Big concerns over small loans

• High interest rates: The effective interest rate charged by microfinance institutions (MFIs) to their clients has varied between 24% and 40% per annum. Given that default rates on microfinance loans are extremely low, these rates seem “usurious". MFIs justify them, citing high operating costs involved in serving remote areas with small loans. However, recent equity market valuations suggest that in reality, stable return on assets are 8-10% for an efficient MFI charging 28%—much higher than that of banks and other non-banking financial companies. So, even while it is true that these rates are lower than those charged by informal lenders and within the envelope of returns earned by clients from micro-enterprises, there is clearly massive room for lower rates. But the big question is: How will these lower rates come about?

If economic history is anything to go by, definitely not through regulation that caps rates and shrinks supply. One alternative could have been a benevolent public sector that charges “fair price" for the same service and puts pressure on the private sector. Let’s examine the self-help group (SHG) programme. Banks lend to an SHG typically at 12%. This is, according to the Rangarajan committee, 10-20% lower than the true total costs of a bank even after fully accounting for implicit subsidies from the government by way of cheap refinance and privileged access to low-cost current account and savings account funding. SHGs acting as quasi-banks, in turn, lend this money (and internally raise deposits from a few members) to the end client at around 24-48% per annum. These rates are comparable to those charged by MFIs and mean that there is no pressure on rates from public sector alternatives.

Therefore, the only way out is to aggressively promote competition between entities and facilitate entry of disruptive new models. However, any mention of competition is met with grave concerns regarding multiple borrowing and evergreening.

• Multiple borrowing and excessive client leverage: Talk of unfettered competition prompts images of borrowers collapsing under a mountain of credit card debt in South Korea. When educated and disciplined South Koreans could not escape this debt trap, how can we expect the hapless illiterate rural Indian borrower to do so? Facile comparison, we think. The low-income borrower is in fact a careful money manager and is not easily enticed by promises of more “easy" money— more so when she knows that it needs to be compulsorily repaid. In addition, the group structure and the threat of credit denial upon default puts enormous pressure on members to be conservative on amounts and purposes. Researchers, on the contrary, rue that microfinance does not help entrepreneurship, given the small amounts and extreme risk aversion created by the group model.

• Evergreening: A related concern with competition is that new loans service old loans. From our experience, the near-zero default rates are a fact. The Grameen Bank methodology requires people to borrow in groups, guarantee each other and make repayments of principal and interest in weekly instalments. Eligibility limits start at ₹ 5,000, rise gradually, and cap out at ₹ 5,000 per member. These limits have remained intact in nominal terms for over two decades, and have thus halved in real terms. This approach results in clients borrowing conservatively and relying on current income for repayments. Research shows that the closest parallel to a microloan is a mandatory/disciplined savings programme. Clients view the loan as a disciplining device to create assets for the household, rather than leverage in the commonly understood sense. The weekly instalments, combined with low default experienced by all players, make evergreening a technical impossibility and fit more neatly with the desired savings patterns of rural households.

• Excessive credit discipline and coercion: When times are good in microfinance, the coercion by groups to repay is applauded as the beneficial power of “social capital". Maintaining a high degree of credit discipline is at the heart of the microfinance success. However, in the case of group-based microfinance, this credit discipline is principally enforced by members of the group on each other because they are desirous of maintaining a good track record with the lender. The key here would be to not weaken overall credit discipline, but to protect clients in events where there is genuine inability to pay; emphasize process discipline at the time that the loan is made; and not rely on high-powered incentives for loan officers linked to collections. Industry participants such as Basix chairman Vijay Mahajan have repeatedly emphasized the role of insurance in providing a safety net to clients during bad times. These are useful directions for MFIs to pursue without losing focus on credit discipline.

It is critical that we don’t let years of hard work and innovation come to naught over imagined concerns or organization-specific episodes. The large, systemically important MFIs are routinely audited by the Reserve Bank of India (RBI). Boards, top management and investors have to be stewards of orderly growth and market discipline in any financial institution. Microfinance is no different. MFIs and lenders to these entities urgently need the certainty and the reassurance from RBI that they will be held accountable to the same standards.

Bindu Ananth and Nachiket Mor are president and chairman, respectively, of IFMR Trust.

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