In the five years till 2010-11, India’s microfinance sector—self-help groups (SHGs) and private companies lending small sums to the poor—doubled its customer base to 90 million, according to an Access report, and increased its loan portfolio by 225 per cent to an estimated Rs 70,000 crore, according to Microfinance Institutions Network (MFIN), a representative body of private lenders. Much of this growth was thanks to funds made available by regular banks, for whom the Government had designated microfinance a ‘priority sector’—to which money had perforce to be allotted. “Microfinance institutions (MFIs) were able to demonstrate that they can reach out to the poor and provide them microloans via a non-subsidy based economically viable model,” says Alok Prasad, CEO of MFIN.
All seemed well, but in 2010, the sector was hit by a crisis. Unethical practices adopted by a few run-riot lenders came to light in rural Andhra Pradesh. Some of them were found charging customers usurious rates and using strongarm tactics for repayments. Then, in response to a series of suicides by over-indebted borrowers, the state government banned microlending. Coercive recovery practices were to blame for the deaths, it said. Although MFIs deny any role in the suicides, they do admit that “mistakes were made in the past” (for which “corrective action” has been taken), in the words of Vijay Mahajan, president, MFIN. “The motivation of some MFIs changed from legitimate profit to unethical profiteering,” he says, “which invited a natural backlash from the Andhra government and society, thereby bringing the whole sector to a virtual halt in the state.”
Not only did MFIs operating in Andhra lose their funding, the sector’s lost legitimacy meant that vast numbers of borrowers simply stopped repaying their loans. About 7 million customers refused to pay MFIs back an estimated Rs 7,000 crore. “The AP legislation has robbed the poor of their creditworthiness, who otherwise have been performing so well with a repayment rate of 99 per cent,” complains Prasad.
Many customers had been juggling credit, since they could also borrow from SHGs: groups of villagers who pool money for group members to borrow turn by turn. Since Andhra’s SHGs had access to subsidised funds from banks (as part of state policy), they could lend money at an annual interest rate of only 3 per cent, and that too on flexible repayment terms. In contrast, private MFIs, which had larger loans to offer, were lending at 40 per cent or more. Given the gap, some villagers started borrowing from SHGs to pay their weekly MFI loan instalments. Over time, SHGs saw repayments decline while MFIs got a near perfect payback record. This is why some MFI executives suspect Andhra’s ban of being a measure to protect SHGs from private competition.
However, defenders of the ban argue that MFIs had been exploiting the poor, charging rates far higher than justified by the extra costs entailed in serving customers in far-flung rural areas. Taking a grim view of this, the RBI has regulated the sector since mid-2011, capping loans at Rs 50,000 per borrower, interest rates at 26 per cent, and an MFI’s interest margin at 12 per cent. So if an MFI borrows funds from a bank at 14 per cent and lends to villagers at 26 per cent, the ‘spread’ of 12 per cent is expected to be enough to cover costs.
Such caps go against free-market principles, but MFIs have no choice but to accept them. “In the present circumstances, regulation was necessary,” says Mahajan, “but in the course of time [if the industry behaves itself], the sector need not be micro-managed.” Dilli Raj, CFO, SKS Microfinance, the only microlender whose stock is traded publicly, takes a pragmatic view: “Philosophically, we are opposed to the capping of interest rates. However, abiding by these regulations is the only way to stop contagion risk from spreading.”
The sector is showing signs of revival now. With access to 68 million loan records, MFIs are better placed to identify those who take multiple loans (and are likely to default). Since October 2011, banks have started lending selectively to MFIs. Sensing profit potential, private equity players are keen on investing in some of them. With annual demand placed at Rs 750,000 crore, there is vast scope for expansion. But for India to rely on MFIs to fulfil its ‘financial inclusion’ agenda would be foolish. Instead, their success ought to spur SHGs and other state programmes to get their act together in rural India. “Cooperation and competition will both go up,” says Ajaykumar Tannirkulam, executive director, Centre for Micro Finance, “which is great for clients.”