The traditional microfinance-joint liability group (MFI-JLG) model has been one of the very few banking, financial services and insurance (BFSI) business models which has delivered a high return (20% plus return on equity—RoE) despite regulatory, political, and other impediments. The MFI segment was worth less than Rs10,000 crore in 2011 and, today, has matured to Rs2.40 lakh crore in terms of portfolio outstanding.
But the microfinance institutions (MFIs), might not be able to replicate their growth rates due to structural issues, as per a research report by Edelweiss Securities Ltd.
The MFI business is susceptible to brief tough periods with potential to wash out returns generated earlier.
The Edelweiss report has pointed out that a cocktail of factors has cast a long shadow thereby spooking asset quality of MFIs.
These includes, over 25% compounded annual growth rate (CAGR) over the past five years leading to over-leverage with overall about 45% penetration and more than 60% in key markets. “With penetration in traditional markets already at over 60%, growth will be driven by new geographies, which will have their own challenges,” it says.
It says, COVID pandemic and its effects and outcome would be Black Swan event for MFIs.
In higher buckets visible, the brokerage sees large overdue loan amounts with hardening as well as high tail risk.
It also points out towards political uncertainties in a few key regions. With nine states, including Assam and West Bengal, heading for elections in FY21-22, there are expectations that the resultant political risk could be an overhang for the microfinance sector, it added.
Against this backdrop, players with scale, balance sheet strength and capital will be able to transcend tough times and would be better off. Edelweiss Research believes that the near-term earnings volatility calls for higher cost of equity, in turn, capping valuations.
MFI insiders, however, disagree and say that given the priority of financial inclusion from the government of India, the progress of policies of Reserve Bank of India (RBI) and the fact that there is two-third of the MFI market yet to be tapped, there is still immense potential for growth of the industry.
Last week, India Ratings and Research (Ind-Ra) had released its report on the microfinance segment which said that, while large non-bank MFIs, or those with assets under management (AUM) of over Rs5,000 crore, have a stable outlook, small to midsize non-bank MFIs continue to have a negative outlook for FY21-22.
India Ratings had pointed out that, while the collections have picked-up especially in rural areas, they continue to lag in urban regions. Large MFIs have been able to raise funding, especially since the second quarter of FY20-21, aided by easing liquidity and policy measures, while fund raising has been slow for mid and smaller ones with AUM (assets under management) of less than Rs 2,000 crore.
Here are the key conclusions from the Edelweiss research report:
1) MFI will no longer be a pure penetration play henceforth and growth will soften to 15% over the next five years.
Edelweiss Research expects growth to soften hereon given:
Penetration is already at 45% and over 60% in traditional markets. Hence, incremental growth is likely to be characterised by aggressive competition and over-leveraging.
Growth will be via new geographies, but that will come with its own set of challenges—high risk, high operating expenses, low productivity and aggressive competition.
Customer additions will soften–past two quarters mark the beginning of a trend.
Continued business model transition for small finance banks (SFBs) with focus on product diversification and deposit franchise. Many MFIs had turned into SFBs and reported higher growth than the MFI sector in FY19. Two of the major reasons that accounted for this growth were SFBs diversifying their loan book and getting access to more deposits.
Industry players were able to collect huge deposits, which helped them to raise funds at a lower cost than MFIs and have seen loan portfolio growing by more than 50% in FY19.
Softer momentum in self-help group (SHG) additions because of the above.
2) Asset quality: Stress is set to rise further
One of the key challenges, says Edelweiss, is the difficulty in predicting asset quality outcomes with precision given: a) high contagion risk (defaults are highly correlated); b) lack of coherent database to access income, indebtedness & leverage of customers; c) limited macro impact; d) political interventions; and e) differential regulations, among others. Additionally, the uncertainty on account of periodic events viz., floods exacerbated further by once-in-a-lifetime events such as demonetisation and covid, with massive systemic implications. Edelweiss expects stress to build up despite consensus expectation of it flattening out. Higher volatility in earnings would warrant a higher cost of equity.
3) Covid reality: outcomes will be graver than what most anticipate
While covid is still uncertain and evolving, demonetisation saw quick resolution. Permanent loss of personal and household incomes due to COVID can be seen. Rising balance sheet risk : rise in customer riskiness (lower income + higher expenses), but still rising exposure (top-up loans). Thus, higher credit losses (more than 7% at system) versus demonetisation (5%-6%) can be expected. Though we have seen an expected initial rebound, international experience indicates its sustenance is doubtful.
4) Challenges: Long forbearance, politics, regulations conformation
The moratorium granted for COVID-19 implicitly means that some borrowers have not paid even a single instalment for over nine months. Additionally, the political uncertainty in a few key regions, which are up for elections. These factors add to the uncertainty over asset quality. Further RBI’s recent stricture of regulatory conformity across players (though much needed, positive in long term) burdens an already hard-pressed market segment. While these issues might get resolved in a year or so, business challenges might drag on.
However on the other hand, the report has also pointed to structural positives: a) Evolution of credit bureaus and wider availability of public data (albeit some fallout needs monitoring).
b) Managements’ experience in handling several crises.
c) Patient private capital keeping tabs on sector developments.
d) Strengthened regulations. Hence, pay-off from investing in players who could deliver better risk management could be high.
Edelweiss Research has given a thumbs up to players with scale, balance sheet heft and capital as these attributes would help them navigate the choppy waters and generate better returns on cross-cyclical basis. Businesses which are more traditional, operate with scale, have a JLG model rather than individual, involve frequent customer connects, have a strong liability base and have diversified risks (geography and product) would be well-equipped to consolidate during the occasional but deep troughs, while delivering strong returns otherwise.