Are MFIs a lost opportunity?

Shakespeare once said, "A rose by any other name would smell as sweet". But, in the case of the Indian microfinance industry, this phrase did not work too well. If you call yourself a microfinance institution (MFI), armed with a social cause, you will get slammed if you only chase profits. Maybe, this will work in your favour for a while. But soon enough, the basic rules of economics start to kick in. More on this point later.

Andhra Pradesh (AP) alone accounts for around 30-40% of India's overall US$ 6.5 bn microfinance portfolio. It is also the birthplace of a number of big name microfinance companies including SKS Microfinance, Spandana, Share, Asmita etc. It is the proverbial cash cow of the business in the country.

Source: Financial Times website

When a few players in an industry earn abnormal profits, other players then decide to join the party. The established few, e.g. SKS, Spandana had some knowledge on microfinance operations, handling borrowers, etc. The newer, more aggressive players in their aim for quick profits opted for strong arming techniques in order to earn their share. The poor borrowers eagerly lapped up loans initially. But, ultimately they overleveraged themselves. And with interest rates hovering between 27-30%, this was not a good idea.

The entire microfinance model is based on group lending. If one borrower defaults, the others have to carry their weight. Rather than facing the shame of default, some of the women borrowers turned to suicide. When these numbers racked up, the authorities started crying foul. But, 2010 was not the first time that this happened. The first case of suicides due to aggressive operations happened in the same state of AP in 2006. A number of branches were shut for operations and the industry faced a temporary crisis.

But, the crisis did not go away. Lending rates were still prohibitive. Borrowers were overleveraged. And, post the listing of SKS Microfinance, a lot of unresolved issues came to the fore. Anyway, this time, the government finally took matters into its own hands. In October it passed an Ordinance to help regulate microfinance activity in the state. Recently in December, the government passed a Microfinance bill, with similar provisions. This bill is expected to be soon enacted into a law, but it faces strong opposition from the MFI network.

Some of the main features of the bill include a monthly instead of weekly collection period. They are also not allowed to lend to women self-help groups (SHGs) already serviced by banks. In order to prevent coercive lending practices, the MFIs are now only allowed to collect their repayments from a designated government location such as a village panchayat. Earlier, they could visit borrower's houses to recover money. There was no interest rate cap declared, however.

All these moves, since the passing of the ordinance materially impacted the operations of MFIs in AP. Collections dropped to 20% from 95% previously. SKS' shares were hammered on the exchanges. You may think that these moves would lead to the failure of the industry. But, after facing these challenges, the industry can, and will grow stronger.

Taking away the capital that helped a young woman set up a business in a village, is devastating. Once she has tasted the power of being an entrepreneur, the desire can never go away. Banks, PE, and Venture capital firms who lent money to the billion dollar industry, all cannot write off these loans as bad. They do see microfinance as a key growth driver for Indian financial sector.

The industry has to bounce back stronger than before. It will have to work around the new laws and regulations that will come up in AP and other states. The business model needs to be reworked. It needs to find that 'magic number'. The interest rate that is both reasonable and profitable. It will have to try and manage the delicate and difficult balance between social good and business profits. Having said that, the industry will take some time to become lucrative for shareholders.