Microfinance – An overview

{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.

Bandra Worli Sea Link – eyewash for Mumbaikars

A project conceptualised in 1987 with a estimated cost of Rs. 50 crore, finalised sometime in late 90s for Rs. 400 crore and planned to be opened for public in 2004, finally got completed in 2009 for cost of Rs. 1600 crore. This is a brief story of bridge commonly known as Bandra Worli Sea Link in Mumbai, Maharashtra, India.

I started my professional career in Oct 2003 with a company called Marico in its office at Bandra. I used to drive on my two-wheeler 13 kms one way (from my home) to office which took 30-45 minutes. While I joined the company I had people telling me “few more days and you would take 15 minutes as this bridge gets completed in 2004”. I was waiting for that day and the day finally arrived in Jul 2009. A bit late, I had already left Marico by then, did my MBA from ISB and then joined Aditya Birla Group. What a co-incidence, I waited for 5 years to use that sea-link and the bridge got delayed exactly for that period. On a lighter note, even if it were open before I left Marico, I would not have been able to use it, because I use a two wheeler and it is not allowed on the sea-link.

The bridge was inaugurated recently with much hype. Many big names were invited for the inauguration and it included the president of ruling party, the prime minister of country, former chief minister if state and others. This despite knowing that we have made a structure costing 4 times more than its projected cost and taking twice the budgeted time.

So what does this mean? Have we provided an in principle approval for all such infrastructure projects to over run its budgeted cost by few times and get delayed in implementation by few years. The media coverage and the praise that the inaugural ceremony received were really surprising. If we build all our infrastructure projects at this speed, we would certainly be a different place to live in a few decades down the line. As per the website of this bridge; it is 5.6 km long and the expected benefit is Rs. 100 crore per annum savings in vehicle operating cost due to reduction in congestion in the existing roads and lower vehicle operating cost on the bridge.

With these statistics I am afraid of few questions that my son would ask me once he knows some basic mathematics which would be 3 years from now. I expect the following questions and do not have any answers:

• This is a brilliant piece of engineering dad. Your generation build a bridge of 5.6 kms on sea and spent Rs. 1600 crore for building the same. This would mean Rs. 285 crore per kms; isn’t that awesome. Can we check the cost per km of a bridge in some other countries to see how it matches with international standards? Ah, maybe I need to do some more searches on the internet.

• The cost you spent is Rs. 1600 crore and the benefit expected is Rs. 100 crore per annum. Hence assuming that these numbers are accurate you will take 16 years to recover the cost, is that correct? Yes dear but I am not sure if it was planned that way. My son is too young to understand the concepts of discounting and compounding and hence if we were to calculate a discounted payback it would be much more than 16 years.

The site also cites reduction in accidents as one of the benefits of this sea-link. Though I am not an engineer by qualification and hence may not be the right person to comment on this, but I fail to understand how a bridge can reduce accidents.

All in all there is only one conclusion that I can come at. This sea-link and its inaugural ceremony is a testimony to Indian politics on how to depict a shoddy performance as the most superlative one. If there is an award ceremony on eyewash of the decade, I am sure the sea-link would be on the top of that list. I would also sincerely request some of the most respectable politicians to stay away from such inaugural ceremonies as it suggests a stamp of approval from them which may not be their intention.

It’s time we need an execution commission instead of planning commission.

Air India – God save our Maharaja

Started in 1932 as Tata Airlines by J.R.D Tata, Air India was formed in 1953 when air transport industry was nationalised. Since then the Maharaja has been a household logo and a strong brand in itself. However since last decade a complete mismanagement of the organisation by its owner; government of India has led it begging for a ‘bailout’.

Some really foolish decision in the national carrier; Air India and Indian Airlines that would make even a layman raise eyebrow:

• There were 2 national carrier; Air India for international and Indian Airlines for domestic for more than 50 years, but we learnt about word called ‘synergies’ in 70s or 80s. Was there a need for distinction between domestic and international operators? Better late than never; finally there were some talks of merging both the national carriers which began sometime in 2000 which finally happened in 2007.

• In late 2005 a plan to re-brand Indian Airlines as India was rolled out. That is a big joke when one knows that we are going to merge both the national carriers and the identity of Indian Airlines is anyways going to be lost, why was there a need to re-brand. Further I travelled once in a rebranded Indian and the experience was no different from Indian Airlines. It was just a cosmetic change; something similar to what many public sector banks did a year ago (refer my post on re-branding public sector banks). I am sure that there was huge amount of money that was wasted in this process.

• The worth of new fleets ordered was more than the revenue of the entity. Now this is something that can never go well with any person. Though there has been big acquisition by large conglomerates in recent past; but they were exception than a rule. I am not sure if there was even a rough plan on how would the payment for these fleets by arranged?

These are just few examples that make us raise eyebrows on the governance structure of operations of national carriers which is now National Aviation Company of India Limited (NACIL); the parent company of Air India and Indian. There could be many more but these are enough to raise questions on the people managing the show. The minister who has been responsible has been continued for more than last half decade and now he is being asked to prepare a restructuring plan. Can someone tell me; what is the incentive that he gets by turning around this company? In fact the incentive is reverse; the poorer it performs the higher the bailout.

I am sure that we will see more losses than posted by any company historically in India unless we make it run like a private company and bring in some professional managers to turn it around.

The company has already posted Rs. 8,000 crores losses and there is some hue and cry in the parliament. However people in the parliament seem to be busier in protesting against some reality shows instead of focusing on thousands of crores of tax payer money going in drain.

Dear GOI, please bring in some person from industry like you did for Unique Identity Project; else only god can save our Maharaja.

Should you do MBA? too after having corporate exposure for half a decade?

Frankly speaking it is catch twenty two situation. There are many good things that we here from people who have done MBA and also broadcasted by various media channels. Few of them are it broadens perspective (gas), bigger network (most abused term), better job (correlation vs. causation), etc. As I have been crisp in mentioning the meaning of each of these term in bracket let me explain some of them and put down my views:

• Broadens perspective: This is what I said when I wanted to get in, after coming out did it proved right? Yes, it did, but it is individualistic and cannot be true for all. You have to really work to do this and any B school will only provide environment to you but it is finally you who have to take advantage of that and broaden perspective. I would like to quote my favourite Prof. Sanjeev Das here who really helped me do this well. While having a chat with him I asked him what should one look for while deciding the electives. He was apt and clear, “select only those subjects that help you think differently. The problems in this world are same but the solutions could be different. Take subjects that help you think through different solutions”. Bullseye, this is what I think will help broaden perspective.

• Networking: This is the most abused term and a reason for B school. Though I was also one of those who gave this as one of the reason to do MBA, it is now that I realise it was so baseless. In the craziness of networking you will see people doing crazy things to get noticed and hence increase their network. Also with the current plethora of social networking site, I feel this reason has lost its importance whatever little it had. You do connect with few good people but saying that I would do MBA to increase my network seems too immature for me.

• Better Job: Well this was certainly not the reason for getting into MBA for me. But there is a confusion of correlation vs. causation as I have mentioned. There is a high correlation between doing MBA and getting good job, (by the way what is a good job) but good job is not a cause of MBA. People do get good jobs even without MBA. The reason for getting better jobs in the last decade was not MBA but the economic scenario that supported it. However as the tables turned and the scenario was not as good as it had been, things looked sad at all the B Schools. Hence B Schools would help you get a better job is a flawed argument.

Hey, wait there... though I have listed some reasons which I think are incorrect for doing an MBA, there are some reasons why I think MBA makes sense.
I will first put a quantitative reasoning for doing MBA, this would certainly make my economics professors happy.

• Reason 1: There would be more than 2 Lac CAs and more than 1 Lac MBAs (from premier B Schools) in India. However there would be less than 1000 people who are both. Now the choice is yours, whether you are happy being a part of 2 Lac CAs or a part of 1000 CA+MBA.

• Reason 2: Doing an MBA after getting good under-grad degree and a decent work experience sends signal to the outside world that you are serious about your career and better of the lot. It’s like a guarantee / warranty that manufacturers give on their product to signal that their product is better.

Now some gas, which I am really not good at. I have never experienced a campus life and hence doing MBA gave me a taste of campus life where you interact with people from difference background. I enjoyed my stay and learnt a lot from peers and professors whom I would have never met otherwise. I feel this is very important, but difficult to describe why at this stage, maybe once I work for few more years I would be in a position to mention the reason.

Coming to another question of ISB vs IIM, well my view would be its up to you. It is important to select a good B school whichever it may be will not have material impact on the objective.

Few professors from whom I learnt a lot and would certainly remember for life were Prof. Sanjeev Das, Prof. Prashant Kale, Prof. Dishan Kamdar, Prof. Henry Moon, Prof. Shamika Ravi and Prof. Subra.

Few colleagues that were great peers to have at ISB; Amit Uncle and Dilpreet Singh my study group mates and our dear neighbours and block mates Suketu Shah, Sandeep Gupta and Vikram Garg.

This post would be incomplete without mentioning the name of one important person who was my pillar, she is none other than Jinal; my friend and also my wife who put her career at stake and supported me all the time. I owe a lot to her.

Life after ISB

What a year it was... and experience worth having. At first it seemed like life came at stand-still... we were running at the peak speed and suddenly got in a slow train!!!

I had a 2 months break from April to May before I joined Aditya Birla Group from June 1st in their leadership programme. All the planning was in place for visiting to Kutch, then going to Thane for attending KP’s wedding for couple of days, then heading to a silo in Vipassana, post that going to Koregaon – Mahabaleshwar – Thoseghar, finally going to Nageshwar. Wanted to go to Shirdi but that did not happen as Moulik was not well.

Felt like writing about each journey but skipped that idea as it would be too boring. But certainly felt great after ISB. The first change was no internet, no email and no work. What a relief it feels when you have all the time at your disposal. At times you also feel that internet and email have done more harm than benefit. I really felt at bliss not checking emails except when it came from ABG (and that too courtesy Aditya Satpute who informed me whenever there was a mail). But certainly we missed ISB, more than me Jinal missed it a lot. You get addicted to the atmosphere at ISB and is a bit difficult to come to reality after a year there.

A standard question after ISB was should you do MBA after doing CA and having five years of work experience? The answer would be a bit long and hence I have made a separate post.

All in all ISB was a refreshing break for one year.

Term 8

Prof. Shamika Ravi, ISB

Business Law – Prof. Sumesh Reddy, DRL

Strategic Innovation Management – Prof. MB Sarkar, Fox School of Business and Prof. Anand Nandkumar

Term 7

Cases in Corporate Finance – Prof. Suren Mansingka, University of California

Change Management – Prof. Ramnarayan, ISB

Economics of Strategy – Prof. Louis Thomas, Wharton