Archive for: microfinance crisis in Andhra Pradesh

Like most microfinance practitioners, particularly in the sub-continent, I have thought a lot about the issue of over-indebtedness in the last few months. It’s not that it was any less of an issue before, but the Andhra Pradesh meltdown really made me question seriously whether we in Bangladesh have also been cavalier to the point of being reckless about the amount of credit we have sold to our clients.

Milford Bateman in an earlier post  in this series seemed to suggest that it was the ‘commercialization’ of microfinance and alleged tendency of senior managers to enrich themselves that are to blame for borrower over-indebtedness. Maybe he is right with regard to some other countries, but this is not the case as far as Bangladesh is concerned. Sure, MFIs in Bangladesh have “commercialized” insofar as they have moved away from donor funded microfinance in the 1990s to a self-sustaining microfinance model in the 2000s. But almost all microfinance players here are non-profits that re-invest surpluses back into their portfolio and there is little or no evidence of abnormally high salaries or private enrichment of senior managers.

Yet, though due to the absence of any credit profile I have no way to know the exact percentage of borrowers who fall in the over-indebted category,  I have a hunch that the percentage is high enough, particularly in certain regions of the country, for us to be concerned about it. While I don’t agree with Mr. Bateman that it is commercialization that is solely to blame, I do agree that almost all the microfinance players bought into the idea propagated by some advocates that microcredit is the silver bullet to eradicate poverty and all that the poor people need is more and more microcredit.

This belief prompted MFIs to seek fantastic growth in the numbers of borrowers and sizes of portfolio over a 15 year period in which they, or we, did not stop to assess whether more and more credit was causing some people to become over-indebted. (I strongly believe though that the vast majority of microfinance borrowers in Bangladesh have economically benefitted from having access to institutional financial services.)

I completely agree with Richard Rosenberg that every credit program will leave some borrowers worse off. This might be because of pure bad luck, as Mr. Rosenberg has demonstrated with a great example in an earlier post. In Bangladesh, many borrowers become unable to repay their loans midway through the loan cycle because a sudden health shock in the family or a natural calamity wipes out their assets and income source.

In these cases as well, one cannot blame the loan officer or the borrower for taking a loan that ultimately made her worse off. What matters in these types of situations is what action the MFIs take once the borrower starts to default, as that can further deepen vulnerability or help build resilience. That, however, is a separate discussion.

But what about those instances where a borrower, at the very outset, takes on more debt than she can possibly repay, or will become economically worse off as a result of paying back? I have heard some microfinance practitioners argue that the MFIs are not to blame for this because they are not forcing anyone to take loans. The problem, they say, is created by the borrowers themselves because they don’t know when to stop. There is of course some truth to this. However, I belong in the camp that thinks that the MFIs here are, at least in part, to blame for borrower over-indebtedness, whatever the extent of it may be.

It is true that often the borrowers take on too much debt, wittingly or unwittingly, and the loan officers lack the capacity, the information, or both, to recognize this and pull back on disbursements. But just as often if not more so, it is the loan officers of MFIs who seduce their clients into taking on too much debt because they are incentivised on hitting sales targets that, at least for some time, were over ambitious. This was made worse by the fact that the microfinance industry, though chasing fantastic growth on one hand, had stopped innovating on the other and was offering much the same product to every type of borrower.

Whether it is the borrowers who took on more debt than they could handle or the MFIs that pushed too much debt on to borrowers or whether both have been complicit in this, I believe that MFIs now have a responsibility to intervene on both the demand and supply sides to counter the problem of over-indebtedness.

On the demand side, the MFIs can work to increase the financial literacy of their clients so that borrowers can take better financial decisions. Providing financial literacy training to millions of borrowers will, of course, drive up costs. But perhaps the time has come for governments and donors to subsidize these kinds of activities of MFIs rather than the loan fund itself. On the supply side, the MFIs can work to ensure that too much credit is not pushed on to borrowers through a number of steps.

First, the MFIs can set more realistic and sensible growth targets that are desegregated over space and time. Second, MFIs can re-train their frontline staff and assess their performance not only in terms of sales targets and portfolio quality but also in terms of other non-financial indicators of borrower wellbeing. Third, MFIs can work towards a greater sharing of information among themselves through the setting up of a microcredit bureau so that decisions are not based on partial information in a country where multiple loans are an endemic feature of microfinance.  And lastly, there is tremendous scope for innovation and product development in the microfinance space.

I do see signs of progress on most of the issues in Bangladesh, particularly on the supply side. The large MFIs seem to be revising down their growth targets, there are ongoing experiments with new products and there is some hope that a microcredit bureau, at least on a limited scale, will see the light of day within a year or so. These are positive signs as far as I am concerned and indicate that MFIs have begun to counter the problem of over-indebtedness before it becomes a major issue in this country.

–Shameran Abed, Programme Head, BRAC Microfinance Programme

This post is the next in the blog series on over-indebtedness. In the coming weeks we’ll be featuring a variety of voices from across the globe on this topic. We welcome your participation in this discussion through comments.

In late summer/autumn of 2010 the perfect storm hit microlending in the Indian state of Andhra Pradesh. In July SKS, the largest and fastest-growing microfinance institution in India with about 6 million clients, issued an IPO. The company valuation reached the top of the offer band price at US$1.5 billion, and five weeks after trading on the Bombay Stock Exchange, the share price rose 42%. In early October Andhra Pradesh’s chief minister passed a punitive ordinance that effectively stopped business for the microfinance institutions in the state. Today microfinance institutions in the state are struggling to survive.

The microcredit crisis in Andhra Pradesh was precipitated by a number of causes. CGAP has written about the context for the crisis and implications for microfinance more broadly here.

Now Vijay Mahajan, oft described in the Indian media as the “high priest of microfinance,” has set off on a spiritual and literal journey across India to explore the reality of what microcredit has done for poor people.

Vijay, who is the current Chair of CGAP’s Executive Committee and Chairman of BASIX, a microfinance and livelihoods business headquartered in Andhra Pradesh, has been on the front lines of the battle in Andhra Pradesh. His journey by foot, public transport, and by car—what he calls a “hybrid yatra” —will take him across five thousand kilometers of his country, walking through the villages and driving across the country to meet and talk to poor borrowers, and get the real, grassroots-level answer to an existential question: has microcredit been good for the poor or bad? Vijay is blogging about his journey here. The yatra, which will take him across 12 states, is ‘an inquiry into the lives and livelihoods of poor people’.

The yatra is a uniquely Indian phenomenon: a journey of self-purification. Vijay began his devotion to rural development in the 1980s, and the 2011 yatra is a chance to reconnect with his roots and to rethink the organization he founded—BASIX. His journey will end with visits across the state of Andhra Pradesh.

The Economic Times quoted Vijay as saying that his “soul searching on the need to reinvent microfinance started after he was elected as the chair of the executive committee (board) of the Global Consultative Group to Assist the Poor.” So we are following the journey closely, and Stephen Rasmussen, CGAP’s regional manager for South Asia, will join Vijay in the final days of his journey. Stay tuned.

–Jeanette Thomas

“Acting responsibly is almost against human nature – we always seem to need external restraints.” At the recent Responsible Finance Forum, Alok Prasad (CEO of MFIN, the association of Indian commercial MFIs) offered a hard-hitting assessment of what went wrong in Andhra Pradesh, focusing on how investors contributed to the situation and what they can do to help avoid other “APs.” The room was full of institutional investors, DFIs, and fund managers, more than 40 of whom had just signed the “Principles for Investors in Inclusive Finance.”

Alok ticked off the ingredients in the “potent cocktail” of the crisis. First, five years of annual growth rates exceeding 70% led to troubling practices, client problems, and market-level distortions. The growth was fed by the second ingredient: money — plenty of money, including debt financing from Indian banks and equity from mostly foreign social and not-so-social investors. Add to that cocktail a political system that is highly sensitive about the poor and tends to be skeptical that private markets will help reduce their poverty. Finally, top it off with incentives for practitioners, politicians, and providers of capital to act in ways not always in the long-term interests of low-income clients.

The result? The aforementioned very fast sports car, hitting the gas and careening around tight curves while endangering passengers, pedestrians and the other cars on the road.

Alok urged investors to do their part now to build a financing “eco-system” that will produce more responsible behavior in India and elsewhere. He advocated investor action on six fronts:

• As foreign investors, you must be “engaged owners, not just sleeping partners.” The industry needs active governance, especially around the decisions that affect client welfare.
• Do your due diligence. You can’t just fly into India on Monday, review the CEO’s projections, meet some senior staff and fly home on Thursday. You need to ask hard questions and counsel the promoters. Seventy percent this year and 150% the next? No sector can sustain or manage this kind of growth.
• Insist on compliance with the industry code of conduct. It’s not enough for the network to say “come on, guys, let’s do the responsible thing.” Bank loan covenants should address this, and other investors have influence too.
• Get regular feedback from the networks. Is your MFI partner a member in good standing of MFIN? Maybe you should urge the networks to do annual certification.
• Really integrate social performance indicators into your investment decision making processes.

Alok closed with an observation that seems relevant far beyond AP: the outcome in the market will hinge on how the clients feel about their providers. There is much to be done by retail providers, to be sure.  But investors all the way up the value chain of microfinance funding also can do a lot to support a safe road to financial inclusion.

–Kate McKee and Alok Prasad

It’s inevitable that a review of the year would highlight the dramatic turn of events in the Indian state of Andhra Pradesh, as well as other fundamental issues about the provision of financial services for the poor that emerged in such stark light in 2010.

Early in the year CGAP released new research that raised concerns about the pace of growth in some markets and the degree to which that could strain MFI systems. By the end of the year, the unfortunate turn of events in South Asia took center stage.

In between, we saw the breathtaking SKS IPO, and much debate about different approaches to delivering services, high interest rates, and the various facets of commercial microfinance.

It wasn’t all controversial or bad news. Financial Access 2010 showed that access to financial services had continued to grow in 2009, despite the financial crisis. The G20 took up the cause of financial inclusion, and in June endorsed “Nine Principles for Innovative Financial Inclusion” at the Toronto Summit. And the Basel Committee–the Vatican of global banking– issued its first guidance on microfinance in August. All signs of progress.

Here is a quick recap from 2010′s most popular and most discussed posts. We hope the CGAP Microfinance Blog provided some context, and perspectives that went beyond what you were hearing in the news. The issues raised last year remain imminent, and the conversation flows into 2011. As new issues emerge, we hope the CGAP Microfinance Blog will continue to offer new ideas, data, and informed opinion, and we hope you’ll offer your views by commenting on the issues at hand.

• The Perils of Uncontrolled Growth by Xavier Reille – “The Morocco microfinance sector wasn’t a casualty of the global financial crisis: this was primarily a crisis of the MFIs themselves.”
• How to Tell Good MFIs from Bad MFIs by Richard Rosenberg – Rich points out how there is no black and white formula to separate the two.
• Perplexed about Over-indebtedness, part 2 by Richard Rosenberg – “What do we mean when we use that term?  This question, like most others about over-indebtedness, gets annoyingly complicated.”
• The Next Decade of Microfinance by Alexia Latortue – “Advancing financial access isn’t just about expanding access from a sheer numbers perspective—though that’s critical—it’s also about the quality of that access.”
• 6 Questions for SKS by Stephen Rasmussen – The post kicked off the blog series on SKS, shortly after the largest MFI in India launched its IPO. Steve asks whether SKS will be passing on the gains from the capital markets to their millions of clients in India.
• Is SKS any Different from Wal-Mart and does it matter if it isn’t? By Malcolm Harper – “Now microfinance is a mainstream business, it’s been “Wal-Martised,” whether we like it or not, Compartamos and now SKS have shown the way, and soon many more will follow. The clock cannot be put back.”
• Who’s the Culprit? Accessing Finance in Andhra Pradesh by Justin Oliver – The Andhra Pradesh crisis has been a critical turning point for microfinance in India and the globe. Justin’s post, which kicked off the series on this topic, was the most read and most discussed post of the year.
• Crisis by Invitation by N.Srinivasan – “More than 15 years of hard work has gone into the (microfinance) sector. For the mindless actions of a few with a profit motive, a large number of customers are set to lose linkages to institutions that had helped them over the years.”
• Andhra Pradesh Crisis or Opportunity by Parmesh Shah – The post argues for creating a pro-poor ecosystem which includes a diverse range of financial products and services that meet needs related to health, food, education, and livelihoods.
• Will the Indian SHG Movement Withstand the Competition offered by MFIs? By CS Reddy – Reddy’s post offers an analysis of why the SHG movement is such a critical way to include the poorest people in India.

Which did you like the best?

–Jeanette Thomas  and Shweta S. Banerjee

SHGs (Self-help groups) need to return to their original fundamentals of being strong grassroots institutions and the market for credit needs to be segmented

The focus of concern in the recent past, and leading up to the Andhra Pradesh microfinance crisis, has been the risk to commercialized microfinance organizations or MFI-NBFCs. Very little has appeared in the media on the risk borne by the clients, until the reported suicides in October brought their risk squarely into the political domain. This post focuses on the risk borne by clients.

First I would like to distinguish between two groups of clients: The first group is the poor who need credit and other opportunities for livelihood activities to survive. The second group is not poor; their livelihood strategy largely includes non-farm activities but they cannot grow to meet their aspirations without access to credit even at market rates.

My position is that the poor need substantial investment, besides credit, for them to move beyond survival and increase their incomes.

This investment includes institutional support- like the self help groups (SHGs) at the base – which provides the poor with the space to set their agenda to support their livelihood strategy. The services required to support livelihood strategies of the poor and to build these participatory institutions like SHGs need subsidy.

In short, this requires a long term perspective.

I do not think the business model of the MFI-NBFCs, which is driven by venture/private capital, quick disbursements, weekly repayments, high profits and remunerations for senior staff, a focus on valuations and IPOs and a quick exit, is appropriate for this group. Short term credit at commercial rates cannot help improve lives of the poor.

In fact, this business model increases the poor’s risk, often beyond a level that they can bear.  The SHG model with links to banks (as it was originally conceived) is the appropriate strategy for this group.

Weekly repayments increase the borrowers risk and vulnerability to local power groups.  Incomes from agriculture are lumpy not weekly; incomes from animal or dairy farming are usually monthly.

In order to repay the MFI loans weekly, clients are forced into activities that can help them earn daily, like wage-labor, or push them into a cycle of multiple borrowing, where they have space to borrow from one and repay to another.

The second group, the non-poor, who cannot get credit from banks because they do not have land records or fixed assets to provide collateral, are better suited to be clients of MFIs.

This group does not have the confidence and skills required to negotiate with banks if they need credit for activities in the non-farm sector and do not have access to working capital from formal financial institutions.

The business model of MFIs can meet the needs of this group provided profit is not maximized to an extent where there is little difference between them and the moneylenders. Good governance of MFIs can play a greater role than regulation; but evidence indicates that good governance is in short supply.

The SHG model is not an effective model for fast disbursement of credit. Therefore, it is not appropriate for this second group which needs credit.

Risk and the official policy promoting inclusion 

Inclusion of the poor (the first group) into the formal financial system of the country involves considerable risks and costs on their part.

The SHG model was an attempt to lower this risk and costs for the poor by providing an intermediary institution which the poor managed. The banks that lent to them were satisfied even though the profits were low because their loans were categorized under “priority sector” lending and repayments far exceeded those from rural development programs in the past.

Between 2003 and 2008 the Reserve Bank of India (RBI) carefully managed India’s integration into the global financial system. Unfortunately the RBI did not take the same careful approach with the MFI-NBFCs in their rapid growth on the grounds that it was urgent to integrate the poor into the international financial sector.

Its focus was pushing the official financial system further into the interior on one hand and, on the other, a “hands off” approach as far as the MFI-NBFCs were concerned, encouraging them at most to self-regulate.

The MFI-NBFCs have not included the marginalized into the country’s financial system but instead included them directly into the international financial system which is not only inappropriate as a first step but raises the level of risk that clients have to bear.

Moreover, the emphasis on credit disbursement to SHGs increased when they were adopted by the Andhra Pradesh Government as part of its official strategy to mitigate poverty. Fortunately, high profits and remunerations were not part of the Government’s strategy.

The SHG Bank Linkage Model had grown till 2000 with adequate investment in building the institutional capacity. When it became part of AP state government policy in 2000, pressure was exerted by dedicated Government officers at the district levels to grow fast and achieve targets.

As a result, the quality of SHGs declined and their earlier emphasis on mobilizing savings, managing repayments and building a supporting environment for a livelihood strategy, considerably weakened.

Instead, SHGs were formed to achieve targets, with the wives of the Panchayat president and secretary dominating proceedings. They borrowed from banks and lent outside the groups at higher rates, at the cost of neglecting their own members.

Official reports focused on disbursements; corrective measures were taken to balance the spread of credit in areas where growth was slow. However, no investment was made to add value or to support increases in productivity and diversification.

Investment in institutions, the very essence of SHGs, was no longer a priority. Instead, the Government was in a hurry to disburse and increase financial inclusion.

Risk and interest rates

MFIs argue that high interest rates are justified because the risk of lending to small borrowers is high, the cost of delivery at the doorstep is high and finally the rates are far less than those of the private moneylenders.

However, high interest rates when offered by MFIs increases risk for the poor.

The State of the Sector report 2010 (N. Srinivasan) indicates that out of 60 MFIs which reported on profitability, six had ROAs over 7%; thirty five had ROAs over 2%.

In contrast the public sector banks in 2009 had average ROAs of 0.6% with the best being 1.6%, while the best private bank had ROAs of 2%. The yield on portfolio confirms this picture; in the case of 23 MFIs it was above 30 %(the highest being 41.29%).

The report also says that economies of scale have not led to lower interest rates or lower yields. This implies that MFIs maximized their profits and competition did not decrease rates as it was expected to.

The largest MFI recorded a 116% jump in net profit at Rupees 81 crores ($18 million) in the second quarter ending September 2010 as against the corresponding period last year.

The level of profit required to meet all costs, cover risks and expand operations is lesser than the level of profit required to meet all these costs and, in addition, attract venture and private capital, and pay salaries higher than the remunerations of the CEOs of the largest private banks.

What should be the interest rate? The figure of 24% is floating around in official circles. The problem is that the effective interest rates of MFIs are far from clear. There appears to be a difference of 5% to 10% between the rates as provided by the MFIs and the rates that emerge from an analysis of the books of clients.

MFIs also argue that the cost of credit from banks is high and that they should be allowed to mobilize public deposits if interest rates are capped. Interviews with clients show clearly that they do not have an idea of what they actually pay over and above the capital.  They are satisfied if credit keeps coming.

In fact interviews with those clients who had succumbed to the temptation of multiple borrowings showed clearly that they wanted to borrow from several MFIs to maintain a cash flow to cope with repayments as well as their expenditure. This increases their risk substantially. In contrast, interest rates of SHGs in Myrada stabilize after two years or so between 12% and 14%, which is about 3% -4% above cost of credit from banks.

Non-profit MFIs who do not pay high salaries but still pay adequately enough to attract experience and capital from banks manage to make a surplus at interest rates between 17% -19%, where the average cost of credit is around 9%-10% and annual growth rates are 40% -50%.

For-profit MFIs should be able to manage their affairs and attract sufficient capital (not venture capital and high valuations) by charging effective rates ranging from 15%-17% above the average cost of credit. This would enable them to charge interest rates in the range of 24% -29% instead of their current rates which are 20%-30% above the average cost of credit.

The poor in SHGs are able to manage interest rates of 12% -14%. They have also managed with interest rates higher than 14% in the initial period of group formation until they have built up their group’s common fund. In my experience, they can cope with interest rates of around 17%. The risk involved is manageable and the cushion provided by the SHG can help them tide over urgent needs.

The non poor in the second group can cope with higher interest rates levied by for profit MFIs but the rates should not exceed 30%.

Competition among MFIs has not reduced rates, neither has self regulation.

Interest rates, commissions, salaries, profits have to be regulated by the board of an MFI.  A decision by the Board to opt for an IPO will force management to focus on quarterly figures because the logic of financial markets dictates that it should.

This will further integrate the marginalized into the free market system increasing the risk of the clients who are particularly vulnerable.

SHG is not a good model for speedy disbursement of credit; but it is a good model for lowering the risks of borrowers as well as lenders. SHGs have savings which they use to cushion irregular cash flows; they are able to adjust to urgent and unexpected situations. Myrada’s analysis of its SHGs shows that their common fund increases year on year.

The SHG model, with lower interest rates and risk, is most appropriate to financially include the poor, while the product offered by for profit MFIs is appropriate for the non-poor who are in need of credit.

–Aloysius P. Fernandez, Chairperson, National Bank of Agriculture and Rural Development (NABARD) Financial Services, India and Founder of Myrada; the views expressed here are personal.

For more information on the history of the SHG movement in India, click here.

A longer version of this post was published by Microfinance Focus on December 13, 2010.

This post is the next in a special blog series on the microfinance crisis in Andhra Pradesh, India. Over the coming weeks we’ll be featuring a variety of voices on the issues raised by this crisis and what it means for the future direction of microfinance. We welcome your participation in this discussion through comments.

This is an opportunity to bring “people practices” at the forefront of the microfinance sector

Three weeks ago, just at the height of the microfinance unrest in India’s Andhra Pradesh state, panelists at the Microfinance India Summit 2010 said that an increased focus on financial literacy, creation of more credit bureaus, and greater pricing and interest rate transparency were all essential to the success of the sector.  Perhaps Jennifer Isern of the International Finance Corporation said it best: the sector “must get back to client-centered, client-focused” microfinance.

The issues that led to the crisis are certainly complex as noted by Beth Rhyne, managing director of  The Center for Financial Inclusion, who wrote an excellent blog calling for policy makers “to think more deeply about the role of MFIs in the financial sector” and to “craft a set of ground rules that promote balanced product offerings, solid institutional development and good governance.”

One area that is often overlooked, however, is the human capital management practices that may also have played a contributing role.

As the Indian microfinance sector responds to the Andhra Pradesh crisis, an opportunity has been created in India, as well as in the global sector, to reevaluate their “people practices” and make them a core part of a system that has provided a safety net for millions.

Based on work Grameen Foundation’s Human Capital Center has done with microfinance institutions (MFIs) around the world, we have found that the following common practices can negatively affect an organization’s financial and social impact:

• A focus on short-term performance targets (often reinforced by incentive plans) that stress portfolio size, quality/repayment rates, and number of clients.  Pick any one of these dimensions and you can see the potential to stray from client-protection principles:

1. Portfolio size – This indicator depends on attracting more clients and/or larger loans, which may encourage relaxed credit underwriting/approval decisions and ultimately increase the potential for client over-indebtedness.
2. Portfolio quality – In an effort to minimize late repayments or defaults, loan officers may resort to collection tactics not approved by the MFI to “encourage” repayment.
3. Number of clients – Similar to portfolio size, this indicator may also encourage relaxed credit underwriting/approval processes.

The organization must be very clear about frontline staff roles and their primary responsibilities.  For example, providing effective financial services and helping to protect client interests are not mutually exclusive objectives, but the organization’s recruitment and selection, learning and development, and rewards practices must all be aligned to help staff meet them.  There must also be quantitative and qualitative performance objectives that clearly define the behaviors expected, such as honesty, respect, transparency, etc.

Now is a good time to rethink the use of incentives altogether.  Some MFIs have either never used incentives or have eliminated them with no negative consequences.  And more and more private sector companies are realizing that employee motivation and commitment depend on many dimensions; money often plays just a small part.

• Organizations with decision-making centered at the top may treat field employees (loan officers, branch managers, etc.) simply as vehicles to deliver profits, with little ability to add value.  People tend to work toward what is expected — whether these expectations are high or low.  In addition, keeping decisions at the top means that they are made far away from the people who have the most current information on clients and local conditions. Providing targeted learning and development opportunities to frontline staff that focus on what is needed to drive both financial and social results will increase capability and ensure that decisions can be made at the levels closest to where the challenges lie.
• Organizational culture that stresses financial over social return. Creating and maintaining a culture that focuses on social as well as financial returns and embraces client protection principles requires intention and appropriate decisions/actions.  Large, rapidly growing organizations may be tempted to cut corners on the selection and orientation and training of new hires, with the result that the organization’s social mission, core values and long-term vision are not effectively communicated to the new hire.  Ensuring the organization’s core values and social mission are understood and embraced by everyone in the organization should be one of the primary roles of the chief executive.  Every internal and external presentation or communication piece is an opportunity to reinforce this message, and all senior staff should be held accountable for modeling these behaviors.  In fact, adherence to these core values should be part of each employee’s individual performance expectations.
• No focus on creating an internal “brand.”  What is the organization’s external brand?  Is this mirrored internally?  Are employees valued and treated as important assets?  Valuing employees in the same way that clients and other stakeholders are valued helps them understand the brand promise and how best to deliver it.  For example, focusing on transparent credit practices should be mirrored by transparent promotion and rewards practices.  And if client education is an important part of service delivery, the organization should make sure that all staff have an equal opportunity to access the learning and development they need.

These practices play a key role in determining the financial and strategic success of an institution.

The private sector has shown time and time again that the organizations that “get” the people side of things are more successful and sustainable than those that don’t.

Reevaluating and revising these practices in the Indian microfinance sector and elsewhere will help support the fundamental social mission of microfinance by focusing front-line employees on client protection, as well as sound credit practices, and by creating and empowering loan officers who are driven by a mission to serve the poor.

–Peg Ross, the director of Grameen Foundation’s Human Capital Center which helps microfinance institutions strengthen their practices and processes for managing staff and align those practices with their overall business strategy.

This post is the next in a special blog series on the microfinance crisis in Andhra Pradesh, India. Over the coming weeks we’ll be featuring a variety of voices on the issues raised by this crisis and what it means for the future direction of microfinance. We welcome your participation in this discussion through comments.

The Andhra Pradesh (AP) government passed an ordinance introducing substantial changes to MFI lending practices in the state. This ordinance aims to “protect the women self help groups” and the interests of the poor by attempting to reduce multiple borrowing, avoiding harsh collection practices, and altering repayment procedures, among other measures.

However, the key questions that remain are: Will clients benefit from this ordinance? And, what do clients like about MFIs and what do they want changed?

In 2009, there were mass defaults in four towns of the neighbouring state of Karnataka when local Muslim organizations banned repayments. In this case as well, there were reports of harsh collection practices and over-lending.

A recent survey of 900 MFI customers, conducted jointly by EDA Rural Systems and CGAP, attempted to study the needs and challenges of customers in the districts of Karnataka where mass defaults had occurred.  This post draws from a forthcoming paper, by Karuna Krishnaswamy and Alejandro Ponce, which analyses the data from that survey.

We analyze the following questions related to the demand side areas that the ordinance has addressed.

1. What do borrowers feel about interest rates?
2. What is their preferred source of lending?
3. Weekly versus monthly repayments, which is better?
4. How much debt can clients carry?
5. Do clients prefer Individual or Joint Liability Loans?
6. What are client perceptions on harsh collection practices by MFIs?

What follows is a quick summary of the answers to these questions.

1. What do borrowers feel about interest rates?

From Table 1 we see that low interest rates are an important lender selection criterion for 21% of the borrowers, while 26% (Table 3) would like to see MFIs reduce their rates even further.

However, 41% of the borrowers are using services provided by MFIs because of lower interest rates. This shows that we should be careful about deriding MFIs on the whole as being usurious and note that they are providing lower cost options for a large number of borrowers.

However, it is important to note that less financially literate customers are less likely to be conscious of interest rate differences and so rates could be a bigger problem than is reported here.

Further, one hopes that the pressure to make a substantial drop in interest rates does not force MFIs to reduce operational expenses such as on loan monitoring. The data shows that customers who have had less monitoring by loan officers and use the loans for non-productive purposes are more likely to face repayment distress, which will make matters worse for the customer and the MFI.

2. What is their preferred source of lending?

We asked, “What is your favourite lending source?” Most of the respondents favoured MFIs, while a few preferred banks, friends and moneylenders. None of them cited the state run SHG as their favoured lending source. Only one respondent said that a private SHG was her preferred lender. We should be cautious about making strong inferences, since only 12 of the respondents were borrowing from the state SHG program and only 10 from private SHGs. In addition, the Karnataka’s SHG program is not as prominent as the one in AP and has different characteristics.

However, it is interesting that customers appear to prefer the MFI model particularly since two of the regions we surveyed (Kolar and Ramanagaram) have seen a lot of problems and bad press about MFIs in the last couple of years.

The tables below show the main reasons why MFIs are the preferred source. The reasons according to clients are, MFIs offer lower interest rates, process the loans quickly and provide services at their door-step.

But MFIs should be aware that treating clients well is important to keep their loyalty and institutions that promote SHGs should note that sometimes clients need quick loans urgently.

Table 1

Table 2

3. Weekly versus monthly repayments, which is better?
It is clear that customers want flexibility of repayment.  Forty percent of the customers said that flexibility (such as repayment everyday or fortnightly or every two months, or paying more during better income months), is the foremost change that they would like to see in MFIs.

Table 3

It may seem obvious to some that monthly repayments are less difficult for customers if they have a good savings product and the discipline to put money away. But it is well known that customers often do not have access to a safe and convenient place to store savings and have many more demands on their money.

Repayment schedules have to be designed with a better understanding of customers’ occupations and varying income and expense streams. In the absence of this, a monthly repayment schedule seems as arbitrary as weekly. In any case, customers should be sent reminders to put away money as and when possible to save up for the monthly instalment.

From the MFI’s perspective, a Field and Pande with IFMR-CMF finds that there is no significant difference between delinquency rates of centers repaying on a weekly schedule compared to centers repaying weekly. It also found that monthly center meetings did not last more than three minutes longer than the weekly ones. This finding implies that MFIs may still have good repayment at low levels of loan sizes while simultaneously reducing their costs through monthly meetings.

4. How much debt can clients carry?
While over-indebtedness is a problem for many customers, it is not clear at what threshold customers feel the burden of repayment and what the remedy is.

When we asked borrowers how much debt they can bear comfortably, answers ranged from Rs. 6,000 ($130) to Rs. 60,000 ($1300). This implies that restricting them to 2 or 3 loans might still not always ensure that the total debt is within their absorption capacity.

Many customers faced repayment problems because of income and expense shocks for which the remedies are flexible repayments, emergency loans or insurance.

The study finds a strong correlation between repayment distress and lower financial literacy especially for lower income customers. It is yet to be seen who is better placed to provide financial education – MFIs or other NGOs.

5. Individual or Joint Liability Loans?
Twenty three percent of the customers wanted no joint liability loans or wanted individual loans or did not want center meetings (Table 3). This means that the majority were comfortable with it. Further, thirty-five percent of the borrowers interviewed said that a group or center member had borrowed from them at least once. Indeed this is what keeps the repayment rates high.

As shown in table 4 below, a substantial number of the customers believe that being part of a group will help them in difficult times.

Table 4

Anecdotal evidence from the field also shows that customers are not comfortable with covering anonymous center colleagues but may be more comfortable covering their group members especially for larger loan sizes.

With regard to repayment rates, a work in progress by Gine, Krishnaswamy and Ponce finds that the higher the number of initial defaulters in a center, the higher the probability that the others will default in a joint liability group model.

6. What are client perceptions of harsh collection practices by MFIs?
We asked customers about the kind of collection practices that MFIs followed and the table below shows their responses.

Table 5

Note: The study team believes that these figures were under-reported by the borrowers.

While noting that there are few cases of harsh collection practices, Table 6 below shows that most customers feel that extended meeting times and making a scene at the member’s house is acceptable, but the latter two practices are unacceptable. Hence, customer protection policies should be designed in collaboration with the borrowers.

Table 6

The key take-away from this analysis is that while the ordinance covers important aspects of customer protection, the specific measures suggested do not appear to be made based on an evidence-based understanding of what customers want and what is most beneficial to them.

Further research and evidence is needed to identify the correct remedies for the problems that customers face. A good start is the formation of a credit bureau which has found wide support. We find that most customers report that their economic lives have improved after taking MFI loans, including those who cited repayment distress. The millions of borrowers (and potential borrowers) in AP and the rest of India would be better served if the ordinance were drafted to assist MFIs in helping their customers.

 –Karuna Krishnaswamy consults with the CGAP Technology Program

This post is the next in a special blog series on the microfinance crisis in Andhra Pradesh, India. Over the coming weeks we’ll be featuring a variety of voices on the issues raised by this crisis and what it means for the future direction of microfinance. We welcome your participation in this discussion through comments.

The Andhra Pradesh MFI Ordinance 2010 has kick-started a much-needed debate on responsible microfinance and what is needed for poverty alleviation in India.

Going back as far as 2003, there have been concerns about certain practices of MFIs in Andhra Pradesh: splitting Self Help Groups (SHGs) to form Joint Liability Groups (JLGs), charging unreasonable interest rates, carrying-out multiple lending and coercive recovery practices. There was no coordination with the State Government and instead an unhealthy competition brewed among NBFC MFIs.

In 2005-06, these practices resulted in the seizure of some of the MFI branches in Krishna district. During that crisis, MFIs evolved a voluntary common code of conduct, promised to reduce interest rates and not engage in multiple lending and coercive collection practices. APMAS played an objective and supportive role to ensure that SHG movement could withstand the competition from the MFIs.

But the NBFC MFIs did not learn their lessons from the 2005-6 crisis and pursued their growth more aggressively as funds became more easily available to them from banks and other financial institutions.

There was no evidence of putting the agreed codes of conduct into practice.  On the contrary, MFIs pursued multiple lending and coercive recovery practices even more vigorously. Profiteering took priority over the mission of “poverty reduction.”

In this post I provide an assessment of India’s SHG movement, which in my view has far greater potential for effective financial inclusion, poverty alleviation, and empowerment of women and other marginalized sections.

Evolution of SHGs
The women’s SHG model is a home grown Indian model.  Based on the principles of self-help, self-management, self-responsibility and self-reliance, the groups were mobilized by promoting institutions (often NGOs).

The self help promoting institutions found that saving and loans could be the binding factor for groups to remain active and pursue their own agenda. In the mid 1980s, there were a few pilot experiments, mostly in Andhra Pradesh and other Southern states. In the early years, it was mostly savings-based groups. Groups circulated their own savings as small loans among their members.

The experiments with infusion of credit began in 1987 when NABARD (National Bank of Agriculture and Rural Development) provided one million rupees as a grant to an NGO called MYRADA to lend to its groups. Similar experiments were initiated by other prominent NGOs like PRADAN, CARE and others with assistance from national and international donors. District Rural Development Agencies (DRDAs) also provided revolving funds to SHGs in different parts of the country. In 1992, the Government of India established the Rastriya Mahila Kosha (RMK), a dedicated organization to lend to SHG through NGOs.

SHG Banking
NABARD launched a pilot to link SHGs to banks in 1992 which provided these institutions with a boost. The Reserve Bank of India (RBI) permitted banks to open saving accounts in the name of informal SHGs and lend to those groups without cash collateral and without asking for the purpose of the loan. Since 1996, SHG banking has been recognized as regular banking activity.  In the process SHGs emerged as mass movement across the country and the largest community based microfinance model in the world.

NABARD’s Microfinance Report 2010 shows that 6.95 million SHGs, with an estimated membership of 97 million poor people, have saving accounts in the banks, with aggregate bank balance of Rs. 62 billion ($1.35 billion). Over 4.85 million SHGs have loan accounts with total loan outstanding of Rs. 280 billion ($6 billion).

APMAS studied SHGs promoted by the NGO MYRADA and found that:

• Members on average have been part of SHGs for about 10 years and each one has been able to create assets worth Rs 150,000 ($3260) and developed diverse livelihoods.
• Women have experienced empowerment within family and society. Members have increased confidence to deal with the outside world especially with banks and officials.
• There was an increase in members’ mobility and their greater involvement in family decisions and access to family income and resources.
• Interest rates in the informal market declined from 60% to 24% and less than 50% of SHG members had loans from informal sources as their credit needs were met by SHGs.
• Money lenders have improved their practices, and they now provide collateral free loans.

Evolution of SHG federations
In the last 10 years SHGs have formed federated institutions at the village and block levels to overcome the inherent limitations of small and informal SHGs, such as limited resource, limited negotiation and bargaining powers, inability to deal with outside world.

By federating, SHGs could reap benefits of economies of scale, inter-group rotation of funds and access bulk loans and grants from external sources. Federations could make the community owned institutions stronger and more sustainable and promote technical expertise amongst members. By July 2010, as per the APMAS assessment, the total number of SHG federations in the country was 163,730.

Many states are now using SHGs to play a key role in various programs like the Public Distribution System, monitoring of works and payments under the Mahatma Gandhi National Rural Employment Guarantee Scheme, distribution of old age and destitute pensions, micro insurance programs, etc. Evidence from different parts of the country suggests that the involvement of SHGs in these schemes has resulted in significant improvement in their targeting and impact.

For example, in Andhra Pradesh about 5.2 million members enrolled in the comprehensive insurance and pension scheme know as YSR Abhay Hastam.

Can SHGs Sustain?
Two decades of the SHG movement has demonstrated positive impact on poverty. The model offers great potential to have millions of member-owned, member-managed and member-used organizations of the poor. However, these institutions face a number of challenges:

Unhealthy competition from NBFC MFIs: It takes 3-5 years to promote a strong and sustainable SHG. However, in their quest for exponential growth the MFIs split well-functioning SHGs to form JLGs. Well trained and active SHG members and federation leaders are lured by MFIs to become their agents. With weekly repayments to MFIs and their strong arm tactics, women find it difficult to repay their loans to SHGs resulting in SHGs defaulting to banks. While the empowering processes of SHG promotion helps them to withstand the pressures from MFIs for sometime, eventually they buckle under persistent pressure of MFIs that offer multiple loans. Lack of regulation & supervision has resulted in MFIs having more than 50% returns on equity and annual growth rates which are over 100%. These institutions are damaging the SHGs, and not helping the poor.

Credit has taken precedence over savings: SHGs are traditionally savings-led organizations. SHG federations registered under appropriate legal forms like Mutually Aided Cooperative Societies (MACS) Act can offer different savings products like voluntary savings, fixed deposits and recurring deposits to the members of SHGs. However, in the last three years or so, there has been undue focus on bank loans. SHGs have become credit management groups that are excessively dependent on banks. They need to return to their roots. SHGs need to improve their bookkeeping systems and conduct regular audits. Governance and management of these institutions and federations needs to improve so that members can have greater trust in their own institutions. Those who promote these SHGs need to have less control and focus on transferring skills to the community.

Banks prioritize MFI lending to SHG lending: Growth rates of Bank loans to MFIs seem to grow at a much faster pace compared to SHG banking. There are wide inter-regional variations. Four southern states got more than three-fourths of the total loan amount administered to SHGs in 2009–10. Banks are reluctant to lend to SHGs composed of scheduled castes and scheduled tribes. In contrast, lending to MFIs is an easier route to fulfill the requirements of priority sector lending. Should bank loans to MFIs be allowed under priority sector lending as MFIs charge very high interest rates.

Sources of SHG promotional funds have dried up: Erstwhile enthusiastic donors, including bi-laterals and multi-laterals have either ceased operations in India or have been attracted by ‘the fortune at the bottom of the pyramid’. Instead it has been up to Governments at Centre and in the States to invest in increasing quality of SHG institutions.  While NABARD remains a major donor to NGOs, SHG institutions have been receiving a fraction of required funds for their development.

Way forward
MFIs have not walked the talk in the last five years, despite plenty of warnings and constant feedback. It is not enough for them to make commitments to responsible codes of conduct in writing. Comprehensive regulation and supervision by a regulatory authority is needed to make them act in a responsible manner.

SHGs are facing the greatest threat from the MFIs today than ever before. In the interest of the poor women who definitely need full range of financial services, including financial literacy, from a variety of sources to overcome poverty, here are some recommendations:

1. Savings must be priority for SHGs and SHG federations. Over a period of time, that will reduce the dependence of the SHGs on the banks and increase their ability to deal effectively with MFIs. SHGs’ self-reliance will enable them to move beyond savings and credit to address issues related to health, education, rights and entitlements. SHG institutions must have self regulatory systems to enhance member-ownership and trust in their institutions, to increase savings.
2. Investments in institutional capacity building and financial literacy are needed.
3. SHGs could have their own apex financial institutions at district or state level that could provide financial services to their members through SHGs.
4. MFIs could transform into full fledged banks and provide full range of micro-financial services. MFIs could lend to SHGs and SHG federations after necessary assessments/ratings. Commodity Cooperatives and Producer Companies owned by SHGs could also be financed by the MFIs based on their business plans.
5. Banks should understand the benefits of SHG banking and invest in the development of SHG institutions and increase their business with SHGs.
6. SHG institutions should be considered a part of social infrastructure much like schools and health centers. Government should invest in the development of these institutions, which could be rally points to mobilize, organize and educate the poor and marginalized sections.

For-profit organizations are more prone to mission drift than not-for-profit or mutual benefit organizations, which may be more suited for poverty lending than for-profits.

The SHG model has tremendous potential to reduce poverty.

MFIs and SHGs should co-operate, not compete, and become partners in the wider mission of poverty eradication.

–C.S. Reddy

C.S. Reddy  is the founding CEO of APMAS, a national level technical support organization for the self help movement in India.

This post is the next in a special blog series on the microfinance crisis in Andhra Pradesh, India. Over the coming weeks we’ll be featuring a variety of voices on the issues raised by this crisis and what it means for the future direction of microfinance. We welcome your participation in this discussion through comments.

Referring to the situation in Andhra Pradesh (AP) as a ‘crisis’ in recent coverage has become commonplace.  Much of the debate and analysis is centered on microcredit. A number of analysts have compared SHGs and MFIs as competitive approaches, offering microfinance services to the poor.  I feel that we are comparing apples to oranges and first need to understand the main characteristics of the self help group (SHG) approach before reaching conclusions.

The SHG approach is not unique to India.  It derives its inspiration from mutualistic approaches which were prevalent in the UK, Europe, and USA in the form of credit unions, building societies, mutual insurance companies, friendly societies, and sickness funds much before the evolution of the formal financial sector as we understand it now.  Mutualistic organizations refer to membership organizations which meet the financial services need of the poor.

Mutualistic approaches in AP
AP is one of the largest examples of the mutualistic approaches in the world.   A total of 10.9 million poor households have been organized into self help groups and their federations through a state supported initiative that has built on the excellent work done by many NGOs and NABARD. This initiative, called Indira Kranthi Patham, is managed by the Society to Eliminate Rural Poverty (SERP), an independent organization housed within the Ministry of Rural Development in AP. The primary aim of this entity is to alleviate poverty and not make profit.

These groups save and meet regularly, do inter-loaning to meet their immediate and consumption needs.  Their cumulative savings amount to more than $1 billion.  They have also developed prudent financial management practices including bookkeeping, appraisal of loan requests, microcredit planning, community auditing, and community based recovery systems.

Significant part of the planning, appraisal, and support services are delivered through federations of self help groups known as Gram Sanghas (village organizations) and Mandal Samakhyas (block level federations).  All these membership organizations are registered under the Mutually Aided Cooperative Societies Act (MACS) and are subject to all the regulations of the cooperative sector in India.  They are functioning as community owned financial institutions.

These investments in creating the community based institutions have been made in AP over the last fifteen years.  Although these institutions have 90% of the rural poor as its members and have achieved quantitative coverage, there is significant scope to improve the quality of these institutions.

Creating a pro-poor ecosystem
Andhra Pradesh has the largest institution platform of the rural poor in the country and has created an ecosystem for social capital based financing and credit.  The most important aspect of this approach is not the volume of the credit mobilized (which cumulatively amounts to over $6.5 billion over the last ten years) but the development of diversified financial products adapted to varied livelihoods and cash flows of the poor households.

These products include food credit line, health risk fund, higher education opportunity fund, cash credit limit for enterprises and nutrition access fund.  The community owned financial institutions have also negotiated elongated repayment periods (18-24 months) and rural cash flow linked repayment installments. A microcredit plan is prepared by each village organization after understanding the livelihood of each household. A commercial bank then funds the plan.

Livelihood services: beyond microcredit
Another aspect which has not been highlighted in the debate so far is the livelihood enhancement and value addition support provided by the community federations to members as producers and participants in the market.  The federations have provided technical assistance to members for dairy, agriculture, food distribution and marketing of various commodities, thus enabling them to earn more from their core livelihoods.  In many cases, income has almost doubled for these households.

Federations have managed milk collection and processing centers, provided quality control and grading of agri-products for both state and private sector as franchisees. Significant investment in human capital has enabled 10,000 rural women to emerge as grass root graders and quality controllers. This has helped link small farmers to value chains and receive better prices for their produce.

Based on this investment in human capital, 300,000 young men and women have also acquired skills and jobs in the modern retail, construction, and service sector.

Investment in SHGs and their federations is a more holistic investment which may start with financial intermediation but over a period of time creates an institutional ecosystem for investment by public and private sector. Eminent thought leader, late Professor C.K Prahalad called this the largest ‘social marketing project for the poor which will democratize commerce’.

AP:  Microfinance crisis
Coming back to the present crisis, this investment in the institutional platform has created a creditworthy client base for both commercial banks and the MFIs in AP.  The commercial bank finance to SHGs over the last decade has exceeded $ 6.5 billion.  The state has a large number of private MFIs which together report a client base of 6.25 million.  I will not get into the number debate as it distracts attention from core issues.  It cannot be denied that Andhra Pradesh has the highest density and intensity of engagement for both commercial banks and MFIs.  The commercial banks are providing credit to both SHGs and MFIs.

My analysis shows that there is an overlap of client base not only among different MFIs but also with the commercial bank lending to SHGs.

The problem is accentuated with concentration of loan portfolios of MFIs in districts like East Godavari, West Godavari, Nalagonda. Warangal, Medak etc. which have ‘near saturation’ penetration under the SHG-Bank linkage model.

Easy availability of credit made poor households borrow indiscriminately from several MFIs and commercial banks.  Multiple loans to same households without proper due diligence and sharing of credit information has ultimately lead to unsustainable debt burden.  The loan tenor and structure of weekly repayments make it difficult to service credit obligations due to irregular cash flows of the poor households.

The altered incentive structure in MFIs due to the pressure to deliver at a very fast growth rate in last two years has lead to customer acquisition in an inorganic way without taking into account the impact on the self help groups.  The rapid growth has also pushed MFIs to move away from the Joint Liability Group approach which is integral to the Grameen model of microfinance.

It is critical to ensure that any financial intermediation in Andhra Pradesh should take into account the unique nature of the mutualistic institutional platform created for the rural poor which delivers a combination of services and products for their members including financial, livelihoods and safety nets.

The members of these institutions are the same poor households that are clients of MFIs.  I think taking adversarial positions is counter-productive for the poor households and others who want to work with them.  It is also important to bring the poor households at the centre of the discussion.

Instead of being obsessed with microcredit, we need to think about livelihoods as a whole. MFIs need to work with this institutional platform which adds significant value to livelihoods of poor households.  This is one of the major causes of strife between the Government of Andhra Pradesh and MFIs.

Ways Forward
It must be recognized that community owned financial institutions and privately owned microfinance institutions have to develop a co-production model where they will work together in AP.

This would mean looking at scale, speed of expansion, business models, sharing of information and investing in an ecosystem which creates win-win situations for both parties.  Some suggestions for moving forward are indicated below:

1. Invest on a large scale in financial literacy and debt counseling services.  This should be undertaken by both SERP and MFIs and draw on databases of MFI and SHG clients.  There is a need to initiate these services immediately for districts where over-indebtedness is the highest. This is similar to approaches being tried in US after the sub-prime crisis.  More credit should be only given after these services are provided.
2. Form client information bureau: Client/Borrower data base is created for both various MFIs and community owned SHGs.  This should help in ensuring that red flags are raised once the household crosses a pre-determined threshold.  Even though efforts are being made in this direction, MFI and SERP staff need to be trained in using this information.
3. Invest in Product development and Research: Commercial banks and large MFIs should work on developing more customized and sophisticated products for rural poor households.  The current weekly repayment model has evolved out of urban settings where cash flows are more predictable.  Similarly pure microfinance service delivery models which focus on adding value on credit should be supplemented by livelihood services to increase rate of return on investment.  The recent product offered in terms of cash credit limit to 100 Mandal Samakhyas in AP ( $ 10 million) is a good example.
4. Engaging SHG Federations as Intermediaries by large MFIs: This will lead to utilization of the existing institutional platform and also build trust between community owned institutions and MFIs.
5. Develop alternate service delivery approaches including branchless banking initiatives that involve SHGs as banking correspondents

I hope this crisis presents an opportunity for Andhra Pradesh to develop a model for sustainable investment in rural areas, building on work done by communities, government, development professionals, MFIs and commercial banks. I hope there can be a constructive dialogue between the Government of Andhra Pradesh, MFIs and commercial banks following which we can arrive at a new equilibrium. One that harnesses the full potential, enterprise and creative energy of poor people.

We owe it to them.

–Parmesh Shah

This post is the next in a special blog series on the microfinance crisis in Andhra Pradesh, India. Over the coming weeks we’ll be featuring a variety of voices on the issues raised by this crisis and what it means for the future direction of microfinance. We welcome your participation in this discussion through comments. Parmesh Shah leads the rural livelihoods portfolio for the South Asia Region at the World Bank, which includes the Andhra Pradesh Rural Poverty Program, also known in India as Indira Kranthi Patham.

The microfinance sector had been given enough warning signals

Governments legislate on conduct of business—from both positive/ enabling and negative/restrictive standpoints. While most regulations on business, commerce and industry are positive, some are highly restrictive on account of the nature of business. For example, manufacturing and using radioactive material or dealing with habit-forming psychotropic substances is restricted on account of the potential harm to society. Now the microfinance business seems to have been equated with, say, trade in habit forming psychotropic drugs.

The law in Andhra Pradesh (AP) is based on the premise that MFI loans are addictive, available freely and can cause damage to the user over the long term. Hence, it seeks to control the availability, delivery process and price of MFI loans. If indeed this premise is correct, the question is does all credit to vulnerable people fall in this same category—or does only MFI credit carry the potential to harm?

But regardless of validity of the law (which has been challenged), did the MFIs do anything to warrant the promulgation of this law? The sector had enough warning signals that the government was hardening (justifiably) its stand.

The earlier Guntur experience in the same state in 2006 apparently had vanished from corporate memory. The Kolar incidents last year brought up the problems of concentration of loan exposures and erosion of lending discipline induced by competition. The reaction of the sector to Kolar was to announce codes of conduct and some arbitrary limits on the number and amount of loans. The more fundamental problems in customer appraisal, pricing, recovery methods, transparency, and customer grievance handling were being taken up for resolution, but too slowly.

The AP government came up with district level task forces earlier this year to enquire complaints against MFIs and very clearly indicated its discomfort. The response from the MFIs was not substantial, either in terms of dialogue with the government, or reforming operations in the field.

The exponential growth and high concentration in AP was not accompanied by the required sensitivity in dealing with vulnerable people. The number of loans of SHG members and MFI customers when put together were more than 10 times the number of poor households in the state.

Any charge of excessive debt is believable, given the large number of loans and the fact that the average MFI loan per household in AP exceeded Rs 65,000 ($1400). While one-third of microfinance loans were given out by MFIs, the remaining two-thirds were given through the SHG linkage program. Which loan was the last straw is not clear.

Justin Oliver in his blog last week referred to the Access to Finance (A2F) survey by IFMR which describes the high propensity to borrow in AP. Of the total microfinance loans of Rs 463 billion ($10 billion) across the country, AP had absorbed almost Rs 170 billion ($3.6 billion). That this level of micro-debt was excessive was not a secret—the government, MFIs, investors, researchers and practically everyone else knew.

Apart from the formal debt for which some numbers are available, there have also been significant levels of informal debt which is estimated at 75% of all debt in the A2F survey. The sentiment was that somehow the high levels of debt will be absorbed without major problems. The State of the Sector Report 2009 (SoS) pointed out the risk of high levels of debt concentration and called for a detailed study before expanding services in the three southern states.

Suicides were linked to microfinance in some of the media. While suicides are extreme decisions, the symptom of excessive burden of debt in some cases is not the real cause. AP has an average of 2000 farmer suicides each year—if 54 suicides as reported in some papers are attributed to MFIs- what are the remaining attributed to?

Do we need laws restricting some other sectors of the economy for the other suicides?

Excessive debt itself reflects that the present levels of income are inadequate. There is a clear role for public policy in creating viable income opportunities for poor people; banks and MFIs at best can finance such opportunities—they neither have the resources nor the competence to promote livelihoods significantly.

An apparently unconnected, but material, development is the successful IPO of SKS, which seemed to have changed the sentiment all around. Such a possibility was highlighted in SoS 2009. The report cautioned “Once an IPO is made and trading on the exchange floor commences, a ‘Compartamos’ like situation might develop. ‘Capitalists making private profits out of poor man’s hard earned money’ would be the subject of media discussions. Political interference capping interest rates and bringing the sector under heavy handed regulation is most likely. This might shut out further private equity flows. Even as investors are willing to offer a good valuation, in the interests of future of the sector and other MFIs that need to grow, the promoters seeking to go public must do so responsibly.”

What is at stake here?

What is at stake is not only Rs 167 billion ($3.8 billion) in microloans in AP, but also the future of microfinance in India. While Rs 52.5 billion ($1.1 billion) is the exposure of MFIs that will be directly affected by restrictions on collections, visits to the borrowers and bundling of weekly installments in to monthly installments, the damage potential is deeper.

The competitive edge of MFIs—frequent contact at the door at a time convenient for customers and maintaining credit discipline through peer pressure—is broken. The meetings with borrowers now depend on the benevolence of panchayat officials. The effect on liquidity of MFIs is devastating because collections are uncertain.

The MFIs’ ability to service their bank loans will be severely impaired (already some MFIs have reportedly defaulted). The asset category—loans to MFIs—would go below investment grade and this would affect loan flows from banks to MFIs across the country and not just AP.

The vitiation of credit discipline would affect loans given by banks to SHGs both under government and non-government programs. The SHG loan portfolio in AP is about Rs 117 billion ($2.5 billion). SHG loans as an asset class will also undergo a re-rating and will likely be downgraded.

On the whole, the problems will not be confined to MFIs, but they will extend to banks. As a result the entire microfinance sector in India will be at risk.

While the law is intended to protect customers, it also opens up rent-seeking opportunities for middle-men. The law requires a voluminous amount of information flow but it is doubtful that the designated registration authorities have the physical or technical capacity to handle that much volume.

Where do we go from here?

More than 15 years of hard work has gone into the sector. For the mindless actions of a few with a profit motive, a large number of customers are set to lose linkages to institutions that had helped them over the years. Here are some things we could do:

Improve communication to customers
MFIs should strengthen their communication with customers. Media campaigns aimed at customers should assure customers that they would get their next cycle loans if they repay in time, subject to legal limits. MFIs should encourage customers to come over to the branches to pay back their loans. In their communication to customers, MFIs should list areas of deficiencies identified in their functioning and how they plan to set them right in future.

Ensure liquidity to MFIs
Banks should ensure that adequate development funding is available to the MFIs to consolidate their operations and move from weekly installments to monthly installments at the customer end. Interim liquidity for the next six-month transition period for MFIs to move from one business model and process to another dictated by law is not only a legitimate requirement but also a dire necessity.

Ensure better and client-focused governance
For the long term, MFIs should have time bound strategies to focus on quality customer appraisals, cash flow based lending, change in lending and recovery processes, transparency in operations and information disclosure. The change in strategies should be communicated publicly to demonstrate that MFIs are willing to learn and adapt to changing requirements and expectations. That will build confidence amongst stakeholders.

Ensure client-focused regulation
For the Reserve Bank of India and the central government, significant legislative effort is required to keep the business of financial institutions away from restrictive money lending laws administered by state governments. While AP might have a large number of SHGs, other states do not have a ready substitute for access to finance if the MFIs close down. Even in Karnataka, the customers of MFIs outnumber members of SHGs. Finding an alternative for about 27 million customers is not easy and in any case beyond any short-term strategy that might be developed. The preferred strategy would be to work with the MFIs and clean up their business.

The microfinance sector does not really require regulation relevant for financial sector. It requires regulation relevant for customer protection. Institutional stability and sustainability issues are best addressed by funding banks and investors in equity. Regulation should just ensure that these institutions, by intent and practice, are providers of responsible finance to vulnerable people.

The 27 million existing and millions more future customers deserve better from MFIs and the government. There is no brand of microfinance that is an unmixed blessing. Hence a battle for supremacy is of little relevance and should not impact lives of vulnerable people adversely.

Even if we cannot work collaboratively, let us resolve not to work at cross-purposes. The customer should be at the core—not only in MFIs and banks, but also in those who seek to regulate.

–N. Srinivasan, the author of Microfinance: State of the Sector Report 2008, 2009 & 2010

This post is the next in a special blog series on the microfinance crisis in Andhra Pradesh, India. Over the coming weeks we’ll be featuring a variety of voices on the issues raised by this crisis and what it means for the future direction of microfinance. We welcome your participation in this discussion through comments.