This story originally appeared in the June 2nd, 2011 issue of Beyond Profit.
Late last year, the Indian microfinance industry, which had seemed like an unstoppable juggernaut, came to a grinding halt after the state of Andhra Pradesh passed an ordinance to prevent coercive collective measures. As collections slumped, microfinance companies failed to settle their own borrowings, leading to a lending freeze from commercial banks.
The chain of events has now all but derailed microfinance in the country. After several years of growth, Sanjay Sinha, the Managing Director of Micro-Credit Ratings International Limited (M-CRIL), estimates that the industry has likely shrunk by 30% in the financial year ended March 2011.
In January 2011, the Malegam Committee, charged with investigation into the crisis, released its recommendations, and last month, the Reserve Bank of India (RBI) released its guidelines—largely accepting those of the Malegam Committee but with some ease of operations for MFIs.
And while the fallout will be felt for a long time, there are valuable lessons to be learned from the Indian experience that can inform both the global microfinance and social enterprise sectors.
Law of the Land
According to Sinha, the biggest issue in Indian microfinance has been the reluctance of regulators to take charge
“This has been has been in the mistaken belief that because microfinance did not represent a significant proportion of the financial sector in terms of money, it did not deserve significant attention,” he said.
According to his own calculations, in March 2010, the outstanding portfolio of MFIs constituted less than 1% of the financial sector in India, which the RBI estimates at $270 billion.
“The piece that they missed, of course, is that it’s large numbers of people,” says Sinha. “Just because those people represent the low-income segment of the population doesn’t mean you can ignore them.”
It’s more important to look at the number of people affected rather than just the size of the financial contribution, he adds, pointing to the interesting contrast in China, where Sinha recently spoke about the Indian microfinance crisis. Although there are fewer than 1 million clients compared to an estimated 100 million clients in India, the regulators just released a 50-page document outlining guidelines for microfinance.
“It’s an impressive document in terms of size and weight,” he said. “Perhaps not all of it was necessary, but the point is that the regulator appears to have taken charge right from the start.”
A recent analysis by the Microfinance Information Exchange (MIX) shows that most MFIs were operating within the guidelines for interest rates and margin caps, an issue that critics have used to label the Indian microfinance industry as usurious.
“It’s an interesting commentary on how the policy doesn’t always fit the reality,” Liz Larson, Liz Larson, the Asia and Pacific Regional Manager at MIX, said.
One of the key differences between microfinance in India and other countries where the industry has seen sustained success – such as Bangladesh – is that Indian MFIs are not allowed to take deposits.
“As a result, what we’ve got is MFIs that are highly dependent on a single source of funds—which is commercial borrowings from domestic banks,” Sinha says. “At the first whiff of trouble, [banks] promptly stopped all their lending, [and] even committed contracts have not been honored over the past seven or eight months. The MFIs have nowhere to go, even those who don’t have a single rupee outstanding in Andhra Pradesh are not getting their current contract disbursements.”
Sinha himself asked the RBI recently about allowing MFIs to collect deposits and was told that ghosts of the CRB Caps failure – a pyramid scheme that collapsed in the 1990s – still walk the corridors.
In addition to diversifying where MFIs get their money from, Leo Hornak, who formerly worked in the microfinance industry and now covers the sector as a journalist for the BBC, questions the value of credit only. Hornak – who made it clear that he was giving his personal views on the subject, not those of the BBC – says that while credit can be useful in certain situations, it’s also a double-edged sword.
“Credit can help you start a business, it can help you get through a difficult period, it can help your own liquidity and it can manage economic shocks, but the other thing with credit is that it can actually get you into more trouble,” he says. “One of the things we found in our research is that there are many areas in Andhra Pradesh where people had taken on multiple loans, and they were taking on microfinance loans to pay off other microfinance loans. That was a recurring pattern.”
Thus, credit on its own, he points out, is not necessarily a beneficial tool. An organization that has taken this lesson to heart, Hornak says, is BASIX. After conducting a study that found simple credit wasn’t very beneficial to their clients, the Hyderabad-based institution changed their products to include other services such as training.
In response to the regulatory challenges, BASIX announced last week that they will open their clients to gold and agriculture loans from partner organizations which will allow it to rely less on core lending to sustain the business.
One of the most common attacks on the microfinance industry in India has been that its rapid fast growth led to multiple loans to the same borrowers, questionable collection processes and overall sloppiness. One of the lessons to draw from this is the idea of responsible growth.
A cautionary tale is that of SKS Microfinance, whose initial public offer – the first for an Indian MFI – in July 2010 raised more than $358 million, an event that was hailed as a coming of age of sorts for the microfinance industry. On May 6, the SKS scrip hit the lower circuit when the stock fell almost 20% on news that JP Morgan had cut its target price by almost half.
“We have certainly learned that too much growth might be a bit risky,” says Larson.
Larson doubts that MFIs had a proper picture of how much it really costs – in terms of financial cost and time to properly train staff – to add as many borrowers as quickly as many MFIs did.
Sinha, who believes the central bank should only “regulate what is controllable,” would be in favor of a regulation that limits the number of states an MFI can work in.
“We have seen over the past couple of years how countrywide operations have resulted in management at head offices not being fully aware of what’s happening in their branch offices,” he said.
For example, in March 2010, MFIs were saying they at a portfolio at risk (PAR) of 0.5% when an independent assessment by M-CRIL put the PAR at 5-7%.
Changing the Perception
Hornak, who worked in the industry in India, says that the problem that microfinance has yet to face is a problem of perception.
“The microfinance industry got used to promising much more than it really could deliver,” said Hornak.
In addition, the industry still projects their mission as one of poverty eradication even though it’s really about financial inclusion.
“No one within the industry is talking about ending poverty anymore,” Hornak said. “People are talking about financial inclusion. I have never met anyone in the industry who actually still believes that microfinance is a route to ending poverty.”
Part of the solution, he says, is coming clean.
“If they’d been a bit more on point – ‘We’re not the solution to global poverty. We’re not ending it’ – then they would have been much less vulnerable,” he said. “The world would have been much less surprised to find out that sometimes financial inclusion does go wrong.”
That brings up the issue of financial inclusion—a term that Hornak sees as mostly a buzzword that is “almost as vague as the original purposes.” Sometimes just being financially included isn’t good.
“Social entrepreneurs need to realize that financial inclusion on its own is not necessarily a benefit to the poor,” he said. “The dalit women I met in Andhra Pradesh who were in debt for thousands of US dollars to MFIs were definitely financially included—in fact, they were over included.”
Lack of Reliable Data
In addition to redefining the mission of microfinance, the way the industry measures that intended impact also needs to change. Currently, MFIs measure impact in terms of loans disbursed and portfolio size even though many of them still define their missions as poverty eradication. In other words, outreach is being mistaken for impact.
Hornak says this leads into the greater lesson that the microfinance sector – as well as the social enterprise sector as a whole – needs more reliable research.
“A lot of money was invested in the microfinance sector before really thorough research had gone into its effect on the poor,” he said. “Even though microfinance has been going for over two decades now, it’s actually only in the past two or three years that academically respectable, large-scale studies have been done.”
The issue with studies like the ones Hornak recommends is that they’re expensive and time-consuming, but billions were spent to start the microfinance sector in India.
“It doesn’t compare to that kind of money if that money was misspent or wasted,” he said. “It’s still a drop in the ocean.”
The Road Ahead
While the RBI recommendations about interest rates and margin caps will play a role in the future of the microfinance industry, Hornak thinks those involved are shying away from talking about the larger implications.
“I think what has happened in India is that there’s been a lot of focus on the specifics of the ordinance,” he said. “I think people have used that as a distraction from the wider lessons. To be honest, I think both sides have wanted to talk about those details because they don’t want to talk about the wider lessons for the future.”
But perhaps, just talking about the larger lessons and attempting to learn from past mistakes is the greatest lesson from this crisis.