Microfinance developments: Let good economics and sound regulation be good politics

The recent developments in the Indian microfinance sector, particularly in Andhra Pradesh (AP), have been disconcerting.

Within a relatively short period, a sector heralded as representing a commercially viable solution to the problems of financial inclusion, poverty reduction and female empowerment is now being accused of various improprieties.

The microfinance institutions (MFIs) are now being criticised as being  detrimental to improving the lives of low income individuals.

Recent developments involve some of the borrowers from the MFIs being over-extended, resulting in repayment problems; and there have been coercive collection methods in some cases.

There have also been well publicised episodes of poor governance practices and alleged overemphasis on profit rather than social objectives by some  MFIs in the country.

Indeed, some sensational reports portray the Indian microfinance sector as nearly on the verge of collapse.

Just as it was unrealistic to view microfinance as revolutionary in mitigating poverty and advancing financial inclusion, its current characterisation as contributing to worsening the lives of millions of sector participants, is also unwarranted.

It is therefore even more essential; that the policymakers in India, and particularly in  Andhra Pradesh let good economics and sound regulation, aided by empirical evidence based on robust data and their analysis be good politics.

Unfortunately, the government of AP has hastily passed a controversial Ordinance. This has resulted in bringing all microfinance repayments to a halt in AP, the state which ironically led the microfinance revolution in the country.

The Microfinance Institutions Network (MFIN), an association of MFIs accounting for more than 85% of the MFI portfolio in the country, has challenged the Andhra Pradesh (AP) ordinance, the outcome of which is being awaited.

As many large MFIs in the country have outstanding loans in AP, this has lead to concerns on the part of their investors and lenders. There are also concerns that the crisis may spill over to other states.

Due to the microfinance sector’s priority sector status, most banks have loan exposure to MFIs and these portfolios are now being rapidly downgraded by credit analysts. There are obvious implications for continued availability of funds for the sector, and therefore for credit access for millions of households.

In principle, there is little to suggest why a microfinance provider of loans to low income individuals at their doorstep, in a manner convenient to them, without insistence on collateral or prior credit history, should cause harm. In practice however, there are instances when it has apparently done so.

While this needs to be addressed, ill conceived regulation, with low implantation capacity, and immature and irresponsible political leadership, could make the situation worse for the low income households, particularly in the medium term.

While a combination of factors may have contributed to the above situation, multiple lending and coercive collection practices are frequently being cited by analysts as the causes of the crisis.

These may be the proximate causes, but there are other underlying reasons. These include the lack of financial education of microfinance customers, the nature of incentives offered to field staff by microfinance institutions (MFIs) and the lack of a uniform code of conduct for the sector. The widespread politicisation of microfinance in AP is an additional contributing factor.

Firstly, lack of financial education is an important factor why some MFI borrowers find themselves in difficult debt repayment situations. While microfinance providers claim that they train borrowers, what they impart is usually product knowledge, aimed at ensuring compliance of the borrowers to the terms of lending.
Imparting financial education empowering the borrower to make financial decisions such as ascertaining the effective cost of loans, and the extent of debt she can handle, rightfully needs to precede provision of financial services. Currently, such education is not being routinely made available to all microfinance borrowers by any stakeholder, government or non-government.

With increasing pressure on MFIs to reduce interest rates, it is unrealistic to expect them to incur additional transaction costs on financial education and so this will necessarily need to be addressed by socially-oriented donor or state funded bodies. It is also desirable that financial education be imparted by an independent entity.

Second, the incentives of the field staff are typically directly linked to the number of new loans and the volume of “on-time” loan collections. Considering that often field staff come from relatively low income segments, these have the  potential to lead to unethical actions.

Third, while there are shortcomings in the operating models of MFIs, the State has also contributed to the current crisis due to the long delay in introducing microfinance regulation, discussions on which have been ongoing since 2007.  A uniform nation-wide code of conduct for all MFIs  needs to established urgently.

One option is that an independent oversight board reporting to the Reserve Bank of India (RBI) with representation from various sector stakeholders oversees the implementation of the code of conduct.

Recent reports suggest that the RBI appointed committee will submit a report on microfinance regulation in January 2011. Its recommendations will inform the Microfinance Bill to be introduced in the budget session of the Parliament. It is hoped that the Bill will include all sector participants in its scope; provide uniform code of conduct; facilitate construction and maintenance of data base; and not impose interest rate ceilings.

All the stakeholders need to acknowledge that the MFI sector is based on collateral free loans and so by its very nature is prone to volatility in repayment. This is the reason why this segment of borrowers has been neglected for many decades in the past. By politicizing the sector, its volatility is only being enhanced.

It is believed in some quarters that the success of MFIs may have adversely impacted state-supported subsidized micro-finance programs whose objectives included developing political constituency for certain parties. Once the perception takes hold that public policies are not being designed with broader public interest in mind, but to serve narrow sectional or political interests, even good policies become harder to implement.

A useful contribution of the microfinance sector has been to show that India’s low income individuals are credit worthy.

It is important to build on this contribution by sustaining the repayment culture inculcated by Indian MFIs, even while introducing adequate safeguards and providing supplementary support mechanisms through civil society and the state.

The microfinance sector is at a stage where it needs decisive policy direction from the government to restore the confidence of stakeholders. The policy course adopted should let good economics and sound regulation be good politics.

The coming  weeks will determine whether a promising avenue for enhancing financial inclusion for low-income groups, particularly women, will progress towards a more mature phase or flounder in the country.

The writer is a professor of public policy, National University of Singapore, and can be reached at sppasher@nus.edu.sg.