Synopsis : International microfinance is at a critical juncture in 2010.  As a sub-sector of the financial services industry, microfinance has evolved from the slow moving tortoise of the 1990s to the nimble hare of the early “noughties” (2000-05) and, since then, into an overcharged bull growing at 70-100% per annum in some markets.  The purpose of this note is to examine some of the key messages propagated by CGAP over the past decade and to propose a substantially modified agenda designed to address the critical challenges faced by the sector today so that the charging bull of the past few years can be transformed into a more serviceable creature in the decade that lies ahead.
The key conclusions of this note are that CGAP needs to modify its conventional messages such as “zero tolerance of delinquency” and “no restructuring of client loans” in the context of emerging over-indebtedness and the financial crisis.  It also needs to strengthen its messages in relation to governance, social mission and improving depth of outreach to the poor. For enabling it to “assist the poor”, CGAP should increase its engagement in graduation programmes for extreme poverty and, radically, expand its mandate so that it can support livelihood promotion as it has supported microfinance.  Above all it must avoid crowding out initiative in microfinance markets and apply strict transparency standards in its own operations in order to strengthen its brand and improve its efficacy.

1          Introduction

International microfinance is at a critical juncture in 2010.  As a sub-sector of the financial services industry, microfinance has evolved from the slow moving tortoise of the 1990s to the nimble hare of the early “noughties” (2000-05) and, since then, into an overcharged bull growing at 70-100% per annum in some markets (Figure 1), wildly chasing down the temptation of high MFI valuations put forth by the Compartamos IPO in 2007 and the private equity sales of some of the major Indian MFIs.  In the dust of its wildly kicking hind legs, the charging bull has raised all manner of dangers – internal control failures, multiple lending leading to significant risk of over-indebtedness, increasing rather than declining interest rates with the growth of the sector and, partly as a result, the looming threat of government intervention as the ills of its over-charged operations become better known and politicians spot the opportunity to earn popularity at the expense of microfinance promoters.

Figure1

Added into this melee is a changing of the leadership at the Consultative Group to Assist the Poor (CGAP), the international technical agency responsible for supporting microfinance and financial access for the poor, worldwide.  This imminent change opens up an opportunity for CGAP’s financial access agenda: the opportunity to reconsider its technical messages in the context of developments in the sector in recent years.
The purpose of this note is to examine some of the key messages propagated by CGAP over the past decade and to propose a substantially modified agenda designed to address the critical challenges faced by the sector today so that the charging bull of the past few years can be transformed into a more serviceable creature in the decade of the “teenies” that lies ahead.  The aim is to propagate a commercially successful sector, with a better managed approach to growth, that meets the needs of its clients by facilitating their financial lives with responsible systems that are fair to all stakeholders, including the community it seeks to serve, at the same time as being economically efficient.

2          Conventional wisdom in the tortoise phase

CGAP started life in the late 1990s, with the then daunting responsibility of transforming a tortoise-like sector run by a set of welfarist NGO leaders with a concern for the poor but limited knowledge or understanding of the principles of effective delivery of financial services.  In this environment, the organization set about developing a set of working norms and practices with the aim of building strong financial systems in the sector and fulfilling its mandate of maximizing financial access for the poor by promoting the growth of microfinance institutions (MFIs).  Some of the earliest principles developed for this purpose and aggressively publicized through technical seminars and training programmes during the tortoise and hare phases were

1        Zero tolerance of delinquency
2        No restructuring or refinancing of client loans
3        Clear awareness of sustainability performance
4        Microfinance services provided by separate, exclusively focused teams with no other responsibilities.
Thus, came to be established the conventional wisdoms of microfinance.  Specifically,

2.1       Zero tolerance of delinquency

In a tortoise environment where grant-funded NGO microfinance providers regarded the welfare of the poor as their primary responsibility, the common concern was that microfinance service providers were too tolerant of delinquency by individual clients (or client groups).  Such tolerance vitiated the credit environment by conveying the message that the lender would take a soft approach to late payments and may even write-off loans if reasonably convinced that repayment would put an onerous burden on the borrower.  CGAP, therefore, propagated the idea of “zero tolerance” in the hope of tightening credit discipline and ensuring that microfinance service providers would do a better job of recovering their portfolio than was the case at the time; non-performing loans of the order of 10-20% were common.

On the principle that “we value – and can manage – what we measure”, CGAP established a criterion  of “overdue for more than 30 days” for determining that a loan was delinquent.  Based on this, a new expression hitherto unknown in the financial lexicon was coined: portfolio at risk more than thirty days (or PAR30).  The PAR terminology implied that the entire principal amount in any loan that was more than 30 days overdue was “at risk” and should, therefore, be subject to both more intensive follow up than loans being paid on time and to loan loss provisioning in case of default.
The message of zero tolerance was simple: no microfinance loan should be allowed to become overdue and if, perforce, such an eventuality arose, the problem should be forcefully addressed both with the client and through prudential financial measures such as provisioning and write offs.

2.2       No restructuring or refinancing of microfinance loans

The tendency of NGO promoters to view clients as beneficiaries and microfinance loans as subventions to be repaid if possible was tackled not only by inculcating a zero delinquency culture but also by ensuring that the delinquency issue could not be by-passed through either restructuring (extending the loan term to facilitate repayment) or refinancing (disbursing a new loan to enable the client to complete payment on the overdue one and make a fresh start on repayments).  The microfinance sector was firmly warned that neither a restructured nor a refinanced loan was any better than an overdue one and the practice should, therefore, be strictly avoided if not banned altogether.  If there were any exceptions to this, such loans should be reported separately and all the financial provisioning rules applicable to delinquent loans should apply to restructured/refinanced loans as well.

2.3       Clear awareness of sustainability performance

NGOs providing microfinance services were typically grant-supported at this time though some borrowing from donors (as returnable grants) and commercial banks was also starting to appear.   However, in keeping with conventional NGO accounting, grants and income earned from the microfinance portfolio appeared as revenue items in the NGO’s financial statements and expenses were deducted from the sum of these to obtain a financial surplus for the year.  Accounting practices varied and grants could even be received directly through the balance sheet and incorporated in equity.  Such practices made it difficult, if not impossible, to establish the level of subsidy received by such organizations.  Many such NGOs had no idea to what extent their microfinance operations were subsidized; what’s more their funders didn’t either.  Transparency was an issue.

CGAP’s response to this situation was to establish clearly the practices appropriate to accounting for grants as separate clearly stated line items on the balance sheet and “below the line” additions to the income statement after calculating the surplus earned or deficit incurred from operations.  To emphasise the importance of this on the “we value what we measure” principle, CGAP developed and propagated the use of two new indicators, operational self-sufficiency (OSS) and financial self-sufficiency (FSS).  These were defined as

Operational self-sufficiency = Income earned from microfinance operations (including interest on loans given, loan processing fees and any other charges associated with the microfinance activity) divided by expenses incurred on microfinance operations (including interest paid on loans taken for microfinance portfolio financing, staff expenses, other operating expenses, depreciation and loan loss provisioning)

Financial self-sufficiency = OSS adjusted for subsidies such as below market rate borrowing for portfolio, in kind subsidies and an adjustment for the depreciating effect on the value of the institution’s own funds (or equity).  The effect of the subsidies and income necessary for maintaining the value of equity had to be removed from the OSS calculation in order to establish the financial self-sufficiency (also often referred to as the financial sustainability) of the microfinance operation.

2.4       Microfinance services provided by separate, exclusively focused teams with no other responsibilities in the field

At this time the typical NGO undertook a range of activities including health, gender, education/literacy, social mobilization and livelihood support as well as the provision of microfinance services.  As a result, it was often the responsibility of the community worker to dispense malaria tablets, hygiene information and gender relevant social messages along with the delivery of microfinance services, particularly loans (and occasionally the collection of deposits).  As a result the community interface of the NGO entailed a combination of the distribution of grant funded commodities (or even grants as cash for the purchase of treated mosquito nets, for instance) at the same time as the disbursement of new loans and the collection of repayments on existing loans.  The community worker was thus cast in the role of benevolent giver, on the one hand, and hard-nosed collector of zero delinquency loans, on the other.  Not surprisingly, the roles did not mix and, more often than not, the benevolent orientation of the NGO prevailed over the strict disciplinarian role of the lender both in the minds of the clients (or beneficiaries) and in the behavior of the NGO staff.

Naturally, the only response to this situation was to recommend the separation of not only social activities (health, education, drinking water, social mobilization, et al) but also livelihood support programmes from the pure financial services function. Despite the clear role of financial services in enabling the pursuit of livelihoods a combination of the delivery of the two types of activities was seen not to work; at the time, livelihoods programmes still entailed substantial grant distribution and pursuit of the two together was incompatible for the reason indicated above.  In addition, the dilemma of a team providing support services for livelihoods expecting to collect microfinance loans at times when the support livelihood was not delivering adequate income for seasonal or cyclical reasons was obvious.  Hence, CGAP promoted the full separation of microfinance teams from the other activities of such organizations and recommended the establishment of separate institutions, if possible, for the provision of financial services.

3          The successful evolution of the nimble hare…warts and all

The early years of the twenty-first century (2000-05) were heady days for microfinance and a tribute to CGAP’s success in gaining acceptance for its principles of good practice.  Not only did the financial practice principles of zero delinquency and no restructuring come to be overwhelmingly accepted and applied but PAR30, OSS and FSS amongst other monitoring parameters promoted by CGAP became standard ratios for benchmarking performance.  The principle of separation between microfinance service provision and other development activities undertaken by an organization became fully accepted.  Most organizations either established separate institutions for microfinance (which came to be known as MFIs) or, in the case of the older established organizations like BRAC in Bangladesh, ensured that financial services were provided by a distinct team not identified with the livelihoods and other interventions of the organization.  As a result, the growth of microfinance accelerated to a healthy 30-50% as illustrated in Figure 1.  While Latin America went through this evolution somewhat earlier, in most microfinance markets of Asia, Africa and Eastern Europe, market penetration remained limited at 20-30% with only Bangladesh of the major markets approaching saturation in some geographical clusters.

3.1       Transparency initiatives…was the MIX really necessary?

In order to contribute to and reinforce the process of monitoring and benchmarking, as well as to improve transparency to funders and governments, a new support services segment of the sector developed at this time.  Support institutions such as MFI networks/associations and training organizations had already started to enable the growth of the sector by the late 1990s; the hare phase saw the widespread use of specialized microfinance rating agencies for better due diligence and greater transparency of MFIs resulting in strengthening the flow of funds to fuel their growth.  Across the world, funders (donors as well as a growing legion of domestic as well as international commercial lenders) increasingly used microfinance ratings as a key due diligence tool for identifying opportunities to place their funds.  Financial performance rating came to be established during this period as an essential facilitator of funds for microfinance.  In India, the world’s largest microfinance market, microfinance ratings (mainly by M-CRIL), an eager development bank (SIDBI) that took the lead in providing debt funds to MFIs and the preferential “priority sector” lending requirement for commercial banks combined to create a situation where an analysis of MFI balance sheets for the 2005-07 period showed that as much as 80% of MFI funds were sourced as debt from (mainly) commercial banks.[1]

CGAP’s major contribution during this phase was the establishment of the Microfinance Information Exchange (MIX) in 2002 for strengthening the transparency that had already started to happen with microfinance ratings.  As its database of reporting MFIs grew, the MIX helped to establish benchmarks based on information from a wider range of MFIs than any of the rating agencies was individually able to do.  During this early stage of its work, however, the MIX benchmarks suffered from being based on information self-reported by the MFIs, sometimes with their own interpretation of the calculation of indicators like PAR and FSS[2] and often with conflicts of interest in reporting vis-à-vis competition.  Whether better results might have been achieved by persuading the specialized rating agencies to pool the data from MFIs they had rated is a question to be considered.

3.2       The suitability of the PAR30 criterion…is a variable criterion more appropriate?

Another issue that emerged at this time was the suitability of the 30 day criterion for determining delinquency.  It is a criterion devised from the experience of the flourishing, urban oriented microfinance sector in some Latin American countries in the mid-1990s.  The average loan term there was four months (120 days) for which a 30 day overdue criterion made sense in determining delinquency.  In the one year loan terms of predominantly rural microfinance in Asia and much of Africa, the suitability of this criterion could be questioned.  In Asia as much as 40-50% of rural microfinance loan portfolios are deployed in animal husbandry activities which have irregular revenues necessitating the repayment of micro-loans out of the borrowers’ family cash flows rather than directly from income from the investment enabled by the loan.  The 30 day criterion applied to such loans, represents less than 8.5% of an annual loan term and just two payments in a monthly payment cycle; conversely 30 days in a four month loan cycle represents 25% of the loan term and is suitable for the mainly trading activities (with daily cash flows) pursued by typical microfinance clients in urban Latin America.  A variable criterion, depending on regional conditions, would have been less convenient but probably more appropriate.

3.3       The lessons of the Grameen Bank experience of “no refinancing”

Finally, problems with the “zero delinquency, no refinancing” principle were also starting to emerge.  Around this time managers of far flung branches of the celebrated Grameen Bank were found to be extensively refinancing loans of delinquent clients, protecting their own standing with the bank’s management if not necessarily safeguarding its portfolio.  The Grameen Bank’s response to the potential hole in its balance sheet should, in fact, have sounded the death knell of the principle.  Grameen 2 allows widespread restructuring and refinancing in the sense that clients may repay varying amounts so long as interest payments and a small amount of principal are covered and it also allows top-up loans.  In conjunction with a flexible deposit scheme, Grameen 2 has become a highly successful programme and the Grameen Bank has become a revitalized force for financial inclusion in Bangladesh.  Yet, few MFIs outside Bangladesh have applied the lessons of Grameen 2 and CGAP’s principles remain the overwhelming mantra of MFIs throughout the world.

The discussion in this section has pointed to the emergence of some issues in the microfinance sector even as it started to grow strongly under the (largely) appropriate technical stewardship of CGAP.  The increased growth and improved performance of the sector during the hare phase was so successful, however, that such concerns as arose at this time were quickly swept aside and even those who dared to raise them were perhaps less assertive than they might have been.

4          The onset of the charging bull…

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In the early part of the past decade, the process of microfinance NGOs transforming into partially or fully regulated microfinance companies had begun.  By the middle of the decade, some of the early movers had already registered high growth rates and had been successful in mobilizing private sector equity funds.  This success infused significant momentum into the transformation process and the pursuit of MFI valuations led to growth (with zero delinquency) becoming the guiding principle determining MFI performance.  Inevitably, it was the markets with highest potential that registered the highest levels of growth. In India, M-CRIL’s India Growth Index climbed to the level 7,178 by March 2009 (and estimated to reach 12,000 by March 2010)[3] – registering an annual growth rate of 65% during 2006-2010.

Elsewhere in Asia, an already large microfinance sector in Bangladesh doubled its number of clients from 9.5 million in 2003 to around 20 million in 2008 and M-CRIL’s composite index of microfinance for the rest of Asia increased from 100 to 367 during the same period.  Worldwide, growth of the typical MFI was of the order of 25% per year during this period (slowing to 15% with some drying up of on-lending funds during 2008).[4] This will have resulted in a typical MFI serving around three times as many low income borrowers in 2008 as in 2003.  The average compound annual growth rate indicated by the MIX data was even higher at 43% for the period 2004-08 .[5] This translates to a four-fold increase in the number of borrowers over this period.  The charging bull of microfinance had truly been unleashed.
4.1       …leaves a trail of destruction as “zero delinquency/no restructuring” fundamentalism causes heartburn

In spite of a slowdown in 2009 due to reduced fund flows resulting from the financial crisis, the numbers served in many microfinance markets have now reached 50-70% of the potential.  The rest of this contemporary story is well known

•    On account of rigidities in microfinance outreach, 50-70% overall market coverage has resulted in significant pockets of local market saturation
•    Saturation has led to multiple lending in many places in the microfinance world
•    Managements have been unable to ensure that controls keep pace with the growth of outreach and portfolio
•    All of the above have caused vulnerability (and sometimes over-indebtedness) in a number of microfinance markets

– most notably in Bosnia, India, Morocco, Nicaragua and Pakistan.[6] Other markets, notably Cambodia, Nepal and various regional clusters in India (apart from southern Karnataka) are lining up for similar problems.

More particularly, the zero delinquency, no restructuring principles adopted by managements rigidly following the CGAP principle have sometimes led to overbearing collection practices at the loan officer-client interface, raising concerns about client protection.  MFIs are now courting reputation risk and are increasingly regarded as no different from the conventional view of moneylenders: collecting willy-nilly whatever the circumstances of the client.  Indeed, in southern Karnataka state (in India) this phenomenon has been the cause rather than the result of a delinquency crisis.[7]

4.2       Without necessarily “assisting the poor” or improving their livelihoods

Impact studies over the years and, more recently, surveys using practical tools for poverty assessment, such as the Progress out of Poverty Index (euphemistically named) and the Poverty Assessment Tool, have virtually established that while MFIs work almost exclusively with the financially excluded, this does not necessarily translate to working with the poor.  The financially excluded population in most countries with active microfinance sectors amounts to 60-80% of the total while poverty rates range from 10-40%.  Since MFIs cover, usually, no more than 20-40% of income earners (as opposed to the microfinance market), the research surveys referred to above have now established that MFIs work largely with the upper strata of poor households along with the vulnerable non-poor just above the appropriate poverty line[8] as well as the non-poor.  By and large studies by M-CRIL and its parent organization (EDA) in Asia and Africa have shown that MFI coverage of the poor (below the national poverty line) is often no more than the proportionate occurrence of poverty in the community as a whole.  Thus, at a time when the national poverty line indicated 25-30% of the population of India as having below poverty line incomes, just 29% of clients across 20 MFIs were found to have incomes below that level. [9]

Further, a series of impact studies with and without randomized controls have failed to establish any direct causal link between better availability of financial (more particularly credit) services from MFIs and increasing client incomes.[10] Indeed, CGAP having successfully promoted the growth and efficiency of MFIs partly by obtaining the separation of livelihood promotion from microfinance service delivery has also de-linked MFIs from enabling livelihoods.  Thus, while there is some evidence of reduced client vulnerability on account of the availability of bridging finance, there is not any overwhelming argument or evidence for CGAP’s work to “assist the poor” having reduced poverty.

Of course, CGAP does not work exclusively with the microfinance value chain – from investors to clients. In recent years (indeed during the charging bull phase), satisfied that much had been achieved in promoting microfinance, CGAP has also turned its attention to other ways of promoting financial inclusion.  Thus, it has engaged with issues such as the use of mobile devices, IT systems and business correspondent programmes aimed at increasing and deepening the outreach of the banking sector to the hitherto financially excluded.  This is a laudable move but has not yet delivered significant results.

4.3       Governance and social performance have also suffered…

While CGAP has excellent achievements in the fields of financial performance and the management of MFIs, it cannot claim to have done as much in some of the areas that are now emerging as the key to enabling MFIs fully to serve the needs of the poor.  These include various aspects of social performance management; while CGAP has a strong initiative on client protection it has not significantly addressed other issues that have emerged as significant weaknesses of MFI operations.  These include

•    the (lack of) depth of outreach of MFIs to the poor
•    the suitability of microfinance products to the needs of very low income clients –  the typical microfinance product is too rigid to do so, yet Grameen Bank has demonstrated that it is possible in certain circumstances to be more flexible
•    the employment effects of microfinance operations; is it perhaps possible to increase employment and “assist the poor” through larger loans and other financial services that facilitate the operations of SMEs (small and micro-enterprises) rather than just cash flow lending to the financially excluded
•    human resource systems (incentive systems and working conditions) that affect the increasing numbers of staff employed by MFIs; in some regions there are increasing concerns about staff working conditions (in terms of the length of the working day), on the one hand, and also about the role of incentive systems designed to increase the charge of the bull (microfinance growth rates) with negative fall out in the form of multiple lending to ‘excluded’ households with risk of client over-indebtedness.

Most importantly, the governance of MFIs is desperately in need of strengthening.  From the mission driven sector of the tortoise phase, microfinance has evolved into the equity valuation driven sector of the charging bull phase.  Starting with the Compartamos IPO in Mexico in April 2007, the increase in MFI equity valuations from 1.5 times book value at the beginning of the charging bull phase to around 2.5 times book value (internationally) in 2009[11] has led many microfinance promoters to think of taking advantage of the windfall of personal profits.  The phenomenon has been most pronounced in India, where valuations in excess of 5 times book value have become common in the past few years.  Since valuations are driven by the prospect of profits in the future, the growth potential of MFIs has become the most important feature for investors; this has reinforced the charge of the bull, often at the expense of depth of outreach and responsible lending practices, negating the stated  social mission of the MFI.  Governance plays a crucial role in focusing an institution’s commitment on social mission and values; beyond platitudes, relatively little has been done to improve MFI governance.

4.4       While there are still questions about capacity enhancement

Whether or not establishing the MIX in its present form was strictly necessary, in the charging bull phase, its database has become widely used for the purpose of benchmarking. To this extent, what it does has a direct impact on stakeholder perceptions of the sector.  Therefore, its efforts to introduce a degree of data oversight and desk verification through local or international resource institutions are welcome; though for reasons best known to its management it has now pulled back from this to establish its own regional offices.  Nevertheless, analysis of the data by region, undertaken by the MIX, helps to establish regional benchmarks and to place them in a practically useful analytical framework.

However, the question remains whether there was not enough analytical capacity around the world without there being a need for the MIX to create more capacity, to the exclusion of analytical efforts within microfinance markets.  Thus, CGAP and MIX donors and management need to consider whether the undoubtedly excellent MIX reports have in fact crowded out the development of analytical capacity in some of the key microfinance countries or regions.  There is, of course, no bar on others doing similar work but the fact is that a well resourced, grant funded institution based in Washingtion DC has the luxury to do more and carries more immediate credibility with observers than the, initially, hesitant efforts of developing country researchers with, often, limited resources.  MIX has not gone out of its way to seek the engagement of local researchers and analysts in developing countries and when it has, it has tended to be so focused on cost that high quality researchers have been by-passed.

Another issue with the MIX is its apparent lack of sensitivity to local variations and financial systems.  To take just one example, its response to the issue of the off balance sheet portfolio management activities of Indian MFIs has not been encouraging.  The 2008 database of the MIX adds portfolio management fees to revenues earned on the MFIs’ own portfolio in order to calculate portfolio yield.  This overstates the yield on owned portfolio and makes the MFIs appear to be charging more than they actually are.  Yet, despite substantial discussion with MFIs and rating agencies on the matter the MIX has not made the changes necessary to present the correct ratios on its website.
An action agenda for calming the charging bull, reducing reputation and political risk as well as reinforcing the efficacy of CGAP vis-à-vis its ambition to “assist the poor” is presented below .

How to calm the charging bull:

An action agenda for the current decade

1        Modify the zero delinquency messages to assure MFIs that non-performing loans of the order of 2-3% of portfolio are common even in the most efficient segments of the financial services industry.
2        Reduce the emphasis on OSS and FSS measurements that serve little purpose at this stage of the sector’s development; modify the PAR criterion with regional variations – in order to standardize, perhaps PAR30 and PAR90 could both be measured.  Other ratios – such as standard measurements of CAR (capital adequacy ratio) and the foreign exchange risk ratio – employed by the rating agencies for some years (and recently advocated by the MIX) should be promoted extensively.
3        Similarly, modify the no restructuring, no refinancing principle to promote a more humane response to genuine delinquency issues.  Encourage a wider dissemination of the lessons of the Grameen Bank so that Grameen 2 becomes the favoured microfinance methodology amongst mission driven MFIs leaving Grameen 1 to be exploited for personal enrichment by microfinance promoters.
4        In order to focus MFIs on better meeting the needs of low income clients, encourage greater product innovation to provide alternatives for different conditions and loosen the rigidity that afflicts current microfinance product offerings.
5        Enhance CGAP’s engagement in strengthening the governance and social performance of MFIs as outlined in the discussion in Section 4.3 above.  Increase engagement with lenders and investors (both microfinance investment vehicles (MIVs) and private equity investors) to strengthen their commitment to improved governance and microfinance service delivery based on social values.
6        Reinforce initiatives in the wider field of financial inclusion to encourage the banking system to provide services to low income families at the lowest possible cost.
7        Expand and increase CGAP’s limited engagement with programmes for graduating the extreme poor to sustainable livelihoods.
8        Redesign the MIX as a coordinator and stimulator of data collection and analysis in a manner that enhances, not crowds out, such capacity in microfinance markets.
9        Finally, expand CGAP’s mandate to include technical support to livelihood promotion initiatives so that it can reinforce its ability to “assist the poor” through a wider, more holistic programme than is possible with microfinance alone.  This is not to suggest that MFIs should mix livelihood promotion services with their financial activities but rather that CGAP should open a radical new channel of work to improve its ability to “assist the poor”.
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Author`s Note :

Thanks are due to my colleagues – Dr Alok Misra, Ms Frances Sinha and Prof Malcolm Harper – for their helpful comments.  Any remaining shortcomings are my own responsibility.
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References

[1] M-CRIL & MIX, 2007.  India Microfinance Review 2007. Gurgaon, India.

[2] PAR was often confused with amount overdue during this phase; some MFIs still do this.  FSS has never

been calculated accurately by MFIs.

[3] March 2002=100.  The M-CRIL India Growth Index (Figure 2) is a composite measure of growth of the 14

leading Indian MFIs combining information on the number of borrowers and portfolio size of the MFIs.

[4] Stephens, Blaine, 2009.  Operating Efficiency: Victim to the Crisis? MicroBanking Bulletin, Issue 19.

[5] Chen G, Rasmussen S and Reille X, 2010.  Growth and Vulnerabilities in Microfinance. CGAP Focus Note 61.

[6] Documented and discussed in the CGAP Focus Note cited above for four countries and by EDA in India.

[7] EDA Rural Systems, 2010.  Competition & the Religion Conundrum.  Gurgaon, India.

[8] National poverty line or $1 or $2 a day as modified by latest practice.

[9] EDA Rural Systems, 2005.  The maturing of Indian microfinance: Findings and policy implications from a national study.  Gurgaon, India.

[10] The most recent being the study of impact of the leading Indian MFI, Spandana by MIT.

[11] Reille, X, et al, 2010.  All eyes on asset quality: Microfinance Global Valuation Survey 2010. CGAP

Occasional Paper 16.

About the Author :

Sanjay Sinha

Sanjay Sinha

Mr. Sanjay Sinha is an alumnus of Oxford University and holds an M.Phil. in Economics from Jesus College, Oxford University. He has 30 years of economic and development research experience in South and Southeast Asia. He has specialized in sub-sector analysis of activities of relevance to the livelihoods of poor people, microenterprise promotion and BDS in addition to microfinance. He is co-founder of EDA Rural Systems Private Limited, one of the leading development consultancies in Asia and parent company of M-CRIL.He pioneered the development of credit rating framework for MFIs and has been instrumental in mainstreaming credit rating and flow of commercial funds to the sector. He has provided consultancy to international organizations like UNDP, ADB & ILO, authored numerous sector reports during his career and has published extensively in major journals as well as in the print media. Acknowledging his achievements and contribution to the sector, Sanjay Sinha was inducted as a Member of the UN Advisors Group on Inclusive Financial Sectors.

Recent Publications by the author (Published by Microfinance Focus) :

Avoiding a Microfinance Bubble in India: Is Self-Regulation the Answer?

Disclaimer

Views expressed in the article by author are his own and do not necessarily represent those of Microfinance Focus. Reproduction in whole or in part without written permission is prohibited.

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Microfinance Focus , March 2010 issue

Download the Latest Issue ( March 2010) of Microfinance Focus

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Is there a microfinance bubble in India?  Can self-regulation help prevent it?   Directors of leading Indian MFIs, Vijay Mahajan of BASIX and P.N. Vasudevan of Equitas share their views on whether such a bubble exists, as well as what Indian MFIs are doing to prevent one from happening.  Daniel Rozas and Sanjay Sinha provide an update on the level of saturation in the Indian microfinance market, and discuss their thoughts on whether self-regulation by Indian MFIs can be effective at controlling overlending.

Microfinance in India: Twin Steps towards Self-Regulation

By Vijay Mahajan and P.N. Vasudevan

The past few years have seen the entire microfinance sector grow exponentially. As with any other boom, suspicion always exists on whether a bust is just around the corner. This is especially true in the current international setting; with a major financial bust that humbled Alan Greenspan to admit he was “in a state of shocked disbelief”. In hindsight, it might seem obvious that the years of heady growth directly resulted in the sub-prime crisis and credit crunch. This heightens the sense of unease over the rapid growth of the microfinance industry and one is often seized of whether we are sitting on a bubble waiting to burst…   Read more

Avoiding the Bubble: Is Self-Regulation the Answer?

By Daniel Rozas and Sanjay Sinha

We live in a time of object lessons.  The economic crisis continues to buffet many countries, including the US, where the unemployment rate has now breached 10% for only the second time in the last 70 years, taking only 18 months to get there – the largest and steepest increase since World War II.  Three years after the first rumblings in the US subprime mortgage market, many banks around the world are still ailing. The microfinance industry has not been immune either – MFIs in countries as diverse as Nicaragua, Bosnia, and Morocco are under severe stress, while many others have seen their portfolio numbers deteriorate significantly….  Read more

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Graham A. N. Wright

Mr. Matthew Fuchs of Microfinance Focus spoke with Graham A.N Wright, Program Director of MicroSave India, a microfinance consultancy firm.

Here are the excerpts from the interview:

Microfinance Focus: MicroSave recently launched the “MFI in a Box.” Can you explain what this project is about?

Graham Wright: We’ve been working with the RBSFI, the Royal Bank of Scotland Foundation India, to develop 42 nascent MFIs in under-served areas of India, in the north and north east and soon on. As part of that program we have basically had to build MFIs from scratch, from the ground up. So what we thought we would do is put all that knowledge together in one reference DVD. It includes all the outline of operations, HR manuals, accounting manuals, strategic business plans, videos of all the processes and so on. We started doing that for the Joint-Liability based systems and then, being MicroSave, we got over-ambitious and we did it for Self-Help Groups and individual lending systems as well.

Microfinance Focus: Who were some of the partners who worked with?

Graham Wright: Nightingale and Grameen Sahara are two of the major partners in the north east. There is also Sanchetna in Lucknow, C-Dot and BMS in West Bengal, SSBWS, and we have Disha and PANI in Uttar Pradesh. BNC is a new partner, as is Sangini cooperative in Orissa, and we have also BPFL in Rajasthan.

Microfinance Focus: What has been the results so far?

Graham Wright: Well, the phase two partners who have been with us for 18 months have increased their portfolio on average 250% and reduced their portfolio at risk by 60%. A lot of them are now attracting equity and debt investments from commercial investors. It demonstrates what can happen when you get first-class systems in place at the basement level when you’re starting MFIs.

Microfinance Focus: So it is critical to get effective systems in place when MFIs are still in their start-up phase?

Graham Wright: Yes, because that is where you are going to manage the risk. We put in several key components to these MFIs: an operational manual based on process maps, HR manual based on HR analysis, basic accounting and financial management system, ratio analysis capabilities, internal audit and controls,MIS and finally governance.

Microfinance Focus: What other projects is MicroSave working on at the moment?

Graham Wright: We have three other big projects and a number of smaller ones. One is an innovation program, looking at in particular how to mobilise savings in low-income earners using electronic and mobile banking solutions and so on. In the other we are working with a social investor doing the Due Diligence, technical assistance and facilitating the investments in the MFIs they choose. These two are the big ones in India.

In the Philippines, we are looking at turning around three of the leading MFIs who found themselves in a situation where their growth was slowing significantly due to high rates of client churn. We have been building new products with them and overhauling existing processes.

Microfinance Focus: Does this relate to what you were saying before about the importance of getting effective systems in place early on?

Graham Wright: Not in the Philippines case no. In this case they put in the products many years ago and haven’t changed them over time – so they needed reinventing to move with the modern market. We are also in the process of turning around a bank in the Philippines that is struggling with its individual lending products, HR and staff incentives, and so we are re-engineering these as well as the branch infrastructure to turn it around.

Microfinance Focus: Do you see a demand from MFIs to offer livelihood programs or are they mostly focusing on credit?

Graham Wright: Most of them are focusing on microfinance and I think that is a very sensible decision. There are very few organisations that can credibly do both. I think strategic alliances with high-quality livelihoods support agencies is a good idea, but I think there are very few high quality livelihoods support agencies. Livelihoods has struggled for many decades and is just re-inventing itself around Value Chain Analysis which is a much more powerful paradigm. We at MicroSave are looking at getting into that more and applying the same rigorous management tools that we use for microfinance to analysing and supporting value chains.

Microfinance Focus: So it is better for microfinance organisations to specialise in microfinance rather then trying to incorporate livelihoods into their operations?

Graham Wright: To be very honest if you look at most MFIs they are struggling with the basics of providing credit services. In the future good microcredit organisations will become microfinance organisations and they will offer a range of services. Each product they introduce complicates their front and back offices and processes. They will have plenty to keep them occupied without getting into a whole new vertical like livelihoods. I have seen this when I worked in Bangladesh and East Africa, and very rarely do you see microfinance organisations that can offer livelihoods services effectively.

Microfinance Focus: Do you see specific problems relating to introducing new products like microinsurance or savings?

Graham Wright: The key to providing new products is to understand what the client really wants. The traditional approach is what I call “bathtub product development”, where the CEO gets out of the bath one day and says “we need to be doing this.” The product is foisted on the client and often they don’t like it. So you have to really get down in the dust and see what the clients really need, and that involves qualitative research to understand the complexity of human financial behaviour. Then you can build products and delivery systems around that.

Microfinance Focus: It is sometimes said that organisations are more comfortable with quantitative, spreadsheet-style analyses. What is the key to conducting good qualitative assessments?

Graham Wright: The moderator. It is essential that the moderator knows how to moderate groups – good moderation is much more than just about sitting under a tree and talking to people. If you have got good moderating skills you do not communicate what you expect in answers, which is how we normally talk – we are constantly giving one another signals about what we are expecting. If you communicate through verbal or non-verbal prompts what you expect to hear to a poor person, they will simply reflect back what they think you want to hear. So when we train people on moderation skills we run a course that goes for two weeks, and much of it is on the ground listening to clients and honing that ability to moderate those groups. That’s the first piece.

The second piece is proper analysis involving triangulation, tally sheets and so on, so that you’ve got a basis on which to draw conclusions to go on and not just a gut feel.

But you are absolutely right, most people are more comfortable in the quantitative arena. It is what we all learn at school and university with all the stats and everything and so people are just more comfortable with it. But as I said earlier, if you want to understand the complexities of human financial behaviour, you have got to go the qualitative route.

Microfinance Focus: Is the increasing integration of the microfinance sector into mainstream finance improving transparency?

Graham Wright: One would hope it would lead to improved governance. But particularly when private equity firms come this could be a mixed blessing because they are driving a particular agenda. It is typically a short term agenda: it is a sales and expand at all costs agenda with a view to getting to the IPO and cashing. So whether it is in the best interest clients or indeed the MFIs themselves I think is very much open to question.

Microfinance Focus: Where do you see the industry in five to ten years?

Graham Wright: The optimistic scenario is that we have a series of MFIs that are able to offer a wide range of services, not just credit but also savings, insurance and remittance services and they do this in a very customer-responsive manner. We have models emerging of that, the obvious one is the KGFS [Kshetriya Gramin Financial Services] model down in Thanjavur, which is absolutely outstanding and is what I believe what microfinance ought to look like.

Microfinance Focus: Can you give a brief description of the KGFS model?

Graham Wright: KGFS, first of all, put the client absolutely in the center of their business, which is the key to successful microfinance. Instead of Credit Officers they have Wealth Managers. The Wealth Managers map out the household and sell financial products to that household in response to their needs. For example, they offer group-based loans but they also offer gold-backed loans, and they offer savings services and insurance and remittance services. So if they see that a household has three buffalo, they will go out of their way to get that household to insure those buffalo. Of course they are still selling loans, but they are not offering one product whether the client needs it or not. They are understanding the household’s needs and they are measured against a complex algorithm that assesses the level of risk in that household. So their mission as Wealth Managers is to reduce the overall risk and increase the wellbeing of the household. That makes your front-line staff behave in a very different way. But to do that you have to have a first-class front and back office that really goes out of its way to serve the clientele well. They are still fine-tuning that model but we are working very closely with them on that and I think it is an outstanding model.

If we see the equivalent of that type of “third generation” microfinance, and there are all sorts of ways you can reach that, with a wide range of services, customer-centric approach, that would be the optimistic scenario.

The pessimistic scenario would be that as a result of one or two IPOs and screaming headlines reading “foreign private equity firms make off with thousands of crore rupees” made on the backs of India’s poor,  the regulatory environment is tightened to extent where a lot of MFIs simply cannot function. That would set India back quite a long way. I sincerely hope that that won’t happen. I hope that as Banking Correspondent requirements are relaxed banks will come further down market and will make savings and remittance services more available. I hope insurance companies will tailor products for down-market and use mobile banking for delivery of that. But we will have to see how that plays out. As usual, it depends on the regulator.
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Graham A.N. Wright was instrumental in developing MicroSave programs, in particular the market-research toolkits. He has had a career of two decades of development experience under pinned by five years of experience in management consultancy, training and audit with a leading accounting firm in Europe.

MicroSave has provided consultancy and support services to MFIs across Asia and Africa since 1998 with offices in Kenya, Uganda and India. Areas of specialisation include strategic business planning, institutional development, product development and impact assessments.

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WaterCredit is an innovative initiative of Water.org that puts microfinance tools to use in the water and sanitation (watsan) sector. It is the first comprehensive program of its kind in the world that connects the microfinance and watsan communities to scale up access to credit and capital for individual- and household-based watsan needs and does so with multiple models across multiple countries. In turn, the WaterCredit partnership models and financing mechanisms serve to channel and redeploy financial resources more efficiently and effectively to enable increasing numbers of people to meet their drinking-water and sanitation needs.

WHY IS WATERCREDIT NEEDED?

The amount of public and private financing currently available to finance the watsan needs of the developing world doesn’t come close to fulfilling the demand. It is estimated that watsan sector investment must grow between $10 and $30 billion annually to cut in half the number of people without access to watsan as defined by the Millennium Development Goals (MDGs). Watsan organizations that can tap access to credit are few and far between, as are microfinance institutions (MFIs) with dedicated watsan loan portfolios or in-house watsan expertise.

Historically, the use of public and development funds for watsan programs has benefited those who need the programs the least: wealthier members of society who already have access to water systems. Meanwhile, lower-income members have paid higher prices for vended water (up to 5-10x greater) and have risked consuming unsafe water. Further, the billions of hours of “unproductive” time that is used to fetch water – women and girls often spend up to 6 hours per day walking to/from water sources and queuing for water – preclude activities such as income generation, which could occur if access to clean water were closer to home and watsan services more reliable.

WaterCredit was designed to solve these problems. WaterCredit starts from the premise that there are people in the developing world who can finance access to safe water and sanitation if they can pay for these services over time, as well as have a voice in their development and operation. Further, WaterCredit assumes that there are financial institutions that are interested in expanding their portfolio of products and services in scalable, sustainable ways. WaterCredit’s role is to link these stakeholders with one another, and to provide strategic watsan expertise and support in order to leverage the impact that microfinance for water, sanitation and hygiene can provide.

WHAT DOES WATERCREDIT PROVIDE?

WaterCredit brings together watsan non-governmental organizations (NGOs), microfinance institutions (MFIs), commercial banks, other financial intermediaries, and related service providers to increase access to safe water and sanitation among impoverished households in developing countries through the creation of loan programs for watsan products and services. Currently, loans are made for things such as household water connections, toilets, sinks, tubewells and rainwater harvesting equipment. In the future there is also potential to fund small water-based enterprises.

WaterCredit does not aspire to be a world water bank that provides loans directly. Rather, we see our role as a facilitator of upstream and downstream investment and an accelerator of natural market processes. As such, we connect partner watsan NGOs and MFIs to one another to develop watsan loan products, and we provide strategic advice directly to these watsan NGOs and MFIs as needed.

WaterCredit provides smart subsidy capital to fund the “software” costs of watsan loan product development (e.g., community mobilization, education and training), market assessments and capacity building. In certain cases we may provide credit enhancements such as guarantees or standby letters of credit to MFIs for their watsan portfolios. We do not intend to provide funding for the loan portfolio or related “hardware” directly; these costs are expected to be borne by MFIs, client and community contributions, and other sources of external capital.

HOW DOES WATERCREDIT WORK?

Part 1: Partnership

WaterCredit creates a new space at the intersection of watsan and microfinance, and a new way to finance the supply and access to water and sanitation in the developing world. At its core, WaterCredit promotes partnerships with MFIs and watsan NGOs to catalyze the provision of small loans to individuals, households and communities in developing countries that do not have access to traditional credit markets. This approach efficiently matches watsan and finance expertise and simultaneously empowers people to address their own water needs. And as WaterCredit loans are repaid, this capital can be redeployed to additional people in need of safe water.

WaterCredit is committed to using different models for partnership and loan delivery, depending on local needs and lending context, the state of the watsan sector and identified gaps, as well as local laws and regulations governing MFIs, NGOs and investment opportunities.

Similarly, WaterCredit seeks MFI partners that represent a diversity of legal structures, sizes, geographic reach and overall scope of microfinance activities. We have considerable experience with identifying, evaluating and certifying organizations for WaterCredit partnership. As part of this we conduct WaterCredit readiness trainings and also engage specialist consultancies regarding local issues as appropriate.

WaterCredit currently operates in India, Kenya, and Bangladesh, and has partnerships with non-profit MFIs, for-profit MFIs and non-profit watsan NGOs. We are growing WaterCredit globally in terms of both breadth and depth of microfinance sector partners, countries and financing models. Moreover, we are actively engaging with local and international microfinance networks and apex organizations.

The role of MFIs within WaterCredit is catalytic. We strongly encourage interested MFIs to propose WaterCredit models, products and lending methodologies that they believe are suitable to their particular needs, clients and circumstances. Candidate MFIs are also encouraged to highlight the areas of watsan expertise and other “software” support where strategic support from Water.org and local watsan NGOs would be most helpful.

Part 2: Financing Models

As noted, WaterCredit does not espouse any one particular lending methodology or MFI approach, and we acknowledge that “one size does not fit all” in the watsan and microfinance sectors. Therefore as the watsan needs of communities and the MFIs’ ability to meet them evolve, we anticipate additional financing models to develop that are appropriate to local context. Water.org stands ready to assist MFIs in these efforts by providing watsan technical expertise and strategic advice regarding delivery of watsan services, both directly and through local partner watsan NGOs. WaterCredit models that have been successfully launched in partnership with MFIs and watsan NGOs to date include:

Smart Subsidies

Capacity Building: Water.org provides a variety of capacity-building grants for different purposes. These include, but are not limited to: market assessments and related start-up expenses; initial loan product development and roll-out costs for MFIs; financial management training for watsan NGOs; hygiene education and related community-based outreach; marketing; and loan tracking technology.

We expect potential WaterCredit partners – both MFIs and watsan NGOs – to be part of the collaborative process that defines needs and appropriate expenses in a way that shows shared commitment to the scalability and long-term sustainability of any WaterCredit loan portfolio. For MFIs, this means actively seeking additional sources of external and commercial capital to ensure continued WaterCredit portfolio growth. To this end, we also invest in external monitoring, auditing, and evaluation of our WaterCredit partners and watsan-program performance.

Key to the success of the capacity-building model is Water.org’s ability to provide catalytic grant capital and strategic watsan expertise to the table that would otherwise be unavailable, and which in turn prompts MFIs and watsan NGOs, along with other funders and stakeholders, to come forth and play a leading role in the development of sustainable watsan loan portfolios for their clients and communities.

Financial Mechanisms

Credit Enhancements: Moving forward, WaterCredit anticipates providing various forms of credit enhancement to its lending partners to help attract additional capital WaterCredit programs and bring them to scale more efficiently.

Examples of credit enhancements include guarantees, first loss loan reserves, standby letters of credit and foreign exchange mitigation instruments. We consider these arrangements on a case-by-case basis, taking into account local law and related requirements, projected growth, financial soundness, and the partner organization’s overall ability to structure and manage these tools.

Revolving Loan Fund (RLF): In this model, Water.org provides grant capital to watsan NGOs that have established (or that seek to establish) a microfinance unit for WaterCredit loans, but that do not have access to other forms of outside capital and do not otherwise engage in lending activities. This seed capital may be used to fund a variety of software activities, including mobilization of women into self-help groups (SHGs), health and hygiene education, financial management training and technical assistance.

Thanks to these funds, the participating watsan NGO is able to set up an RLF that makes loans to local SHG borrowers. The organization is expected to grow the WaterCredit RLF over time by harnessing additional internal resources and attracting additional clients. Ultimately the watsan NGO may choose to partner with an MFI to expand its water-based financing activities.

SHGs repay the loans (with interest) on pre-negotiated terms that ensure loan portfolio sustainability. To date, the RLF model has been very successful, though partner organizations face hurdles to scale as demand for these loans has outstripped supply of capital to deploy.

Direct Lending: In this model, Water.org directly provides loans to watsan NGOs in-country to dig boreholes, install handpumps, and provide other water services to local communities, which are operated and maintained by community based organizations (CBOs). The CBOs charge service fees for water collected and delivered, which provide a stream of income from which to make loan repayments. Although there is great potential for this model under the right circumstances, early experience illustrates that it can be particularly difficult to manage in places with no functioning water infrastructure. It is also very important to take local law and ownership issues into account.

WATERCREDIT BENEFITS MFIs

For MFIs seeking to grow, expand their activities, and effectively meet the broader needs of their clients and communities, WaterCredit offers many advantages:

• Offering a new scalable, sustainable loan product that focuses on one of society’s most basic needs

• Ability to address and achieve multiple Millennium Development Goals (MDGs) simultaneously

• Development of in-house water, sanitation, and hygiene expertise

• Disproportionate positive effect on women clients

• As a result of watsan loans, clients’ time can be used for other productive activities such as income generation and education

• Decrease of water-borne disease bolsters amount and quality of productive time available to clients

• Over time, potential for financing of small water-based enterprises

• In certain cases, increase in discretionary disposable income when borrowers can access water directly rather than only from the local “water mafia”

• Linkages to other watsan NGOs, service providers and funders with potential for future collaborations

WATERCREDIT 2.0: THE NEXT WAVE

WaterCredit is currently at an inflection point and is poised for significant growth in the next three years. This expansion will be guided in part by a set of core principles, built into WaterCredit programs globally. We are:

• Partnering with organizations that can build, operate and transform WaterCredit at a “game-changing” scale

• Utilizing a diversity of MFIs and related financial organizations to develop, finance and attract additional upstream capital to WaterCredit where possible

• Directing “smart subsidies” to microfinance start-up and community development activities

• Abstaining from interfering with effective credit and environmental services markets, and refraining from making investments that would distort such markets

• Providing the management nexus between good capital and good watsan investment projects

• Playing an active role to improve knowledge and foster best practices within the watsan and microfinance sectors, recognizing the value of interchange of ideas and “thought partnerships”

Water.org is well-placed between philanthropic donors and commercial investors to scale WaterCredit. These donors and investors have complementary social and financial return objectives, and WaterCredit provides the link between funders and the myriad local organizations and other stakeholders that want to scale up watsan access. As part of this, Water.org is managing complex watsan projects on the ground, consulting with investors in search of bankable deals, and transferring its expertise to other organizations interested in credit-based approaches in the watsan sector.

in order to reach its goals for WaterCredit over the next three years, Water.org is attracting a blend of smart subsidy (grant) capital, leveraged investment capital and new partner development capital. We seek to raise an additional $10 million in smart subsidy capital to enhance the more than $4 million already raised. Overall smart subsidy capital is expected to be more than 40% of all WaterCredit investments, and we anticipate that this combined $14 million program could attract another $30 million in leveraged investment.

Water.org intends to spend approximately 50% of these funds in Asia, 40% in Africa and 10% in Latin America. Fiscal modeling for the WaterCredit program yields the following estimated beneficiaries and costs per region:

• Asia: 675,000 beneficiaries at an average cost of $10.67

• Africa: 300,000 beneficiaries at an average cost of $18.17

• Latin America: 40,000 beneficiaries at an average cost of $42.00

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In the past few years, Indian microfinance has seen unprecedented growth. As per the Bharat Microfinance Report 2008, published by Sa-Dhan, the MFI channel served about 141lakh clients with a portfolio outstanding of about Rs 5954 crores by 2007-08. The growth over the preceding financial year has been 53 per cent and 72 per cent for client outreach and loan portfolio respectively. The microfinance sector in India is growing despite a legal vacuum.

In fact, seven Indian MFIs ranked in the world’s top fifty MFIs in 2007 (*source – http://www.forbes.com). This trend is reinforced by and further accelerates commercialization of the industry, which is in turn characterized by increased competition among MFIs for clients and a goal to seek profitability. A majority of the top twenty-five MFIs in the country consist of firms that are profit-oriented Non-Banking Financial Company (NBFC)-MFIs or those planning to become one.

Despite this growth, there is considerable unmet demand in India. According to World Bank (2006), only 9% of poor families in India have access to microfinance and of the projected credit requirement of USD 10909 million, only USD 1050 million is met by microfinance. Although demand is widespread, the geographic distribution of MFIs is not uniform. MFIs are clustered primarily in South India, with two-thirds of all MF clients being in Andhra Pradesh (AP), Tamil Nadu (TN) and Karnataka. Fast growing MFIs tend to expand to areas where there is already an incumbent. The reason for this strategy is to leverage training and screening of client by the incumbent MFI and general awareness of microfinance in the area. MFIs in India, by and large, do not distinguish themselves by geographic areas or by offering differentiating products to different client segments. The above trends have lead to competition for the same clients in many parts of the country including AP, Karnataka, Madhya Pradesh, West Bengal, Uttar Pradesh, Orissa, TN and Chattisgarh.

Competition has had beneficial effects on clients world-wide. MFIs improve their product lines to meet clients’ demands; prices become lower; the quality of services provided improves; and overall, MFIs become more client-driven. In terms of governance, MFIs become more efficient and conscious of risk management. Interest rates are often made more transparent. Better governance complements commercialization of the MFIs. Banks and other private investors feel more comfortable investing in MFIs that have good governance. As a result, such MFIs enjoy continuous inflow of funds that makes further outreach of clients possible. Indian MFIs lead the way in access to commercial funds with a commercial funding ratio of about 75% (Microfinance Information Exchange Report, 2006).

On the other hand, there are negative aspects of competition as well. There are sector-wide concerns about unethical staff and client poaching, violation of the ‘code of conduct’ and reckless lending by fast growing MFIs leading to multiple borrowing. Furthermore, recent trends in commercialization have given rise to the apprehension that the social objectives of microfinance – to provide a means for poor to improve their livelihood through financial inclusion – is diluted by targeting richer clients to increase profits, the so-called ‘mission drift.’

This paper focuses on multiple borrowing – which is of critical importance to MFIs and the industry as a whole because it is an issue that inevitably arises in the evolution of microfinance in a country. There are many similarities between India and other more competitive and evolved MF sectors in the world. While intense competition and multiple borrowing are perceived to cause significant deterioration in repayment and dropouts in the sector in India and throughout the world, this stance is not consistently supported by rigorous evaluations (of which there exist only a few in the literature) using large datasets which suggest that the effects of competition and multiple borrowing are not as deleterious. Due to unavailability of primary data, the extent of multiple borrowing in India has been estimated through surveys which are constrained by small sample sizes and the dependence on self-reporting by the respondent.

MULTIPLE BORROWING, CLIENT OVER-INDEBTEDNESS AND DEFAULTS

There could be many motivations for multiple borrowing. A single MFI might not meet all of the client’s credit needs. Even if it does, she might join multiple MFIs because interest rates might be lower in the second MFI, loan products might not be structured appropriately for the needs of specific client businesses or different MFIs might offer different products that the client needs, or so that she has a second option in case of default to the first MFI.

As regards the usage of the loan, an individual MFI’s loan might be too small for a higher level of project investment and hence the client might need multiple loans from different MFIs to stitch together a larger loan size. A mid-term supplemental loan could be used to augment capital, especially for traders. These could be called opportunity-borrowing. Distress-borrowing would include borrowing due to an emergency, or to repay another loan. Alternate reasons could be that she is borrowing for consumption or simply reducing cost of borrowing by shifting away from more expensive sources of credit such as moneylenders.

Whatever the reasons for multiple borrowing may be, the point of interest here is whether the client is able to absorb the extra credit and manage to repay to the MFI, without reducing consumption. In the best scenario, she uses the extra credit to improve her living standards.

Overview of the Theory of Multiple Borrowing and Competition

Micro credit typically replaces informal sources of lending such as money lenders. MFIs start with a smaller loan size and based on repayment performance, the client builds a credit history with the MFI and gets access to larger loan sizes in subsequent cycles. Drawing a parallel to money lenders practices, in the absence of collateral, MFIs develop repeated relationships with the borrowers and prefer that existing borrowers do not contract new loans with other lenders. There are 2 primary considerations that face micro finance clients’ repayment behaviour:

Threat of no further loans in case of default

Peer monitoring and entailing social sanctions

If a lender is a monopolist, threat of no further loans from that lender provides an incentive to repay. When competition brings in other uncollateralized lenders in the same area, the incumbent’s ability to use dynamic incentives is weakened.

Competition and Information sharing

There are a number of theories in the literature on multiple memberships and its effects under different degrees of information sharing (without a formal credit information system) among lenders on their clients’ membership details and repayment history, when there is increased competition for the same set of clients.

A competitive lending environment with no information-sharing between lenders on defaults by clients, leads to an externality due to high ‘enforcement costs’ of monitoring by loan officers, and loss of dynamic incentives to repay which predicts a fall in repayment and an increase in dropout from the incumbent lender as competition rises. In the event of perfect information between institutions, the above concerns do not hold and expected future access to credit will incentivise borrowers to repay uncollateralized loans. This could lead to increased dropouts from the incumbent in favour of better outside options, but in order to improve their credit history, which is visible to all lenders, there would be an improvement in repayment as number of lenders increase.

In the case of information asymmetry as regards the clients’ total amount of loans taken, lenders cannot gauge risk accurately. In this case, only dynamic incentives to repay to incumbent are at play. Impatient borrowers will take advantage of this; they might not drop out but rather take multiple loans, and so repayment performance will fall although dropout may not rise. The outcome depends on the amount of information about indebtedness that is visible to lenders.

Regardless of information sharing, if competition leads to financial deepening, leading to complementarities and increasing returns to scale of investments, if this increased supply of credit leads to an beneficial overall improvement of the economy, then repayment will improve and dropout will not change as all clients face better smoothed, more remunerative business opportunities.

COMPETITION IN INDIA

Overall, there is competition between MFIs, SHPIs, state SHG programmes, banks, cooperatives and money lenders. They are competing for clients, staff, funds, and reputation. This section addresses issues of the MFIs and SHPIs. The competition has increase in last few years.

Nature of competition

Client poaching

A common concern raised by MFIs pertains to the trend of competitors with aggressive growth plans opening branches where an incumbent already exists and actively poaching their clients. This is done to take advantage of both the locally familiarity with MFI rules and the incumbents’ client screening and training, as well as to gain access to the clients’ passbooks and hence credit histories. The clients are reportedly recruited by offering higher loan sizes faster, leading to multiple borrowing which could lead to defaults.

Incidences of dropouts have not been cited as a concern by the MFIs. Poaching is viewed negatively by all incumbent MFIs and is a source of frustration. They feel a sense of lack of control over the client, and the incentive mechanism of an MFI to deny new loans permanently to a client in case of default is lost since she has another option now.

Expansion Plans in a Competitive Environment

Expansion strategies of MFIs is similar to that of banks which tend to open new branches more in banked areas, i.e., growth of financial development is higher in areas with higher initial financial development when left to competitive forces. New branch locations tend to be closer to an urban branch. The marginal cost of opening a remote branch is higher than that of catering to a village near a branch in a town. Many MFIs prefer untapped markets and some have started to move to more remote rural areas for this reason, a move partly driven by competition.

MULTIPLE BORROWING

The concerns about multiple borrowing appear to be based on strong operational-level experience and not on data-driven evidence. The sector feels that MFIs offer larger loans to existing MFI clients leveraging her past repayment history with the incumbent, but are lax with their screening procedures and assessment of the clients’ ability to repay in their haste for fast growth. The incumbent MFI cannot make an educated assessment of the clients’ ability to repay if it does not know which other sources the client is borrowing from. No MFI has categorically stated that multiple borrowing has led to worsening repayment rates and dropouts already, but they are clear that it is only a matter of time. The AP crisis has revealed that MFI clients have a tendency to default to lower interest smaller loans from state run SHG programmes (with less strict repayment enforcement) and instead repay MFIs from whom they have borrowed. This behaviour could extend to defaulting to the incumbent MFI.

Despite asking clients at the time of enrolment whether they have an outstanding loan at the time of joining, the MFIs are not able to prevent multiple membership.

At the surface, the existence of multiple borrowing suggests that clients need larger loan sizes than what the MFIs are comfortable with lending. There is also a concern from experts that reckless multiple borrowing will lead to large scale defaults and bring disrepute to the sector. The group nature of the lending model further lends itself to en masse default. Aggressive lending by the sector might give an impression to the clients that repayment can be avoided without penalty (like with government loans).

It is clear that the sector does have a slightly paternalistic view of its clients as regards their financial management capabilities. While it is not clear what the socially optimal arrears rate is, no one MFI would want to bear the brunt of it.

Distress versus Opportunity-driven Multiple Borrowing

All MFIs would like a practical way to discern between distress and opportunity driven borrowing, but it is not clear how such a way may be devised. There is a case for an optimal amount of joint monitoring of multiple borrowers by the MFIs or for some form of partnership. Both MFIs might be better off by reducing their loans outstanding by letting the other MFI share some of the risk by offering a complementing loan and monitoring could be shared to improve repayment. This calls for a partnership and the investigation into an optimal amount of joint monitoring that reduces costs to both parties.

Effect of Multiple borrowing

As explained in previous section, there could be various reasons for a person in rural areas to take loans from multiple microfinance institutions like the loan amount given by one MFI is not sufficient for the needs of the person, the borrower can access the fund at lesser cost etc. Multiple borrowing is in one sense good for microfinance institutions as they share the risk of the credit given to borrowers because the loans are unsecured i.e. they don’t have any collateral to back up. However excessive borrowing by borrowers from multiple MFIs could lead to debt trap i.e. the borrower takes loan from on MFI to repay the instalments of other MFI. This debt trap is very dangerous for both borrowers as well as the MFIs. This lead to creation of big bubble which when bursts will harm the society at large.

As shown in above diagram, institutions are under high pressure to increase their lending and show better results to their investors and on other side there is continuous pressure from RBI and banks to meet their target for “Priority Sector Lending”. This pressure of increasing their loans results in providing loans without going through proper verification of borrowers and financial institutions ends up paying higher loans without properly checking the repayment capability. We can draw the contrast of this with sub-prime crisis that originated recently in United States where banks didn’t undergo the required checks before giving loans to the borrowers.

Multiple borrowing in microfinance sector will hit the bottom of the pyramid i.e. the people who are living in rural areas and this is critical area which is expected to drive the future growth of the country.

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The whirring sounds from Pashupati‟s paddy-husking mill drown out the cricket chirps and children‟s laughter from the surrounding fields. Pashupati strolls through his mill, brusquely greeting employees, and proudly points out the new rollers he‟s installed recently. In addition to the husking mill, Pashupati‟s “micro” enterprises include a recently constructed 18-foot high brick kiln as well as a large, irrigated plot of land on which locally-hired villagers cultivate paddy, pulses and vegetables an astonishing four times a year. At first glance, Pashupati might seem like a middle-class villager who has managed to leave behind the struggles, tyranny and stigmas associated with poverty. But once a week, Pashupati never forgets to stand and wait in the long queue with dozens of other villagers to draw his ration quota secured under the Below the Poverty Line (BPL) card.

Compounding this oddity is that while the relatively well-off Pashupati receives government rations, many impoverished members of his community are excluded.

Surprisingly, Pashupati‟s story is not an exception in rural India. By some metric or measure, many “rich” poor are provided government aid, while the visibly poorer are ignored. This situation raises the issue of how government-run programs target beneficiaries and the larger question of how to conceptualize poverty. Moreover the government spends a huge sum of money on a number of programs to serve the poorest population of the country. The Economic Survey 2007-08 reveals that the volume of food subsidy in India in 2006-07 was to the tune of Rs 23828 crores1. Hence it is imperative to make the process of targeting the poor efficient. In India, the BPL census is used to identify beneficiaries for a number of aid-based poverty alleviation programs and financial schemes like health insurance, soft loan etc. Unfortunately, widespread manipulation, corruption and mis-targeting have rendered the BPL census method far from perfect. 2 It is in this context that Bandhan, a Microfinance Institution (MFI) based in Kolkata that wanted to target the ultra poor, resorted to another method. Bandhan‟s chosen method, inspired by a similar program of BRAC in Bangladesh, was a Participatory Rural Appraisal (PRA) that targets ultra-poor beneficiaries who are then eligible to participate in their Targeting the Hardcore Poor (THP) Program. Under Bandhan‟s THP program, beneficiaries are given free assets, such as livestock or other inventories, to help them secure a regular source of income and thereby graduate them into future microfinance clients. Social mapping and subsequent wealth ranking are the two key components of the Bandhan‟s PRA targeting exercise. Social mapping entails identifying every household of a hypothetical hamlet on a map, while wealth ranking stratifies the households into different socioeconomic groups. The households which fall into the ultra poor category based on wealth ranking are identified as potentially eligible program participants. Thus the wealth ranking exercise is crucial for the proper selection of ultra poor beneficiaries. The PRA facilitator has to be efficient to ensure an unbiased ranking of households. Following the PRA, Bandhan administers short surveys and a follow-up visit to the households identified as ultra poor to verify the authenticity of information collected.

In 2007, the Chennai-based Centre for Micro Finance (CMF) at the Institute for Financial Management and Research (IFMR), conducted a study in five villages in the Murshidabad district of West Bengal to examine the efficiency of the Bandhan‟s targeting process. 3 In each village a detailed economic census was conducted by CMF that classified households on a 1-5 scale based on their land holding, ownership of assets, housing quality, educational status, and livelihood. In total, 605 households were identified as poor out of approximately 1700 households across five villages. Out of these 605 households a random sample of 178 households was selected for a detailed survey similar to the household survey used by Bandhan. Of these 178 households, 8 households were identified as ultra poor by Bandhan and of the remaining 170 households, 121 households appeared in the PRA lists of the respective villages. For the sake of comparison the final dataset contained only these 121 households and 92 households identified as ultra poor by Bandhan across five villages. Since the survey was administered to a systematically selected poorer segment of population, CMF was also interested to see the extent to which beneficiaries received support from various poverty alleviation programs (in particular, BPL and Antodaya programs, Indira Awaas Yojana (IAY) and National Rural Employment Guarantee Scheme(NREGA)) run by the government. The data collected from surveys was mined to see the targeting efficiency of the government run programs. This was done by comparing the households that received support from the aforesaid government programs with those who did not, using several poverty indicators.

The findings of the study suggest that households ranked as poor in the PRA are in fact poorer compared to other households in the same hamlet in terms of land holding and asset ownership. The average landholding of ultra poor households identified by Bandhan is 1.84 katthas which is much lower than that of non ultra poor households (8.49 katthas). These ultra poor households are by and large financially excluded as only 3.26% of the ultra poor beneficiaries had ever obtained a loan from a formal source (commercial banks, cooperative credit society etc.). The nutritional status and educational attainment of the ultra poor beneficiaries are also pitifully low; close to 40% of the ultra poor households reported not consuming two meals a day.

The results of the study also present a grim picture of the targeting efficiency of government programs. Our results show that the beneficiaries of the BPL rationing and Antodaya schemes are not poorer compared to non beneficiaries with respect to most poverty indicators: per capita monthly food/fuel expenditure, landholding, asset ownership and food sufficiency. However, the NREGA program did a much better targeting since the households which received work under NREGA were poorer than those who did not. Self-selection does play a role however, as employment programs like NREGA look attractive to poor households are unable to get better employment elsewhere.

Identifying and targeting the poor for development interventions is a vexing but crucial task for good programs and maximum impact. Today census and household surveys are still one of the most popular methods of identifying poor but CMF research exposed that surveys often omit or cannot capture certain indicators of poverty (for e.g life expectancy). Identifying the poor through mass participation of a diversity of people, as in case of Participatory Rural Appraisal (PRA), was found to be more effective in targeting the poorer sub-population. Responses of peer members or neighbors often accurately reflect the true socio-economic condition of a household vis-à-vis other households and the socioeconomic hierarchy of a village. It should be noted in that apart from measuring the „endowment,‟ or economic resources of a person, PRAs can also capture relative deprivation in terms of „exchange entitlement,‟ or what he or she can earn in exchange. However, methods like PRA are costly and hence may not be applicable in all contexts. Pilot studies are advisable to test the feasibility and cost effectiveness of PRAs. Having said this, it is obvious that any successful targeting process call for a multidimensional poverty assessment measure and hence targeting based on a single indicator of poverty would certainly be myopic

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1 Economic Survey 2007-08, Chapter 75, pp: 180, table 7.27.

2 a)See Mukherjee, N (2003): “Political Corruption in India‟s Below the Poverty line (BPL) Exercise: Grassroots‟ Perspective on BPL: Good Practice in People‟s Participation from Bhalki Village, West Bengal”, Development Tracks RTC, New Delhi. (http://www.eldis.org/fulltext/Political Corruption India.pdf)

b) See Jalan, J and Murgai R (2002): “An Effective “Targeting Shortcut”: An Assessment of the 2002 Below Poverty Line Census Method”, July (http://www.ihdindia.org/ourcontrol/rinku murgai.doc)

3 The study was done by Profs. Abhijit Banerjee (MIT), Esther Duflo (MIT), Raghabendra Chattapadhyay (IIM-Cal) and Jeremy Shapiro (Ph.D candidate at MIT). An e-copy of the paper is available at:

http://ifmr.ac.in/cmf/publications/wp/2007/21_banerjee_et_al-ultrapoor.pdf

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In June 2006, FOCCAS, a once promising Ugandan MFI with an unusually committed client base, became insolvent and was closed.  Its socially responsible (SR) creditors recovered nothing on their outstanding loans.

In April 2007, WEEC, an up-and-coming Kenyan MFI lost its founder/director to an unexpected death, and defaulted on its debt soon after.  Its SR creditors recovered nothing.

In September 2008, Washington Mutual, one of the largest US banks and also one of the top subprime lenders, was shut down by regulators following extensive losses in its mortgage portfolio and a $17 billion run on its deposits.  Though its shareholders were certainly wiped out, depositors and secured creditors suffered no losses, and unsecured creditors lost “only” $12 billion, that is about 4% of the company’s assets.

On its face, the comparison may seem a bit facetious – a $300 billion bank is hardly similar to institutions that may not even break $1 million.  However, the comparison is important for one reason:  in the microfinance world, recoveries by creditors following an MFI’s collapse are rare.  When MFIs fail, pursuing liquidations is frequently deemed too costly and too difficult for SR investors to attempt.  Even when liquidations are attempted, the results are often woefully ineffective, and so more often than not, SR investors walk away empty-handed.

Why should liquidations matter?  In the course of my research, it has been noted by several prominent individuals in the microfinance community that since MFI failures are so rare, issues such as liquidations are really academic.  To a degree, this is true.  However, as I can attest directly from having worked in the US mortgage market since 2001, periods of good financial performance are exactly the time to be developing strategies for coping with crisis, and not after-the-fact.  As for those who suggest that microfinance is immune from business cycles, recent experience (dot.com, housing) suggests that industries that espouse this belief are treading down a path that leads to a particularly expensive lesson.

Liquidating MFI Portfolios

In traditional liquidations, when the company cannot be sold in its entirety, assets are sold separately to raise the cash to pay off creditors.  For financial companies, that primarily entails selling their portfolios.  The problem with microfinance is that sales of MFI portfolios pose special challenges – microcredit portfolios are so closely associated with the MFI that created them that extracting their value without the original organization proves very difficult.  Specifically the two main issues are that it appears particularly time-consuming and costly to transfer servicing of a microcredit portfolio from one organization to another, even though this is a necessary step in most liquidations.  The second problem is that attempting to continue collections on outstanding loans without issuing new ones can by itself cause delinquencies to rise sharply.

The natural consequence of these two challenges is that the value of a microcredit portfolio becomes closely tied to the default risk of the MFI.  In effect, though creditors may have some type of recourse to the portfolio, their inability to recover on those assets can lead to far greater losses than the MFI’s balance sheet might indicate.

Servicing Transfers

Unless a financial company’s servicing unit is kept intact, a sale of the institution’s portfolio entails transferring servicing to a different organization.  However, the strongly relationship-driven business model of microfinance, where borrowers are in direct and regular contact with their loan officer poses significant challenges when attempting to transfer servicing.  Usually, the loan officer responsible for finding clients and issuing loans is also responsible for collecting the payments.  By comparison, in traditional banking, especially in developed economies, payment collection is often outsourced to separate organizations, or at a minimum, delegated to separate payment processing centers independent of the bank’s neighborhood branches.  When a loan undergoes a servicing transfer, frequently the sole indication to the borrower is a short letter from the new payment processing center, along with the new payment stubs.

However, in a microfinance servicing transfer, new collections officers must be sent to visit clients whom they have never met.  In the unmapped/unmarked address system common in areas served by MFIs, simply the task of finding clients is hardly straightforward, and once found, convincing them that the person seeking the payment is authorized to do so can be another challenge.  For group loans, assuming at least some number of group meetings were already missed in the intervening period between the original MFI’s failure and the arrival of the new collections officer, it will take additional effort to restart group meetings.  Thus, the time and cost of setting up new collections is itself significant, exacerbated further by the small size of the loans.

Perhaps it’s not surprising then, that servicing transfers in a microfinance context appear to have never happened, or have been incredibly rare.  In the groundbreaking BRAC securitization of 2006, the final deal did not contain a provision for a backup servicer, despite the fact that the need for one had been identified.  Similarly, ICICI Bank specifically cited servicer risk as a something to be addressed in its MFI Partnership program.  Yet, in 2008, that is two years after suffering extensive losses because partner MFIs in Andhra Pradesh were prevented by government from collecting their loans, which included servicing the ICICI-owned portfolio, the bank still had no servicing transfer plans in place.

So what about microfinance operations that utilize alternative payment systems – such as local merchants, mobile payments, commercial bank branches, and so on?  In these cases the contact with the individual borrowers is already intermediated, so technically investors would only have to work with the intermediaries, instead of the borrowers themselves, which, at least in theory, would make significant recoveries without the MFI somewhat more plausible.  That said, forgetting the borrowers would be a mistake, because before collecting payments, one must first insure that borrowers continue to be interested in making them.

Repayment incentive

In traditional microfinance, whether group- or individual-based, one of the key repayment incentives for MFI borrowers is their expectation of future borrowing.  This is further magnified by the widespread practice of growing loan sizes at each borrowing cycle for clients with good “repayment culture.”  Naturally, it follows that in the absence of additional incentives, if loans are transferred to a collections company that does not originate new loans, borrowers would lose this key incentive, and repayments would drop.

There are of course alternative repayment incentives, chief among those using borrower’s property as collateral.  When done right, and in legal environments where collateral seizures are reasonably possible, this has proven to be a highly effective, even in the absence of future borrowing opportunities.  Perhaps the best evidence of this was the minor bump (1-2%) in delinquencies experienced by two Croatian MFIs (NOA and DEMOS) when regulatory action forced them to suspend new loan issuances for an extended period.

Theoretically, a credit bureau might also present an alternative incentive – borrowers of a failing institution would still need to repay in order to avoid a negative mark on their credit history and hence access to loans from other lenders.  Indeed, in parts of Latin America where credit bureau reporting for MFIs is relatively common, individual lending portfolios of commercial MFIs are seen as similar to traditional non-collateralized consumer credit, that is as relatively liquid instruments that can be sold to other institutions when needed.  However, what’s not clear is that other banks/MFIs would necessarily treat a default to a failed institution (as opposed to a “regular” default) as a lending disqualifier, especially for a client who otherwise demonstrates a good repayment history.  By extension, we don’t really know how such clients would actually behave following their MFI’s failure.  That situation, as far as I know, has yet to be tested in a microfinance context.

So what is the evidence from past liquidations?  First, there is anecdotal evidence suggesting that borrowers view the closing of their MFI as a forgiveness of the loan.  For example, when an NGO in Bolivia was merging with others to form Eco Futuro, rumors spread among borrowers that it was closing, and they stopped paying.  Defaults among clients are also self-reinforcing – as more clients see others not paying, they stop too, and this happens even faster in group lending, where after a “tipping point” of defaults is reached, the whole group falls apart.  An example of this is the current case of Fundación San Miguel Arcángel, a Grameen replicator in the Dominican Republic:  after extensive internal fraud and subsequent scaling back of new disbursements, it quickly found itself dealing with delinquencies of over 50% and rising.

Risk to MFI investors

It seems a common occurrence for creditors, especially foreign SRIs, to walk away empty-handed from MFI failures.  For the most part, this has little to do with the reasons leading up to the failure – mismanagement, fraud, or portfolio underperformance.  In the case of SOMED (Uganda), the CEO disappeared after allegedly embezzling funds – the MFI’s portfolio simply melted away.  In the case of FOCCAS (Uganda), the insolvent MFI went into a drawn-out liquidation process, during which local banks were able to recover their investments, but, again, the SR creditors got nothing.

One particularly instructive case is the failure of WEEC in Kenya.  One of its SR creditors – Kiva – had an innovative P2P platform with extensive borrower-level data, yet still it was unable to collect anything after the MFI’s default.  At least theoretically, it would’ve had the best chance of any creditor to claim the portfolio lien and collect repayments on its own, yet as Kiva’s CEO, Matt Flannery, had so clearly stated, without the MFI management’s cooperation – whether granted willingly or obtained through threat of reputational, legal or other credible sanctions – there was simply nothing they could do to recoup their funds.

There are, of course, counterexamples. In the case of Bank Dagang Bali (BDB) in Indonesia, after more than five years in liquidation, 73% of the total portfolio and an even higher portion of the microfinance portfolio (the latter represented less than 5% of loans outstanding, but 50% of borrowers) has been already recovered, and the liquidation team expects to recover another 15% before it’s all said and done.  In its case, the SRI creditors might still receive something after all.  Bear in mind though, that BDB’s microfinance portfolio was mostly collateralized, either by physical collateral, or by borrowers’ own savings, which may not be legally pledged to the loans, but function much like collateral in the minds of the borrowers.

Towards Improved Recoveries

Unless an MFI’s portfolio is largely collateralized, or there is an extensive credit-reporting system covering MFIs, it’s likely that traditional financial company liquidations will not perform well.  However, some of the following suggestions may help investors obtain better results.

Pre-default

1. Maximize the MFI’s incentive to repay.  If things go irreparably wrong, the MFI’s management’s incentives would be at least somewhat aligned with the creditor’s.  Having experienced this first-hand, Paul Mayanja of the Stromme Foundation in Uganda shared a helpful suggestion – consider adding some physical collateral to the loan, even if it’s a symbolic amount.  It might not cover losses, but it would create an incentive for management to cooperate.

2. Insure that as creditor you can gain control of the MFI (through a creditor-appointed receiver, for example) in the case of default.  Whether this would actually be enforceable depends largely on the nature and effectiveness of the country’s legal system.

3. Build in debt covenants tied to thresholds (capital ratio, PAR, etc,), the violation of which could accelerate the loan.  At a minimum, this would provide extra time and leverage over the MFI’s management.

Place a small percentage of the investment in a contingency fund that would be beyond MFI management’s reach, but could be tapped under default or insolvency.  This could help fund collections operations when the MFI is experiencing insufficient cashflow.

Post-default

Once an MFI is in insolvency or default, the two primary objectives are to maintain the MFI’s payment collections organization and borrower incentives to repay.  Thus, if loan disbursements have to be halted to existing customers, their suspension should be as short as possible and borrowers given clear and believable signals that they will be getting new loans upon repayment.  In addition, here are some other steps to consider:

1. As early as possible, confer with the other creditors, both local and foreign, SRI and commercial, and try to come up with a consensus liquidation plan.

2. In nearly all circumstances, MFI directors/management will have to be replaced.  The sooner this is done, the better.

3. Realize that it is probably best to repay local creditors first.  Especially in countries were relationships can easily trump legal agreements, the local creditors will likely have inside information, political connections, and other advantages that they will use to undermine any scheme that has them suffering losses they could otherwise avoid, such as sharing recoveries with other creditors.

4. Consider the incentives of MFI staff.  Ideally, they would like to keep their jobs, but if that opportunity is unavailable, they will do the next best thing.  If the next best thing happens to be keeping borrower repayments for themselves, as was alleged at SOMED (Uganda), then that is what they will do.  It may make sense to pay collections bonuses or share a portion of recoveries with relevant staff.

5. Before attempting to sell the MFI, its portfolio, or components thereof, try to stabilize its performance first, and then get a reliable audit.  In most cases, whatever caused the MFI to get to this point is also likely to raise plenty of suspicions of its unaudited financials.

6. If a buyer for loans cannot be found, but an MFI is found that is willing to take on borrowers, even if for free, it’s probably worth taking the deal.  In effect, the new MFI is stepping in to provide the repayment incentive for borrowers, which allows the portfolio to run-off, and outstanding capital to be recovered over a reasonably short time.

Consider adding additional repayment incentives, such as waiving interest in return for early repayment.

These are just some suggestions for creditors to consider.  Learning from prior experience of MFI liquidations, and bearing in mind the two key objectives – maintaining the MFI’s payment collections organization and insuring borrower repayment incentives, creditors may be able to recover significant portions of their investments.

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It has been well established that future of micro financing institutions lies in its capability to generate inclusive economic growth to fulfill the social and economic objective and the alleviation of poverty from the society.

It is obvious therefore that to achieve this objective it would be imperative for these institutions to conceive a model to outreach poor both in urban and rural areas and provide not only succor to them but empower them to engage themselves in sustainable economic activities. Thus the obvious missing point that has become increasingly seen is the growing trend in these institutions to just overlook the core objective of poverty alleviation and also to alienate it from the social mission to achieve their commercial goal to maximize profitability. It is strange that this stark reality is totally overlooked but in almost all conferences and discussions of ideologues and passionate pioneers of micro financing institutions, both national as well as global, these institutions are projected as messiah of eradication of poverty and social and economic inequity.

STRATEGY PURSUED.

The present strategy pursued by most of these institutions is to assist small traders and vendors to acquire adequate stocks of products they trade from wholesalers and medium and small sized manufacturers  on cash payment and get the repayment of the same within a week by when such traders are expected to sell the acquired stocks in their local markets. In other words most of these institutions just have been helping small traders to meet their transaction costs only. Similarly another group of MFIs could be seen helping poor artisans in rural and semi urban areas to acquire their raw materials on cash and make their finished products ready for marketing within a week and sell the same to the middleman of supply chain of organized market or directly in their semi organized markets in rural and semi urban areas and pay back to MFIs out of the proceeds of such sales. Obviously the process is repeated to retain continuum of business.

FACILITATOR OF PAYMENT SYSTEM

It is therefore apparent that these models aimed to act as facilitators of the payment system for small traders and artisans. However another important ingredient of these models was that they leaned more on group lending rather than individual lending and thus enforced group responsibility instead of only individual responsibility to make timely repayment. This way they enforced group guarantee system and abandoned conventional collaterals as safeguard and security to ensure timely repayment. It is true that these institutions have been blossoming by practicing these models as their repayment record is commendable as most of them have almost nil record of non-performing assets. These obviously have enhanced their sustainability and organic growth. But they have failed to improve economic, social and environ ambience of poor people of villages and towns.

NEED RADICAL CHANGE IN STRATEGY

No one should have even an iota of doubt that these institutions have to revisit their strategy to become a true instrument for poverty alleviation in consonance with social and environments improvement to create healthy ambience to live in for all rich and poor in villages and urban areas of all countries- developed and developing. It has to be realized that helping poor to pursue their existing trading and farming activities would not help them to come out from the trap of poverty and this would not happen even if efforts are made to generate supplemental income by assisting female members of the families of poor people to undertake some economic activities and thereby creating a source of additional income for the family. In fact all these have been pursued over the years and laurels have been showered to individuals and institutions but when achievements of their core objectives were measured by both national and international organizations these did not reveal any notable change either in poverty alleviation or in social and environment ambience. However it is true these institutions have grown organically both as national and global institutions. But it is equally true that some of them who have conceived some deviation from the conventional concept could achieve some notable success in poverty alleviation. One such example is SEWA in India that has really transformed the economic condition of its members by providing them comprehensive support in training, management, production and marketing of their products. Of late some other institutions have also started adopting this strategy. In fact it has to be borne in mind that infrastructure is the backbone of developing not only economic activities but also transforming social and environmental ambience of the place. This is one of the major realizations dawning not only in politicians, administrators, industrialists but also among common people. Hence numbers of schemes have been introduced by the various ministries of government of India as well as state governments and even local projects have been prepared by some of the N.G.Os who has been assigned such jobs by the state and central governments. But due to lack of coordination and overlapping of institutions both administrative as well as economic have practically left such projects either totally deserted or partially implemented.

In fact it is perhaps now the most opportune moment for MFIs to as catalyst for all development oriented activities in identified village or villages and become delivery agent of all state sponsored economic and social activities like trading, farming, infrastructures buildings like roads, bridges, hospitals schools and encouraging and sustaining entrepreneurial talents of local people. These institutions could become hub of supply chain for all fund based activities. In fact political institutions should concentrate in governance of law and order as well providing funding support for other areas where normal market source is either inadequate or not available.  Therefore there should be economic institution to handle all funded activities of the state along with its own fund raising through savings of the community and such other financial instruments that are available and or created by the state to supplement market sources.

In fact lead banks of each district should be assigned the job of preparing or getting it prepared by NGOs an action plan for each village or group of villages to generate economic and self sustaining social as well as environment development activities and fund and implement these through MFIs sponsored or supported by the banks.

A Case Study On Cluster Model

This case has been initiated by Mr. Jagat Shah who among other initiatives started many other innovations like Global Network Institute of International Trade in India with branches in Ahmedabad, Banglore, and Jaipur and have conducted training of 82 batches of about 1600 business persons. Similarly in 2000 he also started a hand holding export portal for SMEs and in 2002 he founded the NGO (Cluster Pulse) for initiating and implementing development programs on cluster basis. By 2008 Cluster Pulse promoted MICROFINTECH for not only lending but also providing training micro business entrepreneurs with regard to business development and management but also assisting them to develop market linkages for their products in India and abroad.

In fact he has initiated and developed 82 such clusters for varied types business like agriculture, textiles, engineering, pharmaceuticals, consumer goods etc.

The case highlighted below is one such example.

Introduction to Cluster Pulse-

Cluster Pulse, is a non- profit NGO, professionally managed, self-sustaining, autonomous institution with excellence in implementation of Cluster Development initiatives through the twin approach of market intervention & technology up gradation. It has worked in 66 clusters of UNIDO , USAID , IFC , World Bank , GTZ , DC-SSI , SBI ( Project Uptech) , Textiles Committee , Ministry Of Textiles & State Govt. all over India & in 9 other countries. We have worked in sectors like Textiles, agro, engineering, pharmacy, consumer goods, service sector etc

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Introduction to Alappuzha coir cluster-

Coir is a natural fiber produced from the husk of coconut which is abundantly available in the coconut growing States of India like Kerala. Coir fiber is extracted through a traditional retting process and from the unrated husk; it is extracted through a mechanical process. Its development as an industry in India commenced in the State of Kerala centuries ago. Two ply coir yarns were spun either by hand or spinning wheels throughout the coastal belt of Kerala from time immemorial. Coir yarn is the raw material for the manufacture of an array of furnishing products like mats, matting, rugs, carpets etc. Growth of technology in the sector is resulting in the development of a larger diversity of products. Coir is a fiber with intrinsic strength of multi-cellular fiber giving it the toughness and brushing quality, unlike competing fibers. Today, coir offers a range of options from live-in-style products to geo-applications. The potential of rubberized coir products like mattresses, furniture/vehicle upholstery and insulation pads are immense. Due to natural edge and a skilled workforce in Kerala, Indian coir caught global attention for its color, texture, eco-friendliness, bio degradability etc. earning for it a premium price in international markets.

Micro loans to SHG in coir cluster-

Cluster pulse identified group of women artisan who are working in Alappuzha. They require micro loans for buying raw materials and equipments for making doormats, carpets and other products from coir. Cluster pulse gave them micro loans under SHG (self help group) model. A group of 30 women is defined for this purpose

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Role of Cluster Pulse-

Organize the group.

• Providing training to the group members on product development from coir.

Providing micro loans to the group members.

Role of group -

Group members were responsible for attending group meetings.

• Collecting repayments and give to Cluster team member.

Responsible for loan repayment individually and collectively.

GROUP CONSTITUTION-

Group- 1

Group members- 30

Micro loan amount- 20000 INR per member

Interest rate- 10%

Tenure- 12 months

Repayment term- monthly

Repayment collection- 100%

Impact of micro loans-

Economic-

Raw material purchase- Group started purchasing raw material in group; it reduced the cost of buying individually.

Making products- They made products in group rather than individually. It increased the efficiency of individual member of producing goods.

Selling products- They were able to sell their finished products in bulk so got good price.

Social-

Group members worked together so understood the power of working in unity.

They were shared their personal and family problems in the group and got solutions for them.

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Henry Ford did not love his fellow man – trust me on this!  He did not see the unwashed masses in Detroit – the immigrants, the uneducated, the have-nots – as a vast pool of potential friends and equals.  But he saw the bigger picture, and projected a future that would benefit him as a result of bringing more fairness to the marketplace.

Most of the readers of this publication come from the opposite end of the philosophical, or ethical, spectrum. But there is a lesson for us in this story of Henry Ford, that old reprobate. When we look at the situation of the poor in the communities where we work, when we see the barriers they face to advancement and acceptance into the strata of their societies where there is opportunity, we see that so much that holds them back is a lack of vision on the part of the most powerful within their communities. The poor are certainly not valued – that fact is obvious at a glance.  But the poor, if they had the opportunity to participate more fully in the formal economy, would not only improve their own lives, they would bring virtually unlimited benefit to those who already have prosperity and power.  Here is the challenge – to expand the vision of the wealthy and powerful, and to make them see that their self-interest lies in spreading the opportunity.  This is not charity; this is not even good governance; this is good business.

In developed countries I think we tend to see the poor and underprivileged as net drains on resources.  Not necessarily a fair assessment, but, given the social services and other public spending, and their level of positive contribution to the formal economy, there is some truth to it.  Where the poor are a much larger percentage of the population, their marginalization has a larger proportional impact on the greater economy.  The untapped potential for market growth, consumer base, tax revenues – this has a huge negative effect on the ability of those countries to become fully-participating members of the global economy.  So we keep throwing money at their chronic and acute problems in the form of disaster relief, humanitarian aid, and endless top-down international programs.  There must be a better way to help these countries to be self-sufficient, and to acquire the means to help their own least-fortunate citizens.

In the United States, we recognize that the greatest growth in the economy comes from small business.  I wish I could say that that knowledge leads to effective government planning and assistance to small business – we have a patchwork of good resources through the federal Small Business Administration and regional and local programs, an ineffective delivery system for those resources, and no coordinated implementation or planning.  But in some sense we know what needs to be done and what could be done – and support for small business is widely accepted as worthwhile.  We have internalized the understanding of the marketplace that Henry Ford had.  Small business is the greatest engine for jobs creation; salaried workers have money to spend and pay taxes; confident, secure, consumers drive business prosperity.

The prosperity of the developed world grew organically, in a generally upward trajectory since the Industrial Revolution.  We can’t wait 500 years for that in the next world, and hopefully don’t have the same amoral pragmatism.  So how can we apply the lessons we’ve learned about organically-grown economic development, ensure the strength that grass-roots evolution brings, avoid imposing inappropriate cultural norms, and still achieve the objective of encouraging community economic development that will democratize opportunity and alleviate poverty in large numbers?  At MicroVenture Support we believe we have the system that will nurture small business in a culturally appropriate way, and will also develop a professional class of in-country small business development consultants who will be able to disperse our methods for rapid deployment.  We believe that, in any market, the 80/20 rule applies to business management training.  Train the entrepreneurs in the basic skills – market analysis, financial management, cash projections, product development, inventory management, marketing, etc. – and the entrepreneurs with these skills will build businesses that will create jobs and expand markets.  This is the bedrock of the middle class, and this is where market growth and stability are created.

Everyone is talking about the “missing middle” in funding for small business.  How to capitalize small business is a thorny problem.  We certainly recognize that there’s a huge gap between the lending capacity of the microfinance sector and investment funding for small businesses with growth potential.  And just as in micro-lending, investment at this level requires much more support than in conventional venture capital. But the benefits of developing this sector are enormous, and their potential for impact on their economies is as well.  So it’s vitally important to develop systems for investment and, more importantly, developing management capacity, so that a growing, thriving, local economy is encouraged.

What is required to develop a supportive environment for small business?  Once the entrepreneur has acquired the tools for business success, how does (s)he overcome the barriers to full participation in the formal economy?  How can regional and national government come to value her? When will the local bank solicit his trade?  We encounter many leaders of MFIs with big hearts who came from the ruling classes.  But how to gain support from the larger power structure?  I believe the key is to convince them that there are great advantages to them in the prosperity of all. Take a lesson from Henry Ford.  A stable, growing, economy is in the selfish best interests of all of us.

Read more at: “http://www.microventuresupport.org” where you can access our position paper, A Transformative Model for Socially Responsible Investing.

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