Signs of froth in microfinance?

The microfinance segment is buzzing with activity.

On Tuesday, IDFC Bank Ltd said it will acquire a Tamil Nadu-based microfinance company with an asset base of 1,500 crore for a reported 300 crore. A few weeks before that, Axis Bank Ltd announced its entry in the urban microfinance segment.

In the equity market, microfinance stocks have been scorchers. Shares of Bharat Financial Inclusion Ltd (formerly SKS Microfinance) have gained over 50% from the start of this year, while others in the business like Muthoot Finance Ltd have gained a similar amount. Ujjivan Financial Services Ltd and Equitas Holdings Ltd, the two microfinance companies looking to convert into small finance banks, have gained 90% and nearly 60%, respectively.

These may seem like disjointed facts, but when strung together they go on to show that interest and excitement around the microfinance segment is at a high. Not convinced? Look at the kind of growth that the microfinance sector is seeing.

The gross loan portfolio of microfinance institutions (MFIs) stood at 53,233 crore as of 31 March 2016, up nearly 84% from 28,940 crore a year ago, according to data from the Microfinance Institutions Network (MFIN), a self-regulatory organisation for the industry. While the loan portfolio jumped 84%, the client base increased at roughly half that pace of 44% and branches increased just 22%, Mint’s Sahib Sharma reported on 27 June (Read here: http://bit.ly/28XnmBc).

In fact, growth rates have been on the rise over the past few years. In fiscal 2015, the gross loan portfolio grew about 48%, while in the previous year growth was at 69%. Since financial year (FY) 2012-13, the gross loan portfolio of the sector has grown from about 11,600 crore to more than 53,000 crore as of March 2016.

“If there is a sharp growth in lending amounts, and no concurrent growth in the physical outreach of branches and employees, then it is most likely that the credit checks of identity, pipelining and utilisation may be short-changed. This would happen with aggressive growth targets for the credit officer, as the person is stretched to add more portfolio. The growth rates are themselves driven by investments and valuations. At this time, we have all the ingredients of a potential crisis,” wrote M.S. Sriram, a visiting faculty at the Centre for Public Policy, Indian Institute of Management, Bangalore, in an article published in Mint on 26 January. (Read here: http://bit.ly/1KKzVds )

Let’s analyse the issue using three lenses—the level of penetration of microfinance loans, the quality of data based on which lending decisions are being taken, and certain socio-economic realities.

There is a general belief that given India’s large population and the proportion of the unbanked population, the scope for growth in an activity like microfinance is huge. That may ring true at first. But if you look at the penetration levels in some key states, you may come away with the impression that the addressable market, or at least the low-risk addressable market, is not that large.

In a report published in August 2015, analysts Parag Jariwala and Vikesh Mehta of Religare Capital Markets showed that the penetration levels in key microfinance states are no longer that low. For instance, penetration of microfinance as a percentage of total households is at above 20% in Tamil Nadu, Karnataka and West Bengal. When assessed as a percentage of poor households, penetration is even higher.

The states where penetration levels are low are northern and western states like Bihar, Uttar Pradesh and Gujarat, and these are some of the states where microfinance firms are trying to expand. This expansion is essential so that they can maintain the kind of growth rates they (and in some cases their private equity investors) are targeting. The point here is that penetration levels in themselves may not be low enough to justify the rapid growth.

The second issue is of the quality of data that microfinance companies are using to assess the credit track record of a client. There are two loopholes in the data. Firstly, there isn’t enough historical data, particularly in some of the newer markets to understand what customer behaviour will look like at different stages of an economic cycle. So, the data will tell you the credit worthiness of a client at a certain point in time but not how it has changed. The data also does not take into account loans taken by microfinance customers from banks and other sources.

Jariwala makes another important point here. The default rates are unnaturally low for a lending business where non-performing loans are natural. His contention is that clients will repay till they see the prospect of getting a higher loan the next time. But loan ticket sizes can’t rise forever. Jariwala asked that once the promise of additional lending based on repayment track record goes away, could default rates rise?

The third issue that is worth pondering over is whether the experience of microfinance across southern states can be replicated across states such as Uttar Pradesh and Bihar, which are now hotbeds of microfinance activity. Given the divergence in women empowerment trends in the south and in the north, could the experience of lending to women be very different across regions?

To be sure, there is nothing in the reported data yet to suggest that the microfinance sector is hurtling towards another crisis.

There are also much more stringent checks and balances that have been in place since the Andhra Pradesh crisis. Even so, there is enough reason to keep a sceptical eye out on what is happening in the space.

Ira Dugal is deputy managing editor, Mint.