Learning from experience: The key to drafting a good microfinance bill for India

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. {break}

Crisis situation # 3: The Andhra Pradesh and Indian microfinance crisis of 2010

Legal form and regulation/supervision: In terms of legal form, microfinance institutions (MFIs) are mainly for-profit companies registered as NBFCs with the RBI. While there are other forms of MFIs including non-profits (societies, trusts and section 25 companies) and mutual benefit organisations (like different types of co-operatives), the large MFIs that dominate the Indian microfinance market are predominantly for-profit NBFCs.

RBI is the regulator/supervisor for the largest group of MFIs–NBFCs. In addition, SEBI is the market regulator when such NBFC MFIs get listed. In terms of regulation/supervision, it is basically statutory filings and compliance checklist type regulation for the NBFC MFIs. There is no serious on-site or for that matter, even off-site supervision. The other legal forms are supposedly regulated and supervised by the registrar of societies, trusts and cooperatives under various acts of the central and state governments–in reality, statutory filings and checklist compliances are predominantly relied on by these regulators.

Growth and competition: The NBFC MFIs experienced burgeoning growth, through the years, and especially from April 2008 onwards until the crisis in October 2010. During April 2008 to March 2010, six of the top 14 MFIs were headquartered in Andhra Pradesh and these MFIs increased their gross loan portfolio outstanding by a little over $2 billion and added almost 9.59 million clients. This is phenomenal growth by any standards.

Although a large part of India remained unsaturated as far as microfinance services were concerned, several pockets–especially urban and peri-urban areas of Andhra Pradesh, Tamil Nadu, Karnataka, West Bengal and Orissa–witnessed significant competition. And multiple/successive/ghost lending to same clients became the norm for growth. In other words, many MFIs aspired to be the fastest to disburse a loan. As a result, clients and joint liability groups (JLGs) were shared between MFIs and different MFIs serviced the same clients/JLGs on successive days. Surely, a recipe for long term disaster. Burgeoning growth also meant that frauds (ghost lending) increased, as admitted in the financial statements of several MFIs, mainly due to failure of credit delivery and other systems.

Group entities and non-transparent transactions: The MFIs made the related entities concept even more complex with the introduction of not-so-legal entities like Mutual Benefit Trusts (MBTs) a part of the overall group structure. MBTs were strange animals because they had no real law of legislature backing their existence, let alone their regulation and supervision–I am still puzzled as to how they can be called as a body corporate. There is also strong evidence of non-transparent relationships between these group companies as espoused by dilution and/or liquidation of MBT shares and the like.

There are also clear cases of significant related party transactions between group entities and promoters–like loans given by a large MFI to the promoter to buy shares in the same MFI (as per Professor Sriram’s article in the Economic and Political Weekly, June 2010). And further, there are so many legal entities involved in similar and related activities under the same group – an NBFC, a society, a section 25 company, several MBTs and even cooperatives. All of this makes the various institutional relationships within the group very complex and as a result, the microfinance operations are like a black box. And as with the other two crises, the promoter and his chosen colleagues ‘managed’ the various situations. What however needs to be ascertained is whether the auditors were involved in some of these non-transparent transactions.

Financing, governance, systems and operations: By and large, most MFIs had access to priority sector lending funds from commercial banks and soft loans from DFIs (like SIDBI) and donors–these were typically large, collateral free, soft interest loans with no personal guarantees. They were generally available on virtually unlimited scale during the years preceding the crisis. Many MFIs also had access to significant equity investments–both from secondary and primary markets. IPOs had indeed become the buzzword just before the crisis in October 2010. Last but not the least, some MFIs received grants from donors, which were subsequently capitalised, and often in the names of the promoters!

Further, despite corporate governance and transparency awards (from CGAPiii /others), many MFIs have weak governance as espoused by the happenings in recent years (2010 included). The tampering of board minutes, loans to founder promoters, irrational compensation to MFI promoters in many instances, and the unceremonious sacking of a CEO who led the concerned MFI through a spectacular IPO, are all aspects that raise serious questions about corporate governance.

Additionally, MIS is nascent and suffers from several weaknesses too—including lack of aggregation across geographies, clients and products. Internal controls and audits are also weak and risk management is almost absent and all of these make the microfinance industry a perfect setting for (potential) institutional failure.

It is now clear from several sources (including emails in circulation between MFIs) that centre leaders and local political leaders functioned as MFI agents and pushed loans to poor people, and used coercive methods and greening techniques to recover loans from them.  In fact, the audit statements of some MFIs themselves point to the presence of ghost and non-existent clients, misappropriation of client repayment collections and several other kinds of frauds, primarily caused by the decentralised MFI model that uses different kinds of broker agents. The current financial statements reconfirm the trends of ghost clients and the like.

It is now also apparent that some MFIs (perhaps even many) have engaged in not-so-desirable practices like multiple lendingiv , top-up loans, over-lending to the same clients and even creation of non-existent borrowers (sometimes to manage delinquency) and so on. In my opinion, the above illustrations of not-so-good governance, poor systems and non-transparent operations, along with client suicides, acted as one of the major triggers of the present microfinance crisis. Everything else, more or less, follows from these.

Target clients and impact of crisis: Most of the target clients were low-income and financially excluded people. The vulnerability of the clients and lack of sufficient livelihood opportunities for them are major factors in their getting exploited by the system. The multiple loans wreaked havoc in the lives of clients and the enhanced indebtedness was certainly a very important factor for the suicides.

The rural and urban low income (credit) economy is in shambles. Many of the low-income clients could lose access to finance in the long term as financial institutions may be reluctant to lend to them (anymore), especially in the wake of the various problems identified during the present crisis.

Shareholders of the only listed MFI took a beating as the stock price plummeted and continues to be volatile, causing significant erosion of investor wealth. Further, the private equity investors are left without an exit strategy and many of them, have actually suffered huge losses as they had bought the MFI shares at abnormally high valuations. And last but not the least, the reputation of microfinance, as a pro-poor industry is in tatters and its image has taken a severe beating. MFIs are no longer considered the torchbearers of development and poverty reduction.

Lessons from the crises

We can take some key lessons from this comparative analysis.

•    First, every potential crisis situation has early warning signals, which, if ignored, could snowball into a major one. I am sure that all of us recognise the ‘early flash points’ in the various crisis situations (including the incidents in 2009/2010 with regard to the microfinance crisis). That these did not catch the attention of the regulators/supervisors is something that needs to be noted very carefully.

•    Second, in almost all the three situations, the companies that were involved were once much-feted and had received (corporate governance) awards and significant (positive) media attention. Their fall from grace was however swift, post crisis. Clearly all that glitters is not gold and it is better to avoid face value interpretations of corporate governance based on the mere presence of a high-profile board. Five-star boards do not guarantee good corporate governance and let us get that clear!

•    Third, in almost all three crisis situations, the companies/entities involved were purported to be doing something exceptionally innovative but perhaps legally untenable. They were therefore probably given the long rope, which is often a double-edged sword that will ultimately cut.

•    Fourth, in all three cases, there was no (one) serious regulator, and the lack of coordination among them perhaps led to regulatory arbitrage, thereby resulting in institutional failure. Alternatively, it can be argued that ‘hands-off’ regulation is a common factor that aided the crisis and, from this, it is clear that any well meaning regulation must be coupled with commensurate and effective supervision on the ground. Otherwise, the ‘subjects’ of regulation (companies, NBFCs, MFIs, etc) will claim to be complying, even while actually engaging in not-so-good practices. Thus, a hands-off regulatory approach could lead an industry to a serious crisis and well-intentioned regulation is of no real use if not backed by strong and local level supervision, which clearly indicates a role for state governments. This is a serious aspect that needs to be appreciated and taken cognizance of by the concerned stakeholders drafting the microfinance bill.

•    Fifth, in each of these cases, it was extraneous events that led to the crisis erupting and getting large-scale public attention and only after that did the regulators come in!  Thus, all these three crises situations symbolise regulatory failurev to some extent and the fact of the matter is that these regulators/supervisors were perhaps caught unawares. Further, interestingly, the regulatory responses, in two casesvi , were stringent to the point of crippling the operations post crisis, indicating an extreme and complete swing of the regulatory pendulum. Balance in regulation is therefore critical, as otherwise regulation may strangulate the very industry that it is trying to serve. Therefore, regulation must also seek to enable and incentivise behaviors rather than merely prescribe rules and rely on compliance checklists, which suits most companies/entities.

•    Sixth, self-regulation does not and will not work on the ground and this is a clear message from all the crisis situations. In fact, ‘self-regulation’ could lead to the crisis deepening further, as the concerned stakeholders (or subjects of regulation) rarely have right incentives to comply.   

•    Seventh, multiple regulators can only lead to chaos on the ground and whenever you have several regulators, there is confusion and important aspects are not properly enforced–like corporate governance for private limited companies and/or NBFCs, where circulars exist but are not fully promulgated and/or implemented, thereby enabling the subjects of regulation to engage in not-so-good practices. The issue of related party transactions for NBFCs is a case in point. Please see the RBI circular on corporate governance (of May 2007 on the RBI web site), parts of which—including loans to directors—have been kept in abeyance.

•    Eighth, regulation must first and foremost provide legitimacy to the industry and this legitimacy must be backed by certain non-negotiables and safeguards including minimum standards for governance, client protection, various systems (finance and accounting, internal controls, internal audit, human resources management and management information systems, etc), operations (lending and recovery aspects included) and the like. I hope that the proposed microfinance bill takes all of this into account.

At this point, I would like to reiterate that the Ministry of Finance, which is said to be drafting the proposed Microfinance Bill 2011, the Reserve Bank of India, which is said to be preparing detailed guidelines for the MFIs (based on the Malegam Committee Report) and the Planning Commission, which is said to be writing an approach paper to microfinance for the next (12th) plan period, should analyse and learn from these past and present crisis situations. Without question, we should not waste the lessons derived from these crisis situations after all...

iTo set the record straight, no offence is meant to anyone including regulators/MFIs/Companies/Other stakeholders and I am merely doing this analysis so that we analyse, learn and take sufficient precautions for the future. I recognise the hard task of regulation in a country like India and do sincerely appreciate the hard work done by the regulators but there is a critical need to learn lessons from the past in an objective manner and that is exactly what I am trying to do.

ii Cheap is low cost essentially as public deposits are the cheapest source of non-subsidized capital
iii A multi donor body which functions from The World Bank – CGAP Stands for The Consultative Group to Assist the Poor. I wish it were the Consultative Group to Alleviate Poverty.
iv This is yet to be examined seriously in terms of a national study but available evidence provides some support for the above assertions. The regulators and supervisors must order a neutral and objective study of the same
v To set the record straight, I recognize the hard task of regulation in a country like India and do sincerely appreciate the hard work done by the regulators but there is a critical need to learn lessons from the past in an objective manner and that is exactly what I am trying to do.
vi This is true of the RBI and State Government directions (in Tamilnadu) in the 1990s. The Andhra Pradesh Micro Finance Institutions (Regulation of Money Lending) Ordinance, 2010 is another case in point as also its subsequent enactment as a Bill.

(The writer has over two decades of grassroots and institutional experience in rural finance, MSME development, agriculture and rural livelihood systems, rural/urban development and urban poverty alleviation/governance. He has worked extensively in Asia, Africa, North America and Europe with a wide range of stakeholders, from the private sector and academia to governments.) 

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