The last-mile gap with microfinance and the way ahead for MFIs

In a country full of paradoxes, it should have come as no surprise that one of India's most profitable business sectors is also one that claims to provide a platform to lift its millions out of grinding poverty.

After a brief lull, microfinance institutions are back in the news with a big bang. First came the spectacular $354 million IPO of SKS Microfinance followed by an ongoing debate about the ethical concerns with making profits out of poor people. Then came the acrimonious ouster of the CEO of SKS under mysterious circumstances.

Now, following a number of high-profile suicides allegedly driven by harassment from usurious micro-lenders and mounting opposition, the Andhra Pradesh (AP) government has cracked the whip on microlenders. An ordinance has been promulgated capping the interest rates charged by micro finance institutions (MFIs) and introducing stronger regulatory requirements. In AP alone the MFIs are estimated to have given loans worth Rs 3500 Cr so far this year, against Rs 2358 Cr given by government banks (against annual target of rs 7500 Cr).

On the face of it, there should not have been any competition between MFIs and government-financed SHGs, especially in AP. The SHGs financed by the government of AP receive considerable interest subsidy, leaving them to pay an interest of just 1% if the group maintains regularity in repayment for six months continuously. The linkage amounts too are large, Rs 75000 for the first linkage (given to groups after six months of satisfactory thrift activity), Rs 2-4 lakhs for the second linkage, and so on.

In contrast, the MFI groups recieve smaller amounts and at usurious annual interest rates of 24-60%. The repayment terms are much more onerous - weekly repayment (as opposed to monthly for government SHGs) and the threat of force and public humiliation for recoveries. Despite these obvious disadvantages and attractions of the other side, women groups prefer MFIs in large numbers. What are the last-mile gaps that force poor people into making such apparently irrational choices?

Unlike the bureaucracy-layered loans grudgingly given by the scheduled banks as part of their priority sector lending to government managed SHGs, MFI loans come with the red-carpet rolled-out. While the group members are forced into making multiple visits to bank branch, the MFIs offer loans at the door-step. And the paper-work and other procedural formalities are minimal with MFI micro-loans. The repayment procedures too are convenient. The always-available nature of these MFI loans as opposed to the still-distant nature of bank microloans, also ensures that they fulfill the critical timeliness requirements of poor people.

There are also the attractiveness conferred by way of lack of regulation and absence of standard due-diligence requirements. MFIs encourage formation of groups followed by immediate sanction of loans, whereas the government banks insist on six months of continuous thrift activity to become eligible for the first round of loan linkage. The same group can access loans from multiple MFIs, without any questions raised about repayment capabilities.

In simple economic terms, thanks to all the aforementioned last-mile deficiencies, the opportunity cost of accessing micro-loans offered by government banks is much larger than the cost of the MFI loans, even with their usurious interest rates.

My argument that follows is neither in favor nor against MFIs. On the one hand, there is ample evidence that most MFIs indulge in unhealthy business practices that ends up exploiting the very people whom it intends to help. It is by now widely-known that apart from the downright illegal strong-arm tactics to recover defaulting loans, they also employ unethical practices that conceals the true cost of loans from their unsuspecting borrowers.

On the other hand, it is undoubtedly true that MFIs are only the latest in the long-line of businesses that have seized the opportunity to exploit the massive profits that characterize virgin markets. The only difference being that unlike their predecessors, MFIs have been making their super-normal profits even as they maintain pretensions of helping the poor and complementing the efforts of the government in lifting people out of poverty.

In simple terms, it cannot be denied that the MFIs are merely exploiting an extra-ordinary business opportunity. However, it can be argued that they are free-riding on public externalities (tapping into the existing SHGs and the social capital and trained field personnel created by the government microfinance movement) to run an exceptionally lean and low-cost business model. In the purest capitalist language, any business enterprise which, notionally atleast, purports to play by the rules of the game, and generates a return on investment far in excess of 50% is arguably efficient.

It cannot also be overlooked that MFIs, like money lenders, play an important role in meeting credit requirements of the poor. In recent years, MFIs have proliferated in response to the realisation of huge un-met credit demand among the poor, arising partially from the government's own inability to provide universal access to formal credit mechanisms. In other words, MFIs are a form of the cliched "necessary evil".

The challenge now is to ensure that the MFIs contribute towards meeting the credit requirements of poor people, without compromising on the their undoubted capitalist efficiency and entreprenurial drive. In other words, how do we get MFIs to shed their predatory and unethical business practices and start to function like normal businesses? The instinctive answer to such questions is stringent regulation - interest rate caps, severe punishments and so on.

I am inclined towards a more nuanced position. While regulations are essential, it needs to be borne in mind that they can be successful only if the state has the capability and commitment to enforce them. As is the case with similar regulations on a host of other sectors and activities, neither pre-requisites are available. In the circumstances, regulations have to be supplemented with strategies that can re-align the profit-maximizing incentives of micro-lenders with achievement of the desired public-policy objective of expanding access to formal credit mechanisms.

One way to achieve this is to formulate the market for micro-loans in a manner that makes borrowers effectively sub-ordinated equity partners in the enterprise. Profits beyond a pre-defined bound, and after accounting for the regular shareholder dividends, could be ploughed back into the respective accounts of the borrowers as bonuses that effectively lowers the final interest rates. This would enable an efficient form of price-discovery on interest rates which reconciles both the commercial imperatives of the MFI and the reasonableness of the interest rate borne by the poor borrower.

Another approach would be to have a sliding scale for appropriating some of the super-normal profits. In simple terms, a graduated system of taxation can be introduced that internalizes some of the earlier mentioned public externalities that have been captured free by the MFIs. Governments could then reimburse this as an interest subsidy to the borrowing groups.

The administration of both these strategies could become dramatically simpler with the coming of UID and the introduction of UID-linked bank accounts. It also becomes easier to enforce regulatory requirements on capacity-related eligibility norms for groups, on the number of separate loans a group can hold, and other factors.

In conclusion, MFIs may or may not have succeeded in their ostensible mission as social enterprises. It may also be debatable as to whether their activities will be to the benefit and long-term good of their customers. However, it is undoubtedly true that they have enormously enriched their promoters.