Fresh perspectives and radical (systemic) changes are required for developing an enabling micro-finance regulatory and supervisory mechanism that can really work on the ground for the benefit of large numbers of low income people

Moneylife reported last week that charges of serious misreporting and mismanagement have again surfaced in the public domain with regard to Indian micro-finance. Specifically, the article reported that Sahayata Microfinance Pvt Ltd, which was the darling of so many investors, lenders and stakeholders had apparently gone astray - with its now suspended CEO and senior management supposedly involved in serious misreporting and mismanagement. (http://www.moneylife.in/article/award-winning-sahayata-microfinance-is-the-latest-to-go-astray/21549.html)  

As several previous Moneylife articles have noted, the dominant model in Indian Micro-finance is the commercial model where the MFI is registered as an NBFC with RBI and taps commercial funding (debt and equity) through different means. This model is based on fast tracked growth and generally carries a standard loan product - delivered to clients through joint liability groups and/or agents-based on weekly repayments and having (mandatory) loan related insurance. The emphasis is on-efficiency, standardized processes, large outreach and enhanced profitability – all elements of hardcore commercialization, strongly supported by agencies such as CGAP.

While there could be some modifications to the above model to suit different contexts, the above description is true, by and large, of most NBFC MFIs. The dominant NBFC MFI model is also based on the notion that, to reach and include vast number of unreached and excluded people (including the poor), MFIs must tap commercial funding in a big way from lenders and investors – Mr. Vijay Mahajan’s (Chairman, BASIX, Chairman, MFIN and Chair, Executive Committee, CGAP) statement to this effect, when SKS was to tap the capital markets, strongly resounds in memory. To do this successfully, the model also believes that commensurate (market) returns must be provided to the commercial investors. It is important to note that much of the basic tenets of this (commercial) model have evolved from the global development of new wave micro-finance – which was spearheaded by several stakeholders including CGAP, especially since 1997 onwards. This is a description of the commercial model as I understand it. And as long as the game is played fair and square (no frauds, no multiple/ghost/over lending, no tweaking of performance results etc), I have no problems with the commercial model.  

That said, let us get back to the 2010 Indian micro-finance crisis. A critical point to be noted here is that the fastest growing MFIs, who perhaps contributed to this crisis in India, are primarily NBFCs MFIs that come under the purview of the Department of Non-Bank Supervision (DNBS), RBI. These NBFC MFIs grew at a phenomenal rate, adding several million clients and dollars to the gross loan portfolio over the period April 2008 to March 2010. The following basic facts are discernible from the data (www.mixmarket.org):

• 13 of the top 14 MFIs (ranked on the basis of active clients and gross loan portfolio added from April 2008 to March 2010) are NBFCs. One  of them is an NGO MFI registered as a trust
•  6 of them are Andhra Pradesh headquartered NBFC MFIs and they constitute the largest chunk within this group of 13 NBFC MFIs. 9.76 million clients were added by these 6 Andhra Pradesh headquartered NBFC MFIs from April 2008 to March 2010 whereas the other state 7 NBFC MFIs and one NGO MFI added just 4.52 million clients (this is less than 50% of the outreach of Andhra Pradesh headquartered NBFC MFIs).
•  Likewise, these 6 Andhra Pradesh headquartered NBFC MFIs increased their gross loan portfolio by 2.076 billion US $ during this period whereas the 7 other state NBFC MFIs and one NGO MFI recorded a growth of just an additional 703 million US $ (which is less than 1/3rd of the gross loan portfolio of Andhra Pradesh headquartered NBFCs)
• All of the 13 NBFC MFIs (including the 6 Andhra Pradesh headquartered NBFC MFIs) file quarterly papers with the department of non - bank supervision (RBI). This is a point to be noted with significant emphasis
•  As the above data indicate, there was phenomenal growth in gross loan portfolio (GLP) and active clients for many of these NBFC MFIs.

Please note that the phenomenal growth spurt was led by 5 large Andhra Pradesh headquartered MFIs (SKS, Spandana, Share, Basix and Asmitha), who added 2049 million US $ and 9.59 million clients between April 2008 and March 2010 – which is very significant indeed. This is equivalent to each of these 5 large Andhra Pradesh headquartered NBFC MFIs, adding a gross loan portfolio of Rs.78.55 crores per month, month after month, quarter after quarter, year on year for the 24 months in question (Rs.1 crore = Rs.10 million and exchange rate assumed is Rs. 46 per dollar).

And as noted in box 1 below, the department of non-bank supervision RBI is supposed to supervise every NBFC that has a loan portfolio of over 100 crores closely. As noted above, each of these 5 AP headquartered MFIs were adding (on an average) almost the equivalent of 78% of that threshold value of (Rs. 100 crores portfolio) every month during the period April 2008 to March 2010.

• What was/is the motivation of these NBFC MFIs to grow at this never before seen pace? This is a very critical question indeed!
• How were they growing so fast? Did they still use green field client acquisition which is how micro-finance initially grew in India? Or were they relying on other strategies such as sharing of clients, takeover of SHGs, cannibalizing JLGs of other MFI’s etc? What role did agents play in all of this burgeoning growth? Were client level controls and KYC norms being violated? Was appropriate and required KYC documentation available, especially given the very rapid pace of growth?
•  Did growth occur due to market skimming (first time loans to new clients), financial deepening/repeat loans to older clients and/or several other strategies? Was there any evidence that growth may be due to multiple, over and/or ghost lending, driven by perverse (unnatural profit maximization) incentives (a term often used by Dr Y V Reddy and Mr Vijay Mahajan)?
•  What was the logic behind the business model of the NBFC MFIs? What were its ethical underpinnings? Was the overall model in accordance with the real spirit of inclusive finance, RBI NBFC regulations and the RBI code of conduct? Did the business model of the NBFC MFIs push (or incentivize) the MFIs to grow faster and faster? Was there any difference between the MFI model stated on paper versus that actually implemented on the ground? What caused this difference between theory and practice in strategy implementation?
•  Where and how were the MFIs getting the resources (debt, equity etc) for this burgeoning growth? What was the motivation and track record of these investors? Where exactly were these resources coming in from (India, Abroad etc)?  Please read India Today (June 6th, 2011 issue) which states that there has always been a lurking doubt that terrorist, Dawood Ibrahim, may be involved in both secondary and primary equity markets, under the guise of foreign institutional investors. Under these circumstances, I am sure, it would be important for the regulator/supervisor to know about the antecedents of the various foreign institutional investors (FIIs) investing in micro-finance. Again, I am not sure whether the department of non-bank supervision, RBI was aware of the burgeoning equity investments by foreign institutional investors (FIIs) (including their antecedents) in Indian micro-finance, especially during the years, 2006 -2010
•  What was the impact of this burgeoning growth of consumption oriented micro-credit on the low-income clients in terms of over-indebtedness, quality of life and other aspects?
•  Were the RBI NBFC and other codes of conduct being followed in letter and spirit? Did the NBFCs have sufficient governance and systems to manage this turbo charged growth and, more importantly, not to violate any of the provisions in the law and the codes of conduct?
• And several other questions

At this juncture, it seems pertinent to look at what Dr. Rangarajan and others have had to say about the business model of the NBFC MFIs and also apply the same to this analysis.

"The business model of microfinance institutions is faulty. They must revisit the model to support the income earning ability of the borrower," Prime Minister's Economic Advisory Council Chairman Dr C. Rangarajan said at an event organized here by Skoch Consultancy. Rangarajan said multiple lending done by MFIs is inconsistent with the very repayment capacity of borrower. He said MFIs have been indulging in multiple lending and large parts of the loans are given for consumption purposes and this model of business has landed them in trouble. "Income earning capacity must be criteria for granting loans... The provision of credit for consumption must be a small part of the total loan," Rangarajan said” (http://economictimes.indiatimes.com/news/news-by-industry/banking/finance/finance/mfis-business-model-faulty-pm-panel/articleshow/7225090.cms)

Others have tended argue for the same and I reproduce a quote from Dr. Al Fernandez’s post on the CGAP blog. As Mr. Fernandez argues,

“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.” (http://microfinance.cgap.org/2011/01/06/shgs-for-the-poor-mfis-for-the-non-poor/)

The cornerstone of these arguments is essentially this:

Many MFIs engaged in excessive and multiple lending for consumption purposes and often granted loans without assessing the loan absorption capacity of the clients. Implied in this statement is the fact that many MFIs (in their desire to reach scale and show better results) pushed loans indiscriminately to low-income clients for consumption purposes without any sensitivity to their debt servicing ability and tried to grow (very fast) showing unnatural profits so as to attract capital at high valuations. This is evident from the Indian micro-finance experience and also as noted in a CGAP paper (CGAP, JP Morgan, occasional Paper: Microfinance Global Valuation Survey 2010, March 2010). Thereafter, they had to justify these high valuations by providing better returns to investors. And investors likewise, as they had paid huge premiums, wanted to recover their investment fast and hence, were perhaps pushing the MFIs to grow faster. Hence, as diagrammed in figure 1 below, there appears to have been a mutually reinforcing cycle of multiple/over/ghost lending, fast growth, high profits, very high share valuation, equity investments, faster growth, greater profits, more returns, turbo charged growth and so on.