By Sanjay Behuria,

Microfinance Focus, December 28, 2010: What is being termed as the death of microfinance is really the death of microfinance institutions. As long as there are poor people in need of capital to eke out a living - microfinance will exist. In the wake of the AP Government ordinance - now Bill, on MFI activity in the state, questions are being asked by all stakeholders whether MFIs are moneylenders working in the guise of social activity - wolf in sheep's clothing? This paper is being written after making intensive visits to the field and interviewing various stakeholders. There are two major questions that will be answered during the course of this paper - whether some MFI's  killed the golden goose in their quest for quick money and whether the rest of the MFIs continued to see the naked emperor in  clothes until the government removed the wool from their eyes?

What is Microfinance?

Microfinance has evolved as an economic development  approach intended to benefit low-income women and men, mostly women. The term refers to the provision of financial services to low-income clients, including the self-employed. Financial services generally include savings and credit; however, some microfinance organizations also provide  insurance and payment services. In addition to financial  intermediation, many MFIs provide social intermediation services such as group formation, development of self confidence, and training in financial literacy and management capabilities among members of a group. Thus the definition of microfinance often includes both financial intermediation and social intermediation. Microfinance is not simply banking, it is a development tool.

Microfinance activities usually involve:

• Small loans, typically for working capital

• Informal appraisal of borrowers and investments

• Collateral substitutes, such as group guarantees or compulsory savings

• Access to repeat and larger loans, based on repayment performance

• Streamlined loan disbursement and monitoring

• Secure savings products.

Although some MFIs provide enterprise development services, such as skills training and marketing, and social services, such as literacy training and health care, these are not generally included in the definition of microfinance. BASIX has pioneered these services under the name of livelihood promotion services, and bundled it with its credit services - known as credit plus services, as also some services independent of credit.

What is an MFI?

An MFI is an institution that delivers microfinance, mostly microcredit at cost plus and recovers the principal along with interest. An MFI can be a NGO (society or trust), a not for profit company, a NBFC, a co-operative, or a Bank.

Who are the clients?

The clients of MFIs are those who have an economic activity that has a gap in it's cash flow and therefore needs funding to plug the gap to complete the economic/production cycle for the most effective result. Such gap can be a shortage of combination of financial and non-financial inputs. Their needs are however small -micro and therefore too cumbersome for commercial banks to handle. Any credit need below Rs. 50000 is defined as micro-credit. However, the ultra poor who do not have an economic activity are not microcredit clients, primarily because the borrowed money cannot result in generating positive cash flow in the absence of economic activity. There have been questions about microfinance being used as consumption expenditure by clients. The test here is that microfinance looks at the entire cash flow of the client in a holistic way and is not targeted to cash flow from any particular activity. For instance, if a borrower has an economic activity, but is unable to attend to it due to health reasons and needs a health related loan so that they can return soonest to continue their economic activity - this would be an eligible microfinance loan.

MFI funding strategy?

In the early days MFI loans were made out of grants and charities. There are still many MFIs known as NGOs who use grant funds for their MF lending. Some have leveraged the grant fund to borrow from banks to on lend. The for-profit MFIs invite private capital to build an equity base. They then leverage this equity to borrow from banks up to 6 times the capital to onlend.  In both cases the donor grant and the private equity is only 15% of money lent to the sector. The other 85% comes from Banks which are depositories of public money. It is therefore erroneous to suggest that private capital is the mainstay of the MFI funding strategy. However, private capital is the mainstay of drive for profits which has led to the current crisis. The classic case of killing the goose that lays golden eggs. Instead of looking after the goose which can continue to lay the golden eggs for all stakeholders, the controlling institution (MFI) kill the goose in the hope to get all that is inside, in one stroke.

MFI business strategy?

The current business strategy of most MFIs, especially the for- profit MFIs is to scale up and be sustainable. What this has meant is expand portfolios at a scorching rate and charge whatever and in whichever name as long as no one is objecting. Back this up with social collateral or group guarantees, in whichever name we call it, and lend on the basis of this collateral, while the original premises was to lend to meet cash flow demand of the borrower's business cycle.  This has led to multiple lending and multiple charges resulting in overall dissatisfaction. The ordinance has given vent to this pent up feeling which has been reflected in recoveries.

The game is played by capitalists in the guise of social entrepreneurs who invite private capital looking for extraordinary profits. Promise them a return on asset of 6%. Show them a leverage that is six times equity. With Banks having to lend 40% of their portfolio to the priority sector and preferring the indirect mode , this is easily done. End up with a return on equity of 35% and invite more private capital in the name of scaling up. As a result of this, private capital recovers its investment in 3 years and all that is left in the cycle is 100% public money from Banks. This is the time to kill the goose that lays golden eggs. Increase your margins further, show super extraordinary profits and milk as long as possible until the administrators’ cry- but the emperor is wearing no clothes. Time to hide your nakedness. The bad ones run away, the good ones get new clothes to survive and the financial system is stuck with public money indiscriminately loaned out in the chase for super profits by private equity that cannot be recovered.

How the super profits are earned?

The MFIs earn revenues from:

• Interest

• Loan processing fee

• Cash margin

• Commission from value added services - insurance, providing technical assistance, capacity building

The MFIs are accused of earning super profits through high interest rates and imposing other fees and being non-transparent in how they charge their clients. There is no equivalent to "Truth in lending". Thus MFIs charge interest rates either on flat (on loan amount regardless of outstanding) or declining (interest on outstanding balance). They also calculate or compound on daily, weekly or monthly basis. Thus a nominal rate of interest without the qualifications of how it is calculated, does not reveal the real interest rate.

Thus far MFIs have justified the high interest rates, quoting various reasons:

• They are lower than moneylenders - as if that is sufficient reason for charging high interest rates for the benefit of private capital in the guise of social capital

• They are lower than government rates, when bribes, delays and travel costs are taken into account

• The cost is high as the MFIs are not allowed to take deposits and lend borrowed funds

• The cost of delivery is high as the transaction costs are high due to the volume and door step delivery

• The poor can pay - so why not charge them

Thus they charge 24% (or thereabout) interest, which is explained as:

• Cost of funds 14%

• Cost of operations 6%

• NPAs 1 %

The above calculation leaves them a return on asset of 3%.

In the above justification, there is no mention of what is reasonable. According to this author since the MF sector is in the financial sector, the average return on assets of the banking sector can be used as a bench mark for assessing reasonable profit. There may be a case for benchmarking prior to adjustment of NPAs as the MFI sector claims lower NPAs than the banking sector and will be entitled to the higher profits for their efficiency.

They also charge a loan processing fee which can go up to 4% for some.

What is loan processing fee? The MFIs will find it hard to explain the loan processing fee when they account for operations cost in the interest rate. Is the loan processing done by an outsider to whom they have to pay a fee for which they recover from the client? If not what is the basis of the fee - is that not double counting for their operations cost and therefore usurious? Do the MFIs shorten the term of their loans so that they can earn the fee more often when a loan is repeated? Does the shorter term of the loan increase the amount of repayment of principal, thus burdening the borrower to repay faster than its generation of cash flow? In the end does it violate the purpose of the loan and force the borrower to seek cash from another source to repay the demands of the first loan which should have come from the cash flow of the economic activity? Do the MFIs in their quest for faster and higher income, force the borrower to violate the basic principle of a micro finance loan? Then, how can they say that the government or an ordinance or an external stakeholder is responsible for killing microfinance? Have they not hanged themselves by breaking their own principles which led to financial, economic and social success in the earlier years? Did the government expose the emperor or the emperor was never wearing any clothes? These are the questions that must be answered if microfinance is to re-emerge from the mess that it is, for the benefit of all stakeholders.

Cash Margin:

When an MFI makes a loan it insists that the borrower puts up ten percent in the name of equity for equity. This is a fair practice - as long as the borrower's equity is employed in the business - as her stake. Instead, the MFI takes this in as a security deposit at a low interest rate and uses it as a funding resource. By doing this the MFI squeezes its own borrower's working capital and puts at risk the repayment capacity of the borrower through under-financing of their cash flow requirements. It also increases the overall cost of the borrower and fattens the profits of the MFI as this deposit is cheaper than borrowing from banks.

Commission from value added services:

This is a fair charge as long as value is being added. It must be remembered that all services start with good intentions. However, all solutions become the next problem. Also, all solutions have both intended and unintended results. These are natural principles, which we cannot argue with. We can pre-empt and deal with them to the best possible extent that more of intended results flow from such solutions. To calculate them as hidden interest income is also not fair, either to the borrower who needs the services or to the service provider.

Multiple lending:

Currently, multiple lending is being viewed as the scapegoat for all the woes of the MF sector as it may in some cases result in over indebtness. What is multiple lending? Multiple lending happens when many agencies lend to the same entrepreneur for the same activity leading to over finance. Over finance may lead to the start of a new activity, scaling up the existing activity or siphoning off the excess supply for consumption purposes. When the latter happens the borrower uses one source to repay another source and becomes perennially short in cash flow to repay all their obligations. Is multiple lending bad when the borrower is unable to meet the cash flow need from a single source? Do not the large business and small businesses use multiple financing for their businesses when they are underfinanced? As the micro loans are often limited and many micro businesses have additional needs, a single source of supply cannot meet their cash flow needs. Therefore, what needs to be investigated is whether borrowers are underfinanced or over financed. Once that is determined then and then can the vicious cycle of multiple lending be rectified. There will be a need for co-operation of all lenders to start a local credit bureau to share lending information rather than burdening the borrower to go to every lender to obtain a no objection certificate.

Collection practices:

Ever since banking started bankers have needed to visit the borrower on site. This has been required both at the pre-sanction and the post-sanction phase. At the pre-sanction phase it is required to know the place of work of the borrower, to understand the activity and the working capital cycle. To assess the borrowing capacity and evaluate the existing assets. Similarly, at the post sanction phase inspections are carried out to check out the assets, the continuation of activity and for technical assistance. Even if the incidence of excesses in recovery are true, we cannot throw out the proverbial baby with the bath water. If we did, then lending activities will stop as recoveries dwindle and the real sufferers will be the micro entrepreneurs in dire need of capital. Instead, it will make sense to always visit the borrowers in groups where witnesses are available or always invite the neighbors while making site inspections. Any complain must be investigated and the culprits punished accordingly. Personal contact and relationships are an integral and significant part of lending and recovery without which the business will die a swift death.

Joint liability group, co-obligates

The current MF structure is heavily based on peer group social collateral to assure repayment of debt. This has worked well over the last thirty years, but now seems to be crumbling under its own weight. Any leverage is a double edged sword. When capital is leveraged ten times, every rupee earned on assets returns ten rupees on equity. Conversely, every rupee lost on asset results in a ten rupee loss of equity. The current crisis has witnessed that many borrowers are themselves not reluctant to repay, but are not repaying under social pressure.

Joint liability per se is not a sufficient reason for repayment potential. It is only a collateral, even if social, and is secondary guarantee to the cash flow generated from the loan. It is again an unintended result that JLG which was meant to be a collateral has become the primary purpose of a loan. If you have a JLG, you have a loan. Without a purpose, an activity, a cash flow, loans are given as long as JLG exists. What is a secondary reason for repayment, has become the primary purpose of the loan. The only assurance of repayment can come from cash flow from the activity, and therefore it becomes necessary to do individual loans without collateral for microcredit.

Compassion:

Many borrowers complain about how the MF system has lost the human touch and is too mechanical. The MF recovery practices have a fixed date and fixed amount and regardless of the situation of the borrower the money is demanded, even when unforeseen calamities have destroyed the assets of the borrower. There is little scope to understand the borrowers changed circumstances and make adjustment to the repayment obligations leading to distress. Most field staff will answer the borrower, "My system does not allow repayment scheduling - if you don't pay now, I will not know what to do next."

What next?

As long as micro entrepreneurs exist and have a shortage of capital to meet their business needs micro finance will exist. It has morphed over thousands of years from simple money lending to micro finance as it existed before the ordinance. At every stage there have been shenanigans who have crossed over from being do gooders to evil doers and killed the golden goose. However, such acts have every time  pulled more do gooders to fill the vacuum, and this time there will be no difference. Let us now look at the possible future of the sector and how the funding and associated needs of the business at the base of the pyramid will be met.

We have already established that the existence of private capital is more myth than reality. Most of the MFI portfolio as they exist now is either grant money or public money. The banks who have employed the public money have taken little responsibility to protect the public money and have basked in the successes of the MFIs doing all the work while they have achieved their priority sector targets and earned decent spreads. This story is now dead. The banks must now take direct responsibility for the deployed funds as the collection of those funds can only lead to further lending.  The story so far is that Banks do not know the nitty gritty of microfinance and the MFIs do not have the funds. So the partnership model was the perfect opportunity for both parties to meet their objectives. The third factor that impinged on the current model is the greed of private capital. The answers therefore must lay in continuing the banks to achieve their objectives with higher accountability and responsibility, allowing MFIs to do the job they know so well - without the control over the portfolio and eliminating private capital that comes attached with greed. Any private capital that is willing to invest at a bench marked return and improve on that through introduction of innovation and efficiency, needs to be embraced. There are two possible models to achieve the above objectives.

The first model is - continue the existing model with caveats. A' truth in lending' rule must be adopted which will define every aspect of lending for transparency.

Interest rates - while no caps may be prescribed the interest rates charged must be transparent. All MFIs  will align their interest rates to the standard format - calculate interest rates on daily balances and apply monthly.  They must also clearly specify the all in charge - a finance charge which includes - cost of funds, the operations cost as per last financials reduced at an interest rate percentage, average NPA and desired profit. The desired profit as explained above is a benchmarked rate of the financial sector of the country. There is often criticism about the NPA of MFIs . Using NPA to determine the finance charges will work to negate the perception that NPAs are manipulated. If a MFI declares a low NPA then they lose out on interest rate, if they declare a high NPA, their credit rating suffers.

Loan processing fee: This needs to be eliminated as they are already built into the operations cost. Any institution collecting LPF must be able to justify the additional cost apart from operations cost for his item.

Cash margins: They serve no purpose except to make the loans more expensive and under finance the business cycle by squeezing the cash flow, and therefore needs to be eliminated. However, the borrower may be asked to meet 10% of their financing needs and the fund needs to be in the business rather than sit with the MFI.

Value added services (VAS): While value added services are useful for efficiency, the manner in which they are currently done has led to a perception of manipulation of the borrower by bundling VAS with credit. To delink, the VAS needs to be sold prior to credit or post credit - as standalone services for which the borrower volunteers.

Multiple lending: At no stage must the total repayment of the borrower for all credit needs exceed 40% of their total cash flow generated during the repayment period. This is difficult to apply in the absence of a bureau where credit records of individual borrowers can be obtained. It is suggested that simple credit bureaus are established at Gram Panchayat levels. Since micro finance borrowers obtain credit at home and there is almost no cross over from one village to another to obtain credit, a national bureau is not required. All MF operators may agree to supply data of all their borrowers at a single point. Any lender must obtain full village data of borrowers before undertaking credit in any village. If they undertake any lending, the data must be immediately supplied to this point. This data will help the lender to limit total lending to 40% of the cash flow need of the borrower through an appraisal system that is standardized across MFIs. Since the funds essentially belong to banks, the banks must supervise this activity - the lead bank of a district will be an ideal candidate to supervise this.

The first model does not introduce higher responsibility and accountability of the primary lending institution whose funds are employed by the MFI and therefore is prone to negligence, misuse or even abandonment. The second model proposed here aims to overcome the shortcoming by placing the portfolio with the primary lender.

The MFIs become business correspondents of banks. However, they need to have a stake in the business and therefore provide 10% of the portfolio from their own equity. The entire portfolio sits in the bank as its own assets. The BC is compensated for all its costs and a desired profit which is benchmarked to the overall financial sector profits as already discussed. The compensation is also stepped down as per a declared quality of assets agreement. In this model the MFIs can collect savings for the principal agency and facilitate the transaction of the entire suite of financial inclusion services and provide access to finance, thereby further bringing down costs.

In the BC model the finance cost for the loan can be reduced to 16% for the beneficiary by taking out the MFI as intermediary. This is based on the theory that if a manufacturer can sell a unit of its product at the same price (MRP) regardless of its site of production, why do Banks have to charge different rates to different clients based on their location. The entire cost of operations should be divisible equally between all its clients. When the banks claim that MFI loans are about 2% of their portfolio and they reimburse 7% of portfolio ( 6% operations cost and 1% profit) as BC expenses, the cost of operations for MFI loan is 7/50 or a negligible 0 .14%. In this example the BC earns 9% on its equity from the Bank as well as minimum 16% on its lendable funds). This becomes important as the banks are making the loans out of deposits, which are coming across from various locations. Statistics will prove that rural centers have a more positive CD ratio than urban centers - yet rural clients pay more for receiving their own money! Thus the rate that will be charged will be a sum of and will be known as finance charges:

• Lending Cost or interest rate - 13%

• NPA cost - 2%

• Operations cost 0.14%

• Risk fund for mitigating distress - 0.86%

• Total cost to borrower - 16%

The above is not a ceiling rate, but a desired rate based on the overall market condition. There may be reasons to charge more than this. Since this portfolio is 100% risk weighted, a charge for blocked funds compared to other loans will be justifiable. Similarly, higher loan loss probability charge - this will not be possible if on time recovery of this portfolio is 99% and other portfolio where such loan loss charge is not levied is at 97%. As long as such charge is explainable and reasonable as per such explanation, it may be included in the finance charge.

A financial institution needs to make a distinction between interest charge and finance charge. Interest charge is only a cost of fund and a component of finance charge. All other charges will need to be clearly mentioned in the total of finance charges for reasons of transparency. In such a situation, the FI can answer the criticism of usurious rates charged to MF borrowers.

In both cases the operations cost is made transparent by making public the top ten salaries of the MFI. It is understood that the compensations are not capped but standardized. Again a financial sector benchmark may be used. Any large discrepancy in the salaries of the top people will immediately be noticed by all stakeholders. Also, the percentage share of the top 10 versus total HR cost will help to deflect criticism about the profits being siphoned off as shareholder salaries.

To be compassionate and earn the goodwill of the borrowers it is suggested that all MFIs contribute 1% of their profits, which can be added to the interest rate and build a corpus to help distressed borrowers in times of need. This fund is to be administered by independent ombudsman, who will go into each distressed case and deal with them as per clearly laid down eligibility guidelines. If such a fund existed, the MFIs would not have been blamed for the unfortunate suicides, which may or may not have been solely due to repayment demand abuses.

To save the micro entrepreneurs, to continue to strengthen the intended results of MF activity, it is now imperative that MFIN and Sa-Dhan work together. Set up clearly laid down guidelines with all MFIs as signatories and government intervention against any violating member. Meet with the government and the other stakeholders at the top level and get back to business. Otherwise, they are in danger of falling prey to demagogues who play the short term game and invite disaster to the financial fabric of the country. All must realize that the collapse of the financial fabric of the country, the banks, the intermediaries and the beneficiaries are in no one’s interest - they only feed the demagogues. The question is not whether the business will go on - it is a question of how it will be done and for whom. What is the highest purpose of micro finance - let us all get back to achieve that purpose. We have forgotten the basics, time to get back to basics.

Acknowledgments;

Mr. Vijay Mahajan, The Chairman BASIX and colleagues at BASIX India for their time and in-depth knowledge sharing.

About the Author: Sanjay Behuria is an Independent Director with KBS LAB - A BASIX group Banking Company under BRA (Banking Regulation Act). He is an independent strategy consultant in access to finance and enterprise development.

(Disclaimer: Views expressed in the article by the author are his own and do not necessarily represent those of Microfinance Focus. Microfinance Focus does not take any responsibility for correctness of the data presented by contributors.)