Taming the 'Wild West' of microfinance

The ruthless practices of commercial microfinance institutions, especially their coercive methods of loan recovery, have driven a significant number of their indebted clients, mainly from the rural areas of India, to suicide. Deploring the failure of the authorities to regulate and supervise these highly leveraged moneylenders, Kavaljit Singh says that it is time for real action.

THE recent suicides by over 60 poor borrowers in the Indian state of Andhra Pradesh have brought the operations of microfinance institutions (MFIs) under public scrutiny. It is well documented by both print and electronic media that these debt-driven suicides were due to coercive methods of loan recovery used by commercial MFIs. The commercial MFIs operate as profit-making non-banking financial corporations (NBFCs) in India. 

The majority of suicides took place in the Warangal district of Andhra Pradesh and as many as 17 borrowers of SKS Microfinance were among those who reportedly committed suicide. For the past few months, SKS Microfinance, the largest commercial MFI in India, has been in the news. In August 2010, it raised nearly $380 million in an initial public offering (IPO) - the first from an Indian MFI. Thanks to the IPO, promoters and private equity investors of SKS Microfinance became instant millionaires while their borrowers remain desperately poor. In October, the sudden sacking of SKS's CEO, Suresh Gurumani, raised concern about the bigger problems at the company.

The ordinance

In response to debt-driven suicides, the Andhra Pradesh government issued an ordinance [Andhra Pradesh Micro Finance Institutions (Regulation of Money Lending) Ordinance, 2010] on 15 October purportedly to rein in the 'Wild West' of microfinance.

The issuance of the ordinance (imposing interim regulations) shocked the commercial microfinance industry because for almost two decades, the Andhra government has been actively engaged in the promotion of both commercial and non-profit MFIs in the state. The ordinance aims to discipline commercial segments of MFIs which were indulging in reckless profiteering in the garb of promoting financial inclusion. It is intended to curb coercive practices of loan recovery besides bringing transparency in interest rates. The ordinance makes it mandatory for MFIs to register with local authorities. However, it does not seek to cap interest rates charged by MFIs. 

Andhra Pradesh has the highest penetration of MFIs in India. The state accounts for nearly 30% of the Rs.300 billion portfolio managed by MFIs in the country. Some of the biggest MFIs such as SKS Microfinance, Basix and Spandana are also based in the state.

Exorbitant interest rates

Contrary to public posturing that MFIs are saviours of the poor and charge reasonable interest rates, several big MFIs in Andhra Pradesh have been charging very high interest rates, closer to the ones charged by traditional moneylenders.

Under the new regulations, several commercial MFIs have disclosed to the authorities that their effective rate of annualised interest goes up to 60.5%. Bhartiya Samruddhi Finance Ltd., an arm of Basix, charges interest rates up to 60.5%. In the case of SKS Microfinance, Trident, Share and other MFIs, the effective maximum interest rates are upward of 30%. This is despite the fact these MFIs borrow money from state-owned and private banks at concessional rates (usually in the range of 11-13%) under priority sector lending and other facilities.

For years, several commercial MFIs have been charging exorbitant interest rates despite achieving economies of scale.However, when the threat of regulation became imminent, SKS and others voluntarily decided to reduce the interest rates by over 600 basis points. This episode revealed the magnitude of profit margins enjoyed by the commercial players.

The rapid growth and emergence of institutional moneylenders

Several leading commercial MFIs have returns on assets (RoA) in the range of 5-8%, far above those of the banking system anywhere in the world. In contrast, the State Bank of India, the country's largest bank, had an RoA of 1.04% in 2008-09 while ICICI Bank had an RoA of 1.13% in 2009-10.

Since 2005, credit growth has been much higher for the MFI industry than for the commercial banking system in India. Although bank loans remain the largest funding source for commercial MFIs, several players have been able to raise funds from other sources including private equity funds, hedge funds and angel investors. Since 2007, private equity funds alone have invested close to Rs.20 billion in MFIs. In 2009, there were 11 private equity deals worth $178 million involving commercial MFIs. Some MFIs have also raised money through non-convertible debentures and securitisation. Of late, commercial MFIs have also emerged as an asset class for institutional investors.

In their quest to grow fast and to serve the insatiable appetite of private equity investors, MFIs pushed inappropriate loans to poor borrowers without looking at their repayment ability. Multiple lending, evergreening of loans and loan recycling (which ultimately increases the debt liability of poor borrowers) became widespread. In some ways, lending practices by such commercial MFIs were akin to subprime lending in the US. As defaults became imminent due to high interest rates, MFIs resorted to strongarm tactics that have led the rural poor to commit suicides.

It is a sad state of affairs that instead of giving strong competition to usurious traditional moneylenders, commercial MFIs have become institutional moneylenders with no public accountability and responsibility. In fact, given the scale of business malpractices and reckless profiteering by greedy promoters of MFIs, they appear no better than traditional moneylenders. Not long ago, some promoters of commercial MFIs were conferred awards including the 'Young Global Leaders' and 'Social Entrepreneur of the Year' by the World Economic Forum and others.

Regulatory issues

Without doubt, the Reserve Bank of India (RBI), the country's central bank, has failed to regulate and supervise the activities of commercial MFIs which operate as NBFCs. The RBI should have conducted on-site inspections of large MFIs to assess their business model and actual practices.

Post-suicides, the RBI has formed a high-level committee to look into the functioning of commercial MFIs. The report of the committee is expected by early 2011. In an era of deregulated interest rates, it is unlikely that the RBI will put a cap on interest rates charged by the MFIs, although Bangladesh, the home of microfinance, decided to cap microfinance interest rates in November 2010.

Alternatively, the RBI should impose a cap (in the range of 6-8%) on the net interest spread on loans provided by MFIs. Also, the Finance Ministry could issue a directive to state-owned banks that they should stop lending to rogue MFIs which follow predatory lending and coercive means of loan recovery. Banks should also develop strict screening and performance criteria to lend money to MFIs. The priority sector lending norms should be tweaked by the RBI to check loopholes which have been successfully exploited by commercial players.

The big MFIs and their lobby groups have challenged the Andhra Pradesh ordinance in the state High Court. Their main argument is that the ordinance would lead to over-regulation and would stifle the microfinance industry. However, the real issue is not over-regulation of MFIs but bringing them under some degree of social control and to ensure that they follow minimum norms and standards like any other commercial entity involved in the moneylending business. The new regulatory measures are supposed to usher in transparency, accountability and stability in the operations of commercial MFIs, which is good for their poor clients. After all, the raison d'etre of MFIs is to serve poor people and broaden their access to financial services. What is needed is a dual approach consisting of a regulatory framework and empowerment of borrowers.

Of late, over 30 MFIs have launched a self-regulatory organisation and a code of conduct to weed out bad practices. This is a positive move towards internal cleanup but the fact remains that a self-regulation code is voluntary and non-binding and therefore cannot stop greedy promoters from reckless profiteering. At best, it can complement (not substitute) the regulatory and supervisory measures.

Rethinking the business model

Unless and until commercial MFIs revisit their pure market-driven business model aimed at generating super-profits for their investors, their operations will remain questionable and unjustifiable in India, where 77% of the population survive on less than Rs.20 per day.

In contrast, there are plenty of self-help groups (SHGs) and microlenders in India which follow a balanced approach between financial sustainability and social objectives. The SHG model serves many more poor households in India than the MFI model. The microfinance interventions by SHGs and similar groups have produced better results than MFIs because of their integrated approach towards building sustainable livelihoods.

As rightly pointed out by former RBI governor Dr YV Reddy, commercial MFIs are leveraged moneylenders and borrow huge amounts of money from banks and other financial institutions for on-lending. Besides, commercial MFIs operate on a mass scale serving millions of customers in the country. Therefore, it is high time the big commercial players realised that the 'Wild West' period of microfinance is over.                   

Kavaljit Singh works with Madhyam, a New Delhi-based policy research institute which addresses finance, trade and development issues. This article first appeared on Madhyam's website (www.madhyam.org.in) on 23 December 2010.

*Third World Resurgence No. 245/246, January/February 2011, pp 12-13