measure to finance consumption and other non-productive expenditures.
Not surprisingly, it became near impossible for many MFI clients to meet their interest and repayment commitments. Under pressure, however, to repay, they resorted to further borrowing to meet those commitments. Very often this made them indebted to multiple sources, including in the final analysis to the moneylenders the MFIs were supposed to replace. And in innumerable cases it led to a sale of assets including land, and in some cases even to suicide.
The implications of all this are many. To start with MFI lending cannot support productive activity to any significant extent. Second, MFIs are not really a better option even relative to moneylenders either in terms of interest rates charged or in terms of their operations. And finally MFIs just cannot undertake the development banking role that public formal banks can, and therefore, it is the latter that need to be encouraged rather than substituted. In sum, to the extent that MFIs continue to play a role, they must be regulated. The Andhra Pradesh regulation is welcome. But we, perhaps, need to go even further.