Microfinance: Too Good to Be True
Last week, news broke that one of India’s most respected microfinance institutions (MFIs) is on the verge of closing up shop. The microfinance industry has now come full circle from the heady days of 2007-2009 when for-profit microfinance (MF) was hailed as “the next big thing.”
Given that India’s microfinance sector accounts for 7% of the worldwide microfinance loan portfolio, and that the domestic market is the largest in the world with over 100 million households, the sector in India should have been the leader in terms of demonstrating the positive power of private capital. Instead, corruption, mismanagement, government interference, and undisciplined borrowers have left the industry in tatters. The Indian microfinance story should act as a cautionary tale to the world’s over-eager lenders; if it seems too good to be true, it probably is.
Microfinance essentially is unsecured, sub-prime lending. Therefore, given the high-risk nature of the products involved, MF interest rates need to be very high. When MF first expanded in the southern states of India, repayment records of borrowers were fantastic. As low as 1% of loans were turning into non-performing assets (NPAs), yet lenders could generate extraordinarily high yields (spreads of over 20%).
And herein lay the problem. In the world of debt, extraordinarily high yields do not accompany impeccable repayment records in the long run. Either interest rates fall due to competition, or default rates increase. In India, non-bank financial companies and venture capitalists flocked to the sector with much enthusiasm and little due diligence, only to see it all go pear shaped very quickly.
Detailing how the industry transformed from the utopian fantasy it promised to be into the murky, squalid, political nightmare it has become is complex and to an extent speculative. However, a few key markers can be identified.
In 2010, SKS Microfinance launched the first Indian MF IPO. A few weeks later its CEO was sacked and the company was beset by allegations of mismanagement and corruption. At the same time, stories began to emerge of borrower suicides and strong-arm debt collection methods. In a bid to protect the borrowers, the government of Andhra Pradesh (a state that accounts for over 25% of India’s MF portfolio) enacted stringent regulations for debt collection and credit-based lending. Over the last year, repayment in Andhra Pradesh has fallen to 10%, an absurdly low number, and the contagion has spread to other states with NPAs increasing to over 3%, nationally. As a result, banks are unwilling to lend to MFIs and equity investors are concerned over the quality of assets the industry can generate. All this has culminated in India’s oldest MFI having a negative net worth due to inadequate credit lines and poor asset quality.
The question that now begs asking is twofold: Where do these events leave the industry in India, and what lessons can other countries with nascent MF industries learn? With regards to the former, the central government has proposed a draft regulation that hopes to pave the way for private capital to return to the sector. This is a mistake. MF borrowers in Andhra Pradesh have proved the game theory argument that if one does not have to repay, one will not, ripping to shreds the notion that economically weaker sections of society will display a technically irrational degree of integrity when it comes to repayment (the very foundation of MF). Preventing lenders from relapsing into harsh but effective debt collection methods will not be easy.
At the same time, initial results have shown the enormous benefits of providing entrepreneurial people with small quantities of capital. This is where the second part of that question becomes relevant. There is undoubtedly a place for microfinance in the developing world, but it is not in the for-profit sector. NGOs and government-partnered programs are the way forward because benevolent yet practical lenders are extremely useful tools with which to fight poverty. In the for-profit scenario, investors and lenders providing the capital to MFIs cannot accept write-downs or credit extensions for philanthropic reasons, but non-profits and, to an extent, public-private-partnerships can. The reach of not-exclusively-for-profit MF (not ‘non-profit’) will certainly not be on the scale of for-profit MF, but it will ensure steady progress without the sort of reputation-damaging turbulence currently being experienced in India.
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