India: Macro Growth in Microfinance

Dec 2009
India, December, 08 2009 - The poor pay back prompt, ask any microfinance institution. Yet, the dizzy growth of the microfinance industry in recent years — 90 per cent compounded average in the last four years — has fuelled suspicions of infection spreading through its system.

The poor pay back prompt, ask any microfinance institution. Yet, the dizzy growth of the microfinance industry in recent years — 90 per cent compounded average in the last four years — has fuelled suspicions of infection spreading through its system.

Judging from the entrepreneur interest and inflow of PE (private equity) funds into microfinance institutions (MFIs), further scale-up is inevitable. Can MFIs do so fast, yet without bad debts rising dangerously? Plenty of answers on both sides.

Scaling up

In the financial services business, to scale up fast is to court disaster. But in the case of Indian microfinance, industry experts aver that it need not be so, given the size of underserved market.

The appetite for microfinance is about Rs 1.30-lakh crore a year; in 2008-09, microfinance disbursements were about Rs 28,000 crore.

Others believe that the ‘big potential' argument holds only in theory. Any scale-up without runaway risks is possible only if the expansion is orderly, and orderly growth presupposes a whip-cracking regulator with a penchant for discipline.

Today, a large chunk of the industry is outside regulation; the others are regulated by the RBI only in terms of liquidity and leverage, and the real risks don't show up on the regulator's radar. A good 90 per cent of the MFIs are small, serving fewer than 10,000 borrowers and they are unregulated.

CRISIL, which studied the industry recently, notes that the small MFIs will not be able to weather bad loans. As PE funds began to court MFIs, even some of the larger ones “slackened their provisioning practices to get good valuations,” says CRISIL.

Yet, some players in the industry have demonstrated that rapid and yet painless scale-up is possible.

Joint liability group

Hyderabad-based SKS Microfinance, the biggest in the business with 5.5 million borrowers and a loan book of Rs 3,400 crore, claims a recovery rate of 99.5 per cent.

According to Mr Dilli Raj, Chief Financial Officer, controls begin with the size of the joint liability group (where other members pay if one defaults). SKS insists on five members. Any less, the burden on the others if one defaults will be heavy. Over five, the group will lack bonding. Other MFIs have bigger groups, but any one larger than ten is suboptimal.

Equally important is the frequency of collection. SKS collects its debts once a week, so that the tempo of repayment is kept up. Weekly collection is a mammoth task.

Employees of SKS meet over a million customers each working day. For this, SKS employs a fleet of 18,000 employees organising whom is in itself not only a mammoth task, but also a potential operational risk. However, shorter collection cycle helps keep delinquencies under check.

“Some MFIs collect on monthly or bi-monthly basis to keep operational costs low,” says Mr Raj, “but that is risky.”

Operations risk

Indeed, ‘operations risk' is a bigger danger than ‘credit risk'. “Some companies are growing fast on a platform that they had when they were small,” notes Mr P. N. Vasudevan, Founder and CEO of Chennai-based Equitas Micro


Practically all of the operational risk is employee-related. What if the employee makes off with the money bag? It is impossible to prevent this, but the trick lies in building such a system as would alert the head-office about the fraud in quick time, says Vasudevan. Equitas has created a system, built around home grown software, which tells the Chennai head-office on a real-time basis the attendance and collection at meetings at each centre. The system is designed to show up any inconsistency (as between attendance and collection), which is instantly investigated.

IT driven

The issue therefore veers around to IT. “The system has to be IT-driven,” says Sucharita Mukherjee, Managing Director, IFMR Capital, an NBFC that facilitates capital market access to MFIs and also co-invests in them. An MFI with 100,000 borrowers could typically have 5 million data points. “We are very uncomfortable with manual systems,” says Ms Mukherjee. Some MFIs, she notes, run over Excel spreadsheet, which is not tamper-proof or error-proof.

The way employees are incentivised also has a bearing on operations risk. MFIs like SKS do not reward employees either for loan origination or collection, but only member acquisition. Incentivising loan origination begets lending-exuberance, while rewarding collection results in friction with the borrowers.

Another big operations risk is people borrowing from multiple MFIs. This problem is accentuated by MFIs, flush with PE funds, chase the same set of creditworthy borrowers.

“Part of the reason for defaults is concentrated lending,” says Mr Vijay Mahajan, an industry pioneer, who runs Basix. He calls the areas of East and West Godavari and Guntur in Andhra Pradesh and Kolar in Karnataka as areas of excessive growth.

To address this, an association of the industry has decided to enrol with two credit information agencies, CIBIL and High Marks, to make sure that the same customer does not borrow from more than one MFI. So, there are industry best practices to de-risk the business, but do they make the system fail-proof? Any response to this question needs to be examined in the light of the recent flood of private equity into the sector.

PE funds

The sector is hot. In 2008-09, $178 million poured into the sector, over thrice as much as in the previous year. The trend is continuing into the current year. Typically, the PE investor is a man in a hurry.

PE funds have certainly helped MFIs, providing equity capital and liquidity.

But the deluge inevitably brings with it silt, clogging the canal. Venkat Subramanyam of Veda Corporte Advisors sees merit in the argument that PE funds “will compel the entrepreneur to accelerate growth to an orbit not attempted in the past.”

He points to a potential danger. “The entrepreneur starts expecting high valuations and builds a business plan built to fit such expectations.” Only later does the entrepreneur realise that capital is not the only problem in scaling up.

Then, come the time for exit there will be pressure on the entrepreneur to perform, because the PE funds are themselves under pressure from their investors.

The emerging scenario is leaving cynics even more sceptic about the sustainability of microfinance. Mr R. Thyagarajan, Chairman of the Chennai-based Shriram group, for one is convinced that microfinance will fail as a business, if run in the current model. He feels that there simply isn't enough room for businesses that the funds could support.

“Focus has to first be on creating business opportunities, not on making money available,” he says, pointing to the example of Amul, which fostered a dairy industry before buying milk from villagers. There has to be an assured market, assured price and assured cash-flows — otherwise, it would be putting the cart before the horse, says Mr Thyagarajan, a veteran in the financial services industry.

Thus far, microfinance has been a success story. Before the ‘wow' turns ‘woe', there is a clearly a need for course-correction. There is a need to guard against irrational exuberances.

Source : iStock Analyst

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