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Microfinance Focus , October 2010 : Less than a year ago, Microfinance Focus Senior Analyst, Daniel Rozas, published an article "Is there a microfinance bubble in South India?" which raised a warning flag about a developing bubble in Andhra Pradesh and highlighted the issue of potential over-lending to borrowers. Rozas wrote:

“The spark that sets off a large-scale delinquency crisis can be anything and could come at any time – a rapid drop in economic growth, a populist political movement, a religious decree, or a collections effort gone bad.  One can’t control the spark, but one can control how much fuel that spark can ignite.”

That spark has now been ignited.  Whether the flames can be put out quickly enough to prevent disaster is by no means assured.  We hope they will be.  But it is also deeply disappointing to see the sector having come to this point.   After all, there was no lack of recent examples to learn from:  the US financial market, Bosnia, Nicaragua, Morocco, Pakistan, Kolar, and even Andhra Pradesh back in 2007.  So why are we here?

MFIs were simply too busy to implement real changes. SKS (largest MFI in India) was too busy with its IPO.  Other large NBFCs were too busy trying to catch up to SKS.  Regulators were too busy worrying about profits and interest rates.  Meanwhile, growth has continued unabated, especially in Andhra Pradesh.  As Daniel mentioned, the quest for rapid growth could lead a MFI or industry to be so preoccupied that they do not realize the bubble they have been building up during this growth phase.

We hope that – finally – MFIs will grow up and realize that the status quo is no longer tenable and we hope they will seriously sit down with regulators and find solutions that will finally put an end to fly-by-night operations, unconscionable collections practices, and dangerously weak lending standards.  For if they fail to heed even this signpost, MFIs will deserve the fate that will undoubtedly await them next time around.

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The AP Ordinance on Microfinance – a solution with more problems

Microfinance Focus , By N. Srinivasan : The objectives of the ordinance are laudable.  Protection of low income clients from exploitative practices and enhancing levels of transparency are valid public policy objectives of a sovereign government.  High debt levels, multiple operators providing loans as also pressure on repayment rates are legitimate cause for concern.  The remedy being applied does not seem appropriate to achieve the objectives stated for introduction of the ordinance.

The drafting of the ordinance leaves a lot to be desired.  The definition of Microfinance institution as it stands in the ordinance includes banks, and even SERP and its federations as these entities are either ‘providing loans to low income clients or offering financial support to them’.  The definition of low income client is not available either in the ordinance or anywhere else.  This leaves wide scope for interpretation. The requirement of display of interest rates does not define ‘interest rate’.  Whether flat rates, monthly rates and other confusing rates can be displayed?

The stipulation that ‘interest should not exceed principal’ clearly exhibits the disconnect between the law and ground realities.  Most MFI loans are of one year tenor and the stipulation in the Ordinance is seen willing to allow up to 100% rate of interest!  With practically no loans beyond three years, this stipulation seems redundant for MFIs, but will hurt bank loans of longer duration.  In reality, the stipulation will tend to reduce the duration of loans in all institutions in order to escape revenue loss and incursions in to autonomy of pricing.

While the law prohibits a third loan being given regardless of the source of the two existing loans, the verifiability of information on existing loans of borrowers has not been taken in to account.  Given the fact that in AP the numbers of microfinance loans are more than nine multiples of poor households, neither banks not MFIs have any scope of future operation in the state.  A survey made last year on access to finance in AP[1] brought out that 83% of surveyed families had two or more loans and that the median number of loans per family was four. Informal loans had been taken by 82% of surveyed families and how to verify these when institutions have to reckon ‘loans from all sources’

The requirement that repayments have to be made in panchayat offices only might hurt the banks as they have visit the panchayat office on due dates.  MFIs have a regular system of collection of loan dues in weekly, monthly intervals depending on the structure of instalments, whereas Banks which lend to SHGs get the repayments made in their branches.

The stipulation that effective rate of interest should be made known to the borrower is a valid requirement.  It should also define the term ‘effective rate of interest’ and how it is to be computed.

The requirements of the law are that a list of borrowers with details of each loan should be provided to the registering authority at the end of each month.  With more than 23.5 million microfinance clients in the state, information handling is set to become a nightmare.  The capacity of administrative machinery to handle registrations, monthly returns, complaints, no-objection certificates and penal proceedings may need to be increased manifold.  At present the named registering authority (DRDA) is finding it difficult to handle its existing work of district rural development.  Monitoring the programmes and ensuring achievement of intended plan outcomes has not been easy at the district level.  Loading the authorities with a huge volume of work of a very different nature is bound to cause  delays, frustration and generally chaotic conditions around these offices.

The stipulation of returning the loans taken from a second SHG within 3 months could be harsh and might cause distress especially where the funds are used to part-finance income generating activity.  If the loan was applied for medical treatment or lifecycle needs such as marriage, the return of money within 3 months would be even more difficult.  When loans of adequate size are hard to come by from any single source, forcing customers to refund the loans already availed might end up as disservice.

The threat of fines and imprisonment of directors and staff of MFI for coercive action (which includes repeated visits to the customer for recovery of dues – “frequenting the house or other place where such other person resides or works, or carries on business, or happens to be”) is a sweeping one.  Some directors onboard of banks including senior civil servants in Ministry of finance or RBI can be jailed, if a branch manager or field officer of their bank visits a borrower, say, four times a month.  Professional independent directors may not be willing to take board positions in financial institutions that have operations in AP.

The fast track courts are a good idea.  MFIs by and large do not have access to legal remedies against defaulters.  The fast track court mechanism, if implemented well, would provide millions of customers and the MFIs with a judicial option for settlement of disputes.

The infirmities in drafting create a void between intent and application of this ordinance.  Lack of definitions or precision in definitions, a disconnect from ground realities of business and inadequate appreciation of the volume of work involved in enforcement of the law would tend make the implementation vexatious for all concerned.

A deeper examination of the law suggests that it is intended to keep SHG lending secure from competition of MFIs.  The law creates an uneven playing field by making one of the competitors (the State’s Rural Development machinery that drives the IKP) as the controller and arbiter.  By loosely defining microfinance, it subjects IKP and its mechanisms (VOs, Mandal Samakhyas and SERP) also to the ordinance.  They also need to register, provide monthly information, ask for no-objection and verify whether borrowers already have two loans including from informal sources, etc.  The banks should also comply with requirements of the ordinance as long as they provide loans to ‘low income people’.

While the timelines for application for registration, second loan to SHG members, etc., are specified, no time lines have been specified for disposal of applications.  A deemed approval at the end of a certain period from the date of application would have been appropriate.  The application for no-objection for second loans and monthly lists of borrowers provide information to the competing institutions and could potentiality breach customer confidentiality, especially in the hands of banks.  The basis on which no-objection for second loans would be issued is the information provided by MFIs.  The district authority is vested with the responsibility of enquiring in to whether SHGs have understood the loan terms and whether the loan is likely to provide additional incomes before providing a no-objection.  The likelihood that registering authority will have more information than the financial institution to take a decision on the appropriateness of the loan is remote.  But the mischief potential is that the SHGs can be influenced during the process to withdraw the application from the MFI as the registering authority has responsibilities as a department of the government for the SHG linkage programme.

The propensity to borrow is very high in AP.  CMFs’ sample survey in AP brought out that 82% of families had loans from informal sources.  The median number of loans taken by households was four.  The chances are that three out four of these loans are from the informal sector.  The ordinance does not have the capacity or mechanisms to deal with loans from informal sources.  High rates of interest and coercive processes are issues associated more with informal lending.  Restriction of members from joining more than one self help group militates against basic freedoms granted to people.  The restrictions on providing loans to willing customers (whether second or third) erode the freedom given citizens to pursue legitimate business or commerce.

During a recent visit to AP, discussions with Banks and MFIs as also customers of microfinance revealed that recovery rates of loan dues had fallen to around 85% on bank loans to SHGs even while MFIs posted high recovery rates of above 98%.  SHGs covered under government’s programmes had a comparatively bad repayment record.  Without getting in to a debate on veracity of reported information and underlying mechanics of the recovery effort, the State’s programme is seen to have come off second best.  With an intensely monitored and controlled regime if a State run programme is unable to match recovery efficiency of private sector institutions, it a natural cause for concern.  But the solution to the problem does not lie in the ordinance.  It lies elsewhere.  A critical look at the programme design, capacity of staff, institutional development measures relating to VOs and federations and the exit strategies would provide better answers to the problems.

On the part of MFIs the current situation is substantially of their making.  Some did not heed good advice both from within and without.  Multiple lending and associated problems faced in Kolar were not seriously internalised.  High interest rates even in the face of declining operating costs and the resultant high return on assets have been criticised over the last two years.  The proposition that high growth rates and accelerated expansion of outreach require high profitability has been questioned.  The need for patience in recovering investments and the nature of equity (patient capital) that would best fit institutions in the sector have been time and again debated.  Regardless of the ability of customers to pay high interest rates, the underlying political economy issues of doing business with vulnerable customers have been consistently ignored by some MFIs.  Even with the code of conduct in place from two networks, deviant behaviour was in evidence.  While suicides might not be related to loans at all (and not MFI loans either), by the kind of market behaviour exhibited by some MFIs, the sector added grist to the cynics’ mill.

Regulation should have focussed on rates of return, governance reforms, transparency in dealing with customers, grievance redressal, ombudsman mechanisms and framework for restructuring of debts of customers under stress.  The state could have brought down the level of debt related stress by making available soft funds to MFIs for on-lending under conditions similar to those under which Banks in the state lend to SHGs.   Instead the State has chosen to adopt a combative stance towards MFIs (may be on account of its perception that MFIs are competitors).  This impacts more than 6 million existing clients of MFIs and Rs 4000 crores of loans a substantial part of which is provided by banks out of depositors’ savings.  The stance against coercive practices, on account of the publicity, is likely to erode the credit culture, placing at risk the already weak portfolio of banks loans to SHGs currently put at Rs 11000 crores given to about 12 lakh SHGs in the state.  Where does this leave the government and the sector?  Whether the ordinance will make things better or vitiate the operating environment of microfinance and reduce choices available to people?  Between the government and the MFIs (both claim being champions of the vulnerable customers) 25 million households have an uneasy time.

[1] Access to Finance in AP, CMF- IFMR for CMR-BIRD funded by NABARD