Lessons from the Indian microfinance crisis, an open letter to Andrew Mitchell

Two crucial aspects in microfinance—client origination/targeting and loan appraisal—have been neglected in favour of unprecedented growth (caused by a desire to fully commercialise microfinance and rapidly enhance access/outreach of such services) and this has resulted in the present crisis

An open letter to the right honourable Andrew Mitchell, UK International Development Secretary, on lessons from the Indian microfinance crisis

Respected Sir,

Good afternoon! I am delighted that The UK Department for International Development (DFID) is launching SAMRIDHI (a programme promoting microfinance and impact investment in India)  in partnership with SIDBI in your esteemed presence (Sir) at 6pm today, the 16th December (Friday) at the British Council Division, Kasturba Gandhi Marg, New Delhi. Much as I wanted 

to attend the same, I am unable to do so and hence, this open letter Sir for your kind consideration and necessary action.

Sir, I wanted to draw your attention to some key lessons and findings from the Code of Conduct (CoC) assessments of eight Indian MFIs sponsored as part of the SIDBI World Bank “Scalling up Sustainable and Responsible Microfinance Project” (http://www.sidbi.com/micro/WorldBankInitiative.htm). The findings are very relevant to the SAMRIDHI programme to be launched as noted above.

Sir, in an earlier article (Have sophisticated thermometers ever reduced the temperature?), I pointed to some real peculiar findings from the above Code of Conduct Assessment (COCA) reports where by the fastest growing NBFC-MFIs received the higher (better) scores. This was counter intuitive because it is now widely accepted that burgeoning growth of MFIs caused the 2010 microfinance crisis in Andhra Pradesh—a state which DFID can take great pride in having nurtured significantly through its seminal poverty alleviation and rural livelihoods projects.

Sir, this peculiar fining made me go deeper into the COCA assessments—and not to my surprise, I found that there were too many free points that were awarded as part of the COC assessments (The award of free points in microfinance code of conduct assessments). I must also record that I came across several instances of subjectivity and inconsistencies in the aforementioned COCA reports (Subjectivity and inconsistencies in microfinance code of conduct assessments). I would be grateful if you can read these carefully as they have tremendous implications for DFID’s work globally in relation to microfinance, financial inclusion and inclusive growth! Thank you sir!

And through this open letter, I also wanted to share some key findings from the aforementioned COCA reports. This again should prove extremely useful to DFID not only in its fight against global poverty but also for the SAMRIDHI programme that is being launched today!

Sir, all along I have been saying that two crucial aspects in microfinance (client origination/targeting and loan appraisal) have been neglected in favour of unprecedented growth (caused by a desire to fully commercialise microfinance and rapidly enhance access/outreach of such services) and this has resulted in the present crisis. The above eight COCA assessments present additional evidence in support of my above assertion and I briefly summarise the key issues hereafter for your kind understanding:

a)    On client origination and targeting, it has been found that unauthorised agents were very much present in the operational areas of (some) MFIs. Further, the COCA reports themselves suggest that Ujjivan, Equitas and Basix have used unauthorised agents to source and target new clients. Further, according to the COCA report, Cashpor is said to have experienced this in the past (at least until 2008). While no cases were found at Arohan, the COCA report concludes that Arohan needs to apply internal check systems at all times so as to prevent the risk of informal agents (existing in their operational areas) from infiltrating into their system. And the assessments found no evidence (with regard to use of agents) at SKDRDP, Bandhan and ASA. Not surprisingly, Ujjivan, Basix and Equitas are among the fastest growers (between Apr 2009 and Sept 2010) in this group of eight MFIs for whom COC assessments have been attempted by the SIDBI World Bank responsible micro-finance project.

This apart, the COCA report on of one MFI (http://www.sidbi.in/Micro/COCA%20Equitas.pdf) shows how the use of unauthorised agents evolved and this affords very valuable lessons for DFID:

“From November 2010, the organisation has done away with sales targets as well as the direct monetary incentives for enrolment of clients for its Sales Officers to reduce the likelihood of the Sales Officers misrepresenting indebtedness of clients. ... In the past, Equitas has faced problems pertaining to involvement of unauthorised agents in the client origination process, particularly in some of the branches of Chennai, primarily on account of high sales targets of the SOs and weaker controls.”... “In M2i’s opinion, despite all sincere efforts, some of these agents may still be in existence (though their influence may now be low)”. (Pages 6 and 7)

And a reading of the above COCA report clearly shows that only a crisis could incentivise the MFI to change it is policies. The findings given in the report are best interpreted as follows:
  •   The MFI had ‘high sales targets’. (http://www.sidbi.in/Micro/COCA%20Equitas.pdf, page 7)
  •  The MFI had ‘direct monetary incentives for enrolment of clients for its sales officers’. (page 6)
  •  There was a ‘likelihood of sales officers misrepresenting indebtedness of clients’. (page 6)
  •    The MFI ‘faced problems pertaining to involvement of unauthorised agents in the client origination process, particularly in some of the branches of Chennai primarily on account of high sales targets of the sales officers and weaker controls’. (page no 7)
  •  The MFI had an ‘incentive for collections at the branches and there was a monetary penalty in case collections are not 100%’. (page no 14)
  •   And interestingly, what needs to be noted from the COCA assessment is that, the MFI still received a score of 7.6 out of 9 on client origination and targeting and it also had the highest overall score (88%) in the pool of COCA assessments (please look at Annex 1 page 18 and Section 1: Scores and facts in the above report, page 2).
  •  I leave it to you as the reader to judge whether this COCA rating is indeed appropriate?

Therefore, it becomes clear that the above not-so-appropriate practices were changed only due to the 2010 crisis and herein lies the most important lesson from Indian microfinance that DFID should not ignore:

b)    Likewise, on loan appraisal, the Ujjivan COCA report says:

“At present, information pertaining to income, expenses as well as indebtedness of the clients used for credit analysis is what is self reported by the clients. Given the profile of its clientele, it may not be possible for the organization to obtain documentary evidence of the income, expenses and indebtedness.” (http://www.sidbi.com/micro/COCAUjjivan.pdf, page 11)

Sir, this is the omnipresent reality in microfinance as MFIs typically work with poor clients in the informal sector. Some MFIs use tools (like housing index, asset means test, PPI tool) to estimate the income levels of the clients. But it is impossible to get the exact information from a poor household operating in the informal sector.

The only way to get a better insight on the loan absorption and repayment capacity of the clients is to invest in a long-term relationship with them. However, this requires considerable time and may not deliver the best financial results for the MFI in the short term (but from a longer term perspective, the clients will be better off and that is what ultimately matters). And, most importantly, this calls for a strict “no” to use of unauthorised agents in client origination and targeting so that a good direct relationship can be built with clients. And according to the COCA report, the only MFI that seems to have invested in such a relationship is SKDRDP:

As the COCA report says “The SHGs are required to conduct weekly meetings and undertake compulsory savings for a minimum period of three months before they become eligible to undergo the process of grading. Only SHGs receiving satisfactory performance grades are eligible for applying for loans.” (http://www.sidbi.com/micro/COCA%20SKDRDP.pdf, page 7)

Yet Sir, it is ironical the SKDRDP has received the lowest COCA score! C'est la vie!

Sir, in summary, in many MFIs that had an emphasis on rapid growth, loans were disbursed (indiscriminately) at the fastest rate possible. And greening, informal collateral and abusive collateral substitutes (Tackling informal collateral and collateral substitutes in Indian microfinance) were used to collect back the loans – primarily because the agents behaved like local level thugs. Not enough time was taken by the MFIs to really get to know the clients and to be able to assess their (true) capacity to service the debt. The case of BASIX, which is generally known as one of India’s better MFIs, amply demonstrates this. The fast growth trajectory prevalent in the Indian micro-finance industry (much of BASIX’s peer MFIs in Andhra Pradesh grew at much faster rates than BASIX, prior to 2009) perhaps pushed well intentioned organisations like BASIX (which had sound lending systems originally and I can vouch for how good it was in its early years as an NBFC) to sacrifice their proper lending methodology – that is why as the M2i report on Basix argues,

“However, it was observed that the practice of recording the existing loans of clients in not uniformly practiced across all the units. We found during client interviews that some of the clients had borrowed from other MFIs but this had not been recorded in their loan forms. In one of the units—Kamareddy in Andhra Pradesh—a random inspection of 15 loan appraisal forms revealed that none of them had a mention of any other lender. It is improbable that none of the clients would have borrowed from any other MFI in the region given the prevalence of MFIs. Also, interviews with the LSPs revealed that nearly 70% of his clients had borrowings from other MFIs.” (http://www.sidbi.com/micro/COCA%20Samruddhi.pdf, Page 12)

And this is confirmed by none other than the then CEO of BASIX, who candidly said to The Economic Times,

“That (following sound lending practices) is where we failed,” says Sajeev Viswanathan, CEO of Basix. MFIs lent liberally to individuals who didn’t have a corresponding ability to repay. The mismatch had to hurt sometime, and that’s what is happening now. ...Mr Viswanathan says MFI lending in Andhra rose from Rs5,000-Rs6,000 crore in 2009 to Rs9,000 crore this year. ” (From Microfinance: What's wrong with it, by M Rajshekhar, Economic Times, November 2010)

Sir, all of the above is fine but what then are the positives from the SIDBI-World Bank sponsored COCA reports? After having analysed eight assessments, the most positive aspect that emerges is the fact that the presence and use of unauthorised agents in Indian micro-finance has now been (officially) acknowledged and admitted. I say officially because of the COCA reports are sponsored by the SIDBI-World Bank project and that puts these findings in a different plane altogether.  And M2i, SIDBI and the World Bank certainly need to be complemented for their courage to bring the (widespread?) use of agents in Indian micro-finance officially out into the open. Kudos to all of them!

A major disappointment however is the fact that those MFIs engaged in such (undesirable) practices have been rewarded with highest scores for Code of Conduct Compliance. As a result, not much value can be attached to the scores resulting from the assessments. And without question, as J Nunnally, the Psychometric Guru would argue, the COCA tool will need significant revamping for it to become a reliable and valid psychometric measure, capable of portraying ground level reality in an accurate and unbiased manner. And given that Sa-Dhan and MFIN have just released a joint code of conduct in Indian microfinance, it is only natural that they take on this task of creating an appropriate tool—one that rewards actual implementation rather than glorious intentions on paper.

Sir, coming back to the SAMRIDHI, a programme promoting microfinance and impact investment, I have tried my best to present you with relevant facts and details (in the public domain) with regard to the practice of microfinance in India. I would be very grateful if you can use your good offices to ensure that the available lessons and learning are factored into the implementation of the DFID SIDBI SAMRIDHI programme (being launched today) as well as the DFID Poorest States Inclusive Growth (PSIG) project that is to be implemented in the near future! And please be rest assured sir that your kind intervention will not only enable millions of low income people in India to have a better quality life but also be an integral part of the inclusive growth story in India!

Thank you sir!

With best wishes


Ramesh S Arunachalam

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