{Given below is my understanding / interpretation of various discussions held during the course on ‘Microfinance’ by Prof. Shamika Ravi at the Indian School of Business (ISB), Hyderabad}.
IntroductionThe question that sowed the seeds of microfinance; Can you do business with ‘un-bankable’ clients? By un-bankable clients we mean people who are very poor and do not have any assets that can be used as collaterals. Banking with such people is risky and hence we do not find commercial banks lending or dealing with them.
But is it so easy to eliminate such huge masses from financial system just because they are risky? The recent financial turmoil due to subprime crisis has shown that the so called ‘non-poor’ (people like many of us) are equally risky if not more. Microfinance was invented through innovation in the process of market creation that reduces the risk. It is interesting to note the mechanics of how microfinance institutions operate to understand the innovation, but before that let us dwell in the types of risk that a bank will carry if it extends loan to un-bankable population.
Types of risk
The word ‘risk’ as used in common parlance means a source of danger or possibility of incurring loss or misfortune. Hence when a bank denies a rural labourer (un-bankable person in our case) for a loan, the rationale provided is lending in this case is risky. (The reason that person is taking a loan could vary from setting up his own small shop to renovating his home to getting his children married). What risk are we talking about? A risk that the bank may not be able to recover the loan and it has no collateral; hence it is risk of the loan going bad. The causes for the loan going bad are lack of information about the borrower, and hence inability of bank to distinguish between a good and a bad person based on loan application form and lack of collateral to enforce repayment. Hence we see two major risks that the banks face:
1. Adverse Selection: Neither banks nor other institutions have adequate information of credit-worthiness of the un-bankable population. Hence if banks were to extend loans to them they would need to charge high interest rates to compensate for bad loans from the pool of loan made to un-bankable people. However as the interest rate goes up, a good un-bankable person would avoid taking loan and hence the pool of un-bankable that comes to take loan will become worse. This is similar to ‘market of lemons’ as coined by George Akerlof. Hence the first risk is that to cover for bad loans / defaults the bank would need to charge high interest rates for un-bankable population and if it does that the pool of un-bankable that comes to take loan becomes worse and default increases, the basic cause being lack of information.
2. Moral Hazard: Even if the bank can get some information on credit- worthiness of un-bankable population and it starts extending loans assuming that a few of them would default there is always a risk of moral hazard. When a few people default, other people who ideally would not like to default will always be tempted to delay their payments or default on their loans as they have nothing to lose. Since there is no collateral in all these cases if from a pool of hundred un-bankable people taking loan, one of them defaults, the other ninety nine have nothing to lose, if they default and hence they are certain to default. The bank in this case carries a risk of 100% default due to moral hazard
The next time we see an old Hindi movie, where a village money lender charges exorbitant interest rates from poor people think about the above two risks; namely ‘adverse selection’ and ‘moral hazard’. It is very easy for us to sympathise with the poor person and consider the money lender as villain; but he is only trying to cover the above two risks, he may not be as bad as we think him to be.
Mechanics of operation- Group Lending‘Group lending’ has become synonymous to microfinance operations. A microfinance institution goes to a village and asks the potential borrowers to form groups of 3 – 10 among themselves (depending on the policy of micro finance institution). The lending is first done to only one of the members of a group and repayment is often weekly. Only after the repayment of first loan is completed to certain extent, a second person gets an opportunity to take loan and based on his repayment the third gets his opportunity and the cycle continues. However if the person who takes loan defaults; there is a clause of ‘joint liability’ which makes the other people in the group jointly liable to make the loan good. In case other people do not make good, they would not be extended any credit in future. If one finds it difficult to understand this concept; think of ‘VISI or VISHI’ that is run by many people in our community. The concept of group lending and joint liability is somewhat similar to it.
It is astonishing to see how this simple mode of operation reduces the above two risks of adverse selection and moral hazard to a great extent:
1. Adverse Selection: This risk as described above was due to lack of availability of information with the bank (lender) about the un-bankable borrowers. This was because banks were dealing directly with each borrower. By creating this simple concept of group lending, the lender is now dealing with a group of borrowers and not individual borrowers. Further the group is formed by the villagers who have information about the credit-worthiness of each other better than the bank. Hence while the groups are formed with an understanding of joint liability, each person will ensure that only good people i.e. people with intention of making regular payments form group together. Hence the problem of lack of information is solved automatically for the bank, though the bank remains as ignorant about credit-worthiness of each borrower as before. As this reduces defaults, the interest automatically comes down and hence the pool of un-bankable borrowers becomes better; exactly reverse of what happened earlier.
2. Moral Hazard: This risk as described above was due to lack of any collateral which would mean that the lender may not be able to recover anything in case of default, which is further aggravated by the fact that even if one person in the pool defaults, there is a very high likelihood that all the borrowers will default as they are dealing with bank individually. However with clause of joint liability in group lending, in case anyone of the group of 3 – 10 members defaults than other people need to make that good, else they would not be extended any credit. Hence the onus of recovery now shifts from the bank to the group that borrower belongs to. In this case the other members of the group would help the person who has taken the loan in his work so as to ensure that he does not default. There is also peer pressure and loss of face in case of default; which ensure that the borrower repays the loan instalments as per schedule. It once again surprises us the way in which a simple group lending with joint liability solves the problem of moral hazard; and the bank still does not have any collateral to protect him against default, yet the defaults reduces dramatically.
It is easy for us to believe that group lending is always good; but let us pen down some specific advantages as well as disadvantages of this mechanism.
Advantages:
• Convenient to borrower as the lender comes to his village
• Convenient to lender as the transaction cost is reduced as he is dealing with group
• Reduction of two most important risks; viz. Adverse Selection and Moral Hazard
• Creates a market without any extra information or collateral
Disadvantages
• Collusion by all the group members might result in high defaults
• In case of dispersed, mobile, urban population it may not be as easy
• The correlation of defaults within the groups of same village is very high; this may happen when the entire village is facing natural calamity and is not in a position to repay the loans
Reality check
It is important to do some reality check with practical examples across world to put in context the theory described above.
An example of victory: Grameen bank in Bangladesh started by Prof. Muhammad Yunus in 1976 is a leading success story in the world of microfinance. The bank has 7.86 million borrowers, 97 percent of whom are women; it serves in 84,388 villages, covering more than 100 percent of the total villages in Bangladesh . It was awarded noble peace prize in 2006. The bank has been profitable in most of the years since inception, except 3 years.
An example of debacle: A microfinance institution named Corposol in Columbia started in 1988 and had loan portfolio of $ 38 million in 1995, but it collapsed and went bankrupt in 1996 . Few explanation for this were; aggressive growth on mangers to extend credit to new clients, quality of loan was not monitored, internal controls were poor which resulted in higher delinquencies and defaults.
Beyond Loans: As seen worldwide it is important for microfinance institution to think beyond extending loans. It is important to think microfinance as ‘financial inclusion’ which would mean providing micro-insurance, micro-savings, micro-credit, etc. to the un-bankable population.
Indian Context: The Indian microfinance sector is expected to grow ten times by 2011 to a size of Rs. 250 billion . A few known names in the industry are SKS, Spandana and Basix. The industry currently is concentrated in Southern states and is restricted to lending only. This is because the law does not permit acceptance of deposits by micro finance institutions in India. There are some major developments that are in the pipeline. The Union Cabinet is likely to soon approve the Micro Financial Sector (Development and Regulation) Bill, 2009 which seeks to make NABARD the sector regulator. The new Bill entrust the function of development and regulation of the micro financial sector to the National Bank for Agriculture and Rural Development (NABARD), a subsidiary of the Reserve Bank of India. The passage of the Bill would result in the regulation of the micro-finance organisations not being regulated by any law for the time being. It also has a provision where it would permit the microfinance institution to accept deposits from its clients and hence inculcate a culture of thrift among un-bankables.
Objective: It is important to understand the objective of microfinance institutions. Though it seems that it is more social and that these institutions are not for profit, it is not the case. The objective can be either social (can be referred as ‘outreach’ objective) or profitable (can be referred as ‘sustainable’ objective). Institutions with social objective are formed to help the masses at large. Institutions like Grameen are living examples of the same. The founders of such institutions have a passion to help the society at large and they are formed with not for profit motive. However this is just one side of story. There are many organisations that look microfinance as business opportunity and hence start with profit objective. The profit made is the difference between the cost of borrowing and cost of operations (lending + operations). Approximately the lending rate is 30%, the borrowing rate is 12% and the cost of operations is 15%. Hence there is a 3% spread that is available to microfinance institutions . Please note, we are not passing any value judgements as to whether any objective is good or bad; both the objectives are totally valid and there have been success stories as well as failures in both the cases.
Conclusion
It would be naive for any finance professional to ignore this industry in today’s context when ‘bottom of the pyramid’ is talk of the day. It has the potential to throw various opportunities for all of us in terms of job prospects, consulting assignments as well as entrepreneurial opportunities. Hence it would be useful to have some basic knowledge about this industry; and its mechanics. I hope this article is able to provide a glimpse of the same.
