The art of killing micro financial institutions

A colleague at a well known US university asked me once about areas which are not regulated by the government in India.

I thought about it and the only answer I could give was pertaining to music /dance performances and other art forms as long as one does not want government awards.

Government does not fix the duration of an aalaapana — so far. If any enterprise is doing well and well received by users/customers/borrowers then the government with a perverse intent evolves regulations to destroy that activity. It cannot simply accept success of the enterprise and the benefits that the borrowers/clients derive from it. Micro Finance (MF) is one such area.

In the last decade this form of lending has picked up and micro finance institutions (MFIs) added nearly nine million customers in fiscal 2009 taking their consumer base to more than 22 million. National Bank of Rural Development (NABARD) suggests that there are 800 MFIs but only about 10 have outreach of more than 100,000 clients. Most of the MFIs are dependent on banks for their funding rather than on capital markets.

The poor borrowers are helped by MFIs due to their reach and knowledge about the markets. Banks are not in a position to effectively service the poorer clients running small businesses due to inherent constraints.

So they fund the MFIs at an interest rate of 10 to 14%. The MFIs in turn re-lend it at around at an interest rate of 36%. It is this huge difference in interest charges between the rate at which MFIs take money from the banks and the rate at which they give the customer that the finance ministry is objecting to. It is asking the banks to ensure that the MFIs do not charge “hefty” rates from poor borrowers. Government is even thinking of capping the lending rates of MFIs.

The performance of banks in meeting the requirement of small borrowers is nothing to write home about. The distribution of outstanding bank credit by categories reveals that the share of household sector (consisting of proprietorship /partnerships and individual accounts) was 58% in 1990. It declined to 48% in 2004 and to 33% in 2009. Not only that, the share of loans up to Rs25,000 in terms of number of accounts fell from 93% in 1995 to 36% in 2009. In terms of outstanding or unrecovered loans it was 23% in 1990 and 1.5% in 2009.

The public sector banks in a sense are also not geared to finance businesses like a local cobbler, tailor, plumber, vegetable-seller, since these people need cash flow-based rather than asset-based financing. It is to be noted that the market knowledge and information regarding these activities are not fully available with commercial bankers on an updated basis.

The typical bank manager of a public sector bank has a two- to three-year tenure at a particular branch and is also shifted across activities like foreign exchange, administration, agricultural finance, personal banking, training, industrial lending etc.

This is all the more true of such small and micro business activities where there are significant fluctuations in the cash flows within short periods of time. Hence, the ability to assess the market as well as keep track of daily changes is paramount in lending for these activities.

Studies suggest that more than 60% of the time of a public sector bank manager is spent on personnel- and depositor-related issues at the branch. In such a situation it becomes difficult for the manager of a public sector bank to lend, based on cash flows since this requires constant and continuous monitoring of market changes with a reliable database, which alone would give them a strong feel of local conditions and profiles of borrowers. In other words, risk assessment capabilities are not adequate.

The best solution to integrate our markets is to have a concentric circle of lenders and obviously each will have margin and operating expenses. Also, the computation of interest rates is linked to one’s time horizon or period of planning. If my flower girl borrows at say half per cent per day it should not be looked upon as 180 % per annum since her time horizon is different. One should not telescopically enlarge rates since time horizons of small businesses are different.

RBI has formulated policies for UIB’s (unincorporated bodies like money lenders) wherein they can lend but not borrow money and in the process made many of them go underground and operate.

Let the government not meddle with the MFIs in terms of “Nehruvian” legacy of capping interest rates and strangle that business. The old saying that “if any activity is successful then government cannot tolerate it” hopefully is not repeated in the case of MFIs.