There are critical lessons from the crises we have suffered over the past two decades, that the authorities will do well to learn from, as they plan the course ahead for the microfinance sector

The Union Ministry of Finance is in the process of formulating a bill to regulate micro-finance, which is why it is crucial to learn from past crises. While there have been several crises points in India with regard to corporate India, two crisis situations (the NBFC scam of the 1990s and the Satyam saga of 2009) are somewhat relevant to the micro-finance crisis of 2010 in Andhra Pradesh, at least from the manner in which they unfolded.

A comparative analysisⁱ of these three situations is attempted here, which reveals that we in India, have learnt very little over the years from past crisis situations. I am sure that you would find this comparative analysis interesting and it should also provide valuable insights to regulators/supervisors dealing with such crises in the future. Most importantly, I believe that the lessons from these three crisis situations should be of immense value to the stakeholders involved in drafting the proposed micro-finance bill, as the essence of regulation is to prevent market/institutional failures.

So, let us look at the three crisis points on various parameters:

Crisis situation # 1: NBFC scam of the 1990s  

Legal form and regulation/supervision: The legal entities were different kinds of (for profit) non-bank finance companies (NBFCs) who promised the world to their depositors in terms of returns. Regulation and supervision, although mainly under the ambit of the Reserve Bank of India (RBI), was passive by most standards, as the NBFCs pretty much had a free run in terms of offering abnormal returns for depositors–precisely because they knew upfront that they were not going to refund the deposits to the people concerned.

Growth and competition: The growth was indeed explosive as more and more gullible people deposited money, lured by higher than normal returns. Competition made things worse, as the fight for market share to loot innocent people off their savings led to these NBFCs (especially, plantation companies) announcing outrageous schemes, offering whimsical returns to woo customers–some advertisements (example, like Anubhav Platations and some others) carried the caption, “Can you spot Rs36 lakhs in this advertisement?” . Without question, growth and competition brought their own problems and in many local settings, ‘crisis flash points’ were evident, not to the regulator, who was far away (both physically as well as operationally).

Group entities and non-transparent transactions: Interestingly, this was among the first instances where group companies with complex institutional arrangements could be seen. Transfer of funds through non-transparent transactions was also evident. And much of this was controlled by the promoter and his/her confidantes, with significant support from the auditors.

Financing, governance, systems and operations: ‘Cheapⁱⁱ and unlimited public deposits and other forms of capital were the primary source of funds for these NBFCs, which had weak governance, poor MIS and very little internal controls. Risk management did not appear to be a part of their institutional systems. Ghost plantations and fraudulent transactions were the major phenomenon that caused institutional failure. In fact, the same plantations were sold to many investors–for example, I have personally seen what happened at places like Bodinayakanur (Tamil Nadu), where teak farms (in terms of same land titles and survey numbers) were sold to different clients in Mumbai and Delhi. Unscrupulous agents convinced people to deposit money and then, simply disappeared.

Target clients and impact of the crisis: A majority of the target clients were from middle-income and economically well-off classes. The loss of deposits wreaked havoc on clients who lost their valuable savings, which is a safety net for the rainy day. Many farmers who had sold their land to the concerned companies were affected in terms of not having received their entire sale consideration and of course, their land was already sold.  In institutional terms, the NBFCs became bankrupt and there was significant loss of faith in the NBFC (financial) system in civil society and much of that distrust continues today among the middle-income group.

Crisis situation # 2: The Satyam episode of 2009

About the legal form and regulation/supervision: The legal entities were mainly for-profit companies (Satyam and its related entities) engaged in providing a range of services, in the information technology sector, although the group companies were involved in unrelated businesses like real estate (Maytas). While regulation and supervision were the responsibility of the Registrar of Companies, in real terms it was minimal and perhaps limited to the verification of statutory filings and the like. For those companies in the group that were listed (like Satyam), the Securities and Exchange Board of India (SEBI) came in as the market regulator and again, the emphasis was on checklist compliance rather than real supervision.

Growth and competition: Indeed, competition for Satyam and its businesses were all along burgeoning and margins were perhaps being forced down. Satyam was also often getting caught in its own cycle of trying to catch up and keep pace with its three major IT competitors–in terms of quality, cost leadership, scale and service differentiation.

This perhaps also made the Satyam group look seriously at other unrelated activities like real estate, infrastructure, ambulance services, etc, through related companies like Maytas and others. The strong desire to diversify into various other businesses suggested that all was not well inside. Yet, the subtle signals were not picked up by the regulators, who were busy looking at awards and paper compliances and least concerned about the real operations.

Group entities and non-transparent transactions: The Satyam saga, took the related companies concept to a new height, where several group entities with complex relationships were seen transferring funds through non-transparent transactions on a regular basis. While there had been widespread speculation about the funds diversion, ironically, the cat was out of the bag when the promoter made a proposal to facilitate the funds transfer under the garb of diversification.

In fact, this incident led to the famous 2009 crisis caused by shareholder activism. As in the first situation, much of the happenings were directly controlled by the promoter, Ramalinga Raju, and one/two of his henchmen. Of course, the auditors and other stakeholders also appeared to have been involved.

Financing, governance, systems and operations: Shareholder investment and other liabilities were the major resources for Satyam, although operational surpluses were claimed to be significant. Despite the various corporate governance awards, the company and its group, in reality, had very poor governance and systems–as it became clear when the scam broke out.

This was the first large company in recent times to illustrate the fact that neither corporate governance awards (like the Golden Peacock award) nor the presence of a high-profile board symbolise (and/or ensure) good corporate governance in implementation. It is clear that MIS (including invoices and records) were fabricated, as proved later by the existence of fraudulent financial transactions undertaken by the company.

Controls also seemed to have been manipulated and a self-confession is what led the ‘cat’ out of the bag. Without question, ghost (sometimes, duplicate) invoices to boost operating results and a whole range of fraudulent and very complex transactions led to the collapse of the financial system in the Satyam group and this resulted in institutional failure eventually.

Target clients and impact of crisis: Again, the majority of target clients were middle income to economically well-off classes and they were affected in two ways: (a) The loss of work wreaked havoc on hired (regular as well as surplus) employees who could not even meet their regular housing EMIs. (b) Shareholders were badly affected as the stock price of Satyam and related companies plummeted and significant wealth was lost. Most importantly, the Satyam fiasco dented corporate India like no other event and we are still recovering from the financial and image loss suffered.

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