Microfinance refers to the provision of financial services to low-income clients, including consumers and the self-employed.[1] The term also refers to the practice of sustainable delivering those services. Micro credit (or loans to poor micro enterprises) should not be confused with microfinance, which addresses a full range of banking needs for poor people.More broadly, it refers to a movement that envisions “a world in which as many poor and near-poor households as possible have permanent access to an appropriate range of high quality financial services, including not just credit but also savings, insurance, and fund transfers.”[3] Those who promote microfinance generally believe that such access will help poor people out of poverty
The challenge
Traditionally, banks have not provided financial services to clients with little or no cash income. Banks must incur substantial costs to manage a client account, regardless of how small the sums of money involved. For example, the total revenue from delivering one hundred loans worth $1,000 each will not differ greatly from the revenue that results from delivering one loan of $100,000. But the fixed cost of processing loans—of any size—is considerable: assessment of potential borrowers, their repayment prospects and security; administration of outstanding loans, collecting from delinquent borrowers and so on. There is a break-even point in providing loans or deposits below which banks lose money on each transaction they make. Poor people usually fall below it.
In addition, most poor people have few assets that can be secured by a bank as collateral. As documented extensively by Hernando de Soto and others, even if they happen to own land in the developing world, they may not have effective title to it.[4] This means that the bank will have little recourse against defaulting borrowers.
Seen from a broader perspective, it has long been accepted that the development of a healthy national financial system is an important goal and catalyst for the broader goal of national economic development (see for example Alexander Gerschenkron, Paul Rosenstein-Rodan, Joseph Schumpeter, Anne Krueger etc.). However, the efforts of national planners and experts to develop financial services for their nations' majorities have often failed since World War II, for reasons summarized well by Adams, Graham & Von Pischke in their classic analysis 'Undermining Rural Development with Cheap Credit'.[5]
Because of these difficulties, when poor people borrow they often rely on relatives or a local moneylender, whose interest rates can be very high. An analysis of 28 studies of informal moneylending rates in fourteen countries in Asia, Latin America and Africa concluded that 76% of moneylender rates exceed 10% per month, including 22% that exceed 100% per month. Moneylenders usually charge higher rates to poorer borrowers than to less poor ones.[6] While moneylenders are often demonized and accused of usury, their services are convenient and fast, and they can be very flexible when borrowers run into problems. Hopes of quickly putting them out of business have proven unrealistic, even in places where microfinance institutions are very active
Over the past centuries practical visionaries from the Franciscan monks who founded the community-oriented pawnshops of the fifteenth century, to the founders of the European credit union movement in the nineteenth century (such as Friedrich Wilhelm Raiffeisen) and the founders of the microcredit movement in the 1970s (such as Muhammad Yunus) have tested practices and built institutions designed to bring the kinds of livelihood opportunities and risk management tools that financial services provide to the doorsteps of poor people.[7] While the success of Grameen Bank (which now serves over seven million poor Bangladeshi women) has inspired the world, it has proved difficult to replicate this success in practice. In nations with lower population densities, meeting the operating costs of a retail branch by serving nearby customers has proven considerably more challenging.
Although much progress has been made, the problem has not been solved yet, and the overwhelming majority of people who earn less than $1 a day, especially in the rural areas, continue to have no practical access to formal sector finance. Microfinance has been growing rapidly with $25B currently at work in microfinance loans.[8] It is estimated that the industry needs $250 billion to get capital to all the poor people who need it.[8] The industry has been growing rapidly and there have been concerns that the rate of capital flowing into microfinance is a potential risk unless managed well.[9]
Boundaries and principles
Theoretically, microfinance may encompass any efforts to increase access to, or improve the quality of, financial services poor people currently use or could benefit from using. For example, poor people borrow from informal moneylenders and save with informal collectors. They receive loans and grants from charities. They buy insurance from state-owned companies. They receive funds transfers through remittance networks (like Hawala). They bury jewellery in secret places near their homes, ask relatives to look after their money, and save for family weddings by raising chickens.
There are not many bright lines that can sharply distinguish microfinance from similar activities. Claims could be made that a government that orders state banks to open deposit accounts for poor consumers, or a moneylender that engages in usury, or a charity that runs a heifer pool are engaged in microfinance. Furthermore, correcting the problem of access is best done by expanding the number of financial institutions available to them, as well as the capacity of those institutions. In recent years there has been increasing emphasis on expanding the diversity of those institutions as well, since different institutions serve different needs.
Some principles that summarize a century and a half of development practice were encapsulated in 2004 by Consultative Group to Assist the Poor (CGAP) and endorsed by the Group of Eight leaders at the G8 Summit on June 10, 2004:[7]
Poor people need not just loans but also savings, insurance and money transfer services.
Microfinance must be useful to poor households: helping them raise income, build up assets and/or cushion themselves against external shocks.
“Microfinance can pay for itself.”[10] Subsidies from donors and government are scarce and uncertain, and so to reach large numbers of poor people, microfinance must pay for itself.
Microfinance means building permanent local institutions.
Microfinance also means integrating the financial needs of poor people into a country’s mainstream financial system.
“The job of government is to enable financial services, not to provide them.”[11]
“Donor funds should complement private capital, not compete with it.”[11]
“The key bottleneck is the shortage of strong institutions and managers.”[11] Donors should focus on capacity building.
Interest rate ceilings hurt poor people by preventing microfinance institutions from covering their costs, which chokes off the supply of credit.
Microfinance institutions should measure and disclose their performance – both financially and socially.
Microfinance can also be distinguished from charity. It is better to provide grants to families who are destitute, or so poor they are unlikely to be able to generate the cash flow required to repay a loan. This situation can occur for example, in a war zone or after a natural disaster.
Debates at the boundaries
There are several key debates at the boundaries of microfinance.
Practitioners and donors from the charitable side of microfinance frequently argue for restricting microcredit to loans for productive purposes–such as to start or expand a microenterprise. Those from the private-sector side respond that because money is fungible, such a restriction is impossible to enforce, and that in any case it should not be up to rich people to determine how poor people use their money.
Perhaps influenced by traditional Western views about usury, the role of the traditional moneylender has been subject to much criticism, especially in the early stages of modern microfinance. As more poor people gained access to loans from microcredit institutions however, it became apparent that the services of moneylenders continued to be valued. Borrowers were prepared to pay very high interest rates for services like quick loan disbursement, confidentiality and flexible repayment schedules. They did not always see lower interest rates as adequate compensation for the costs of attending meetings, attending training courses to qualify for disbursements or making monthly collateral contributions. They also found it distasteful to be forced to pretend they were borrowing to start a business, when they were often borrowing for other reasons (such as paying for school fees, dealing with health costs or securing the family food supply).[12] The more recent focus on inclusive financial systems (see section below) affords moneylenders more legitimacy, arguing in favour of regulation and efforts to increase competition between them to expand the options available to poor people.
Structural Evolution of Microfinance Institutions in India
This section outlines the evolutionary and legal context of microfinance institutions in India. It details the types of legal forms available to microfinance institutions and provides some examples.
The exchange of money in the form of credit as well as cash between various participants in the economy is a practice that has been traced back some 5,000 years to the ancient civilizations of Greece and Mesopotamia. Ancient India was one of the early adopters of the monetary exchange system with evidence of its use over 3,000 years ago and the dating of the earliest Indian coins to shortly after the death of the Lord Buddha around 400 BC. India and South Asia developed their own monetary tradition albeit subject to the influences of Iran and the Greco-Roman world. The first references to credit occur in Vedic texts and the Jain followers of the Lord Mahavira initially took on the role of India’s bankers. From the twelfth century AD there are references to the exploits of wealthy Jain bankers who were experts in the exchange as well as the lending of money.
While informal financial services have always been an integral part of the traditional econo-my of India, even semi-formal and formal financial services through agricultural cooperat-ives and banks are within physical reach (less than 5 km) of perhaps 99% of the population of the country. A vast network of commercial banks, cooperative banks and regional rural banks as well as other financial institutions provide such services. Other financial institutions include non-bank finance companies, insurance companies, provident funds and mutual funds. There are more than 158,000 retail credit outlets in the cooperative and banking sectors, augmented by another 13,700 or so NBFCs (of which, however, under 600 have been licensed to accept deposits). Of these, there are some 94,000 cooperative societies or branches of cooperative banks, around 60,000 branches of 27 public sector commercial banks and 196 regional rural banks (RRBs) and another 4,700 branches of 55 smaller private banks, all providing financial services in India. There is also a growing number of foreign banks operating but their reach, through some 200 branches, is limited to the main cities.
Formal financial services are, in theory, available to low income families mainly through 33,000 or so rural and 14,000 sub-urban branches of the major banks and RRBs and by 94,000 cooperative outlets – either bank branches or village level primary societies. Financial services to the poor are also available from - agents of NBFCs. The RRBs, in particular, were established specifically in order to meet the credit requirements of the poor – small and marginal farmers, landless workers, artisans and small entrepreneurs and should, therefore, have emerged as a major source of microfinance. A total of 140,000 institutional outlets serving the rural sector and the poor implies the availability of one outlet for every 5,600 persons – in theory, a very favourable ratio for catering to the financial needs of low income families.
For many years, bankers and senior government officers were fond of describing the Government of India’s main poverty alleviation programme, the Integrated Rural Development Programme (IRDP), as “the world’s largest microfinance programme”. And so it was. It involved the commercial banks in giving loans of less than Rs 15,000 to poor people and, in nearly 20 years, resulted in financial assistance of around Rs 250 billion to roughly 55 million families. The problem with IRDP was that its design incorporated a substantial element of subsidy (25-50% of each family’s project cost) and this resulted in extensive malpractices and misutilisation of funds. This situation led bankers too to see the IRDP loan as a politically motivated hand-out and they largely failed to follow up with borrowers. The net result was that estimates of the repayment rates in the IRDP ranged from 25-33%. Not surprisingly, the two decades of IRDP experience – in the 1980s and 1990s – affected the credibility of micro-borrowers in the view of bankers and, ultimately, hindered access of the, usually less literate, poor to banking services.
Similarly, the entire network of primary cooperatives in the country and the Regional Rural Banks – both sets of institutions established to meet the needs of the rural sector in general and the poor, in particular – has proved a colossal failure. Saddled with the burden of directed credit and a restrictive interest rate regime the financial position of the RRBs deteriorated quickly while the cooperatives suffered from the malaise of mismanagement, privileged leadership and corruption born of excessive state patronage and protection.
Over the past 20-25 years, the resultant vacuum in the financial system has started to be filled, initially with the pioneering efforts of development organisations such as the SEWA Bank (Ahmedabad), Annapurna Mahila Mandal (Mumbai) and Working Women’s Forum (Chennai) but, more vigorously during the 1990s, by the entrance of significant numbers of non-government organizations (NGOs) into microfinance. Current estimates of the number of NGOs engaged in mobilising savings and providing micro-loan services to the poor exceed 1,000 organisations (author’s estimate based on the experience through the research in the field of rural finance and ratings of MFIs in different parts of India).
Initially, many NGO microfinance institutions (MFIs) were funded by donor support in the form of revolving funds and operating grants. In recent years, development finance institutions such as NABARD, SIDBI and micro-finance promotion organisations such as the Rashtriya Mahila Kosh (RMK - the National Women’s Fund) have provided bulk loans to MFIs. This has resulted in the MFIs becoming intermediaries between the largely public sector development finance institutions and retail borrowers consisting of groups of poor people or individual borrowers living in rural areas or urban slums. In another model, NABARD refinances commercial bank loans to self help groups (SHGs) in order to facilitate relationships between the banks and poor borrowers. This movement has witnessed significant progress over the last ten years and has brought changes in the rural banking system.
Though the (mainly) organizations earlier involved in developmental works have made a start in providing “user friendly” formal financial services to the poor gradually transforming themselves into microfinance institutions, its outreach is still minuscule in comparison with the need. Recent compilations of support provided by major financial institutions shows that the microfinance outstandings of domestic financial institutions (including non regulated NGO-MFIs) did not exceed Rs3,500 crores (US$804 million) by March 2005 with an outreach of less than 15 million families – at best less than 25% of the 60-70 million poor families in the country. This includes the NABARD scheme for linking self help groups (SHGs) directly with banks. The available data indicates that progress and outreach in the latter scheme was around Rs2,000 crores (US$460 million) outstanding and covering, at most, 10 million families at end-March 2005.
At the same time, the involvement of commercial banks in microfinance is negligible both in relation to the current volume of microfinance and (even more so) to their broader engagement in rural areas. The total credit from the scheduled commercial banks to the ”weaker sections” is estimated at Rs32,300 crores (US$ 7.5 billion) at the end of March 2004 compared to the total rural deposits of Rs176,000 crores (US$ 41 billion).
Since microfinance was taken up mainly as a development initiative rather than as a commercial activity, the voluntary development agencies (or non-government organizations, NGOs) who were registered either as societies, trusts or Section 25 companies did not think of looking at alternative institutional forms for providing these services – though some cooperatives and one cooperative bank were also engaged specifically in microfinance. As the scale of operations of microfinance activities started growing and, along with that, the desirability of undertaking the microfinance activity on a for-profit basis started coming into focus, the larger institutions started to feel the need for a transformation in their legal structure. As a result, microfinance institutions (MFIs) in India can now be found in the form of non-bank finance companies (NBFCs) as well.
Of the 1,000+ MFIs in the country today, perhaps 400-500 continue to operate in the form of registered societies or trusts. While institutions like ASA Trust, Tamil Nadu and Nav Bharat Jagriti Kendra, Jharkhand were established initially for a wide range of development activities, some key institutions in the country today were established specifically for microfinance but registered as societies for lack of an appropriate alternative. Examples of these are Swayam Krishi Sangam (SKS) based at Hyderabad and operating in the Telangana region of Andhra Pradesh and Grameen Koota based at Bangalore and operating in the rural areas near the city. ASA is registered as a trust under the Indian Trust Act as are other institutions such as Mahasemam and ASSEFA (also in Tamil Nadu).
Another 300-400 microfinance institutions in India operate as cooperatives either under the conventional state-level cooperative acts, the national level multi-state cooperative legislation or under the new state level mutually aided cooperative acts (MACS Act). Notable examples of cooperatives operating under the conventional acts are the Annapurna Mahila Cooperative Credit Society in Mumbai, the Indian Cooperative Network for Women (of the Working Women’s Forum) in Chennai, Ankuram Sangamam Poram in Hyderabad and Pushtikar Laghu Vyaparik Pratishthan in Jodhpur. Some of the district cooperative banks – such as DCCB Bidar (in northern Karnataka) – have also started to take a significant interest in microfinance. Of the state-level MACS Acts there has been a significant impact so far only in Andhra Pradesh – which pioneered this regulatory form. There are now many significant Mutually Aided Cooperative Thrift Societies (MACTS) in Andhra Pradesh which, therefore, accounts for the bulk of the 3-400 number cited above. Some better performing examples of such MACTS are the ACTS Mahila MACTS based in Chittoor, the PWMACTS in Vishakhapatnam and the Indur MACTS Federation in Nizamabad.
More recently a trend to register MFIs as companies has emerged. Some are registered as not-for-profit companies under Section 25 of the Companies Act, at least partially to take advantage of the Reserve Bank of India’s exemption from registration for such companies providing microfinance services. Notable examples of these include the Cashpor Microcredit Company Ltd (CMC) based at Varanasi and operating in the eastern part of Uttar Pradesh and western Bihar and Sanghamithra Rural Financial Services Limited (SRFS) based at Bangalore, operating in Karnataka. However, these are still relatively few in number, perhaps no more than ten.
Another, form of registration that indicates a bolder, overtly commercial (and in the long term institutionally more sustainable) approach to microfinance is the establishment of a for-profit company followed by registration with the RBI as a non-banking finance company (NBFC). A number of MFIs are considering this route and a few have either already transformed into NBFCs or are in the process of doing so. Some of the largest MFIs in the country now operate as for-profit NBFCs. Key MFIs that have already converted their microfinance institutional form into for-profit NBFCs (or started as such) are Bhartiya Samruddhi Finance (of BASIX), Hyderabad (operating in the states of Andhra Pradesh, Karnataka, Orissa and Maharashtra), SHARE Microfin, based at Hyderabad and operating in the states of AP, Orissa and Chattisgarh, Spandana, based at Guntur and operating largely in the urban areas of coastal AP and Sarvodaya Nano Finance (of ASSEFA), based at Chennai and operating in much of Tamil Nadu.
Though a look at the operational profile of each of the NBFCs suggests that transformation of large MFIs into this form has helped them to scale up operations significantly, the form still has significant constraints, particularly in the regulatory limitations on the range of financial services they are able to offer. These limitations are discussed later in this report.
The following section discusses the legislation on which each of the organizational forms discussed above is based before the report reviews the status of the regulatory frameworks and prudential norms that must be adhered to by MFIs operating in India. |
