Economics for Everyone - Managing the microfinance - designing development
Prof. M. Guruprasad, AICAR Business School / 11:21 , Jan 24, 2011
The finance ministry could move a bill in the winter session of Parliament that will make NABARD responsible for regulation of all non-profit microfinance institutions structured as trusts, cooperatives, or mutual benefit societies.
Context I
One of the largest microfinance companies in India, SKS Microfinance raised $358 million in an IPO.
Context II
Pranab tells micro lenders to frame code of conduct- Finance minister Pranab Mukherjee said micro lenders must develop a code of conduct on interest rates and prohibit coercive recovery methods.
Context III
Market regulator SEBI today said it is still investigating the issue of SKS Microfinance sacking its CEO Suresh Gurumani-- which raised the hackles of investors --shortly after a successful Rs 1,600- crore public offer.
Context IV
Microfinance to get a regulator in NABARD.The finance ministry could move a bill in the winter session of Parliament that will make NABARD responsible for regulation of all non-profit microfinance institutions structured as trusts, cooperatives, or mutual benefit societies.
Context V
In addition, the Government of Andhra Pradesh has passed an ordinance that significantly enhances regulatory control on MFIs in the state, reflecting the concerns regarding what the provincial government perceives are high interest rates being charged by the MFIs, and the coercive means of recovery they adopt.
To most, microfinance means providing very poor families with very small loans (microcredit) to help them engage in productive activities or grow their tiny businesses. Over time, microfinance has come to include a broader range of services (credit, savings, insurance, etc.) as we have come to realize that the poor and the very poor who lack access to traditional formal financial institutions require a variety of financial products.
Microcredit came to prominence in the 1980s, although early experiments date back 30 years in Bangladesh, Brazil and a few other countries. The important difference of microcredit was that it avoided the pitfalls of an earlier generation of targeted development lending, by insisting on repayment, by charging interest rates that could cover the costs of credit delivery, and by focusing on client groups whose alternative source of credit was the informal sector. Emphasis shifted from rapid disbursement of subsidized loans to prop up targeted sectors towards the building up of local, sustainable institutions to serve the poor. Microcredit has largely been a private (non-profit) sector initiative that avoided becoming overtly political, and as a consequence, has outperformed virtually all other forms of development lending.
So basically, microfinance has moved beyond micro credit. Now there is a combination of financial intermediation, social intermediation, and in many cases pure social service. Savings has increasingly become very, very important in the field of microfinance because we still lack a good understanding of why poor people save and how poor people save.
For Whom
Access to conventional formal financial institutions, for many reasons, is directly related to income: the poorer you are the less likely that you have access. On the other hand, the chances are that, the poorer you are, the more expensive or onerous informal financial arrangements. Moreover, informal arrangements may not suitably meet certain financial service needs or may exclude you anyway. Individuals in this excluded and under-served market segment are the clients of microfinance.
BACK GROUND
Microfinance has evolved as an economic development approach intended to benefit low –income women and men. It has been estimated that there are more than 500 million economically active poor people in the world operating microenterprises and small businesses.
Microfinance rose in the mid 70’s as a response to doubts and research findings about the state delivery of subsidized credit to poor farmers. In the 1970s government agencies were the predominant method of providing productive credit to those with no previous access to credit facilities- people who had been forced to pay usurious interest rates.
Microfinance arose in the 1980s as a response to doubts and research findings about state delivery subsidized credit to poor farmers. In the 1970s government agencies were the predominant method of providing productive credit to those with no previous access to credit facilities. Beginning in the mid-1980s the subsidized, targeted credit model supported by many donors was the object of steady criticism, because most programs accumulated lage loan losses and required frequent recapitalization to continue operating.
Grameen Bank:
The Grameen (village) Bank was developed by Professor Mohammed Yunus in 1976, when the country was stricken with famine. Using $26 from his own pocket, he lent cash to poor village women so that they could invest in the livestock and materials they needed to make money of their own. He received sponsorship from the central bank of Bangladesh as well as commercial banks, and in 1983 the Grameen Bank became an independent entity.
Reversing conventional banking practice, the Grameen Bank lends to the poorest in society. The bank rests on the principle that those who are too poor to get bank loans are actually good credit bets. Women, who make up 94% of its customers, use loans from the bank to invest in business ventures like matt-weaving and small-scale agriculture.
The Grameen Bank now lends $1.3 billion to 2.3 million borrowers, most of them women. With 1,128 branches, the $2 billion operation serves 38,951 villages, covering more than half of the total villages in Bangladesh. The average loan is $160.
In spite of a national illiteracy rate of 62% (78% for women), economic activity in rural Bangladesh has seen a marked increase since the launch of the bank.
In 1998, Dr Yunus was awarded India's Indira Gandhi peace prize for his efforts to tackle poverty.
REASONS FOR THE GROWTH OF THE MICROFINANCE
The key reasons for the growth of Microfinance institutions are
The promise of reaching the poor.
The promise of financial sustainability.
The potential to build on traditional systems
The contribution of microfinance to strengthening and expanding existing formal financial system.
The growing number of success stories
The availability of better financial products as a result of experimentation and innovation
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Stake Holders in Micro Finance Industry[/b]
All stakeholders in Microfinance industry i.e. Microfinance institutions (MFIs), Private Banks, Nationalised Banks, Development Banks (like NABARD /SIDBI/RRB in India), Credit societies, NGOs, relevant Govt. depts., Social Welfare Clubs or service clubs (like Rotary, Lions, etc), Trusts, Private Players, Corporate CSR cells, Self Help Groups (SHGs), SHG Federations, Consumer Forums, etc.
UNIQUENESS
Microfinance is unique since it promises to serve the key objectives of
• Economic objective and
• Social objective
Thus, the target market for MFIs generally takes into consideration a combination of two factors:
Characteristics of the population group, including level of poverty
The type of micro-enterprises being financed
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Characteristics of the Population Group[/b]
Impact of Microfinance[/b]
Broadly microfinance activities impact analysis fall into three categories
Economic
Sociopolitical or cultural
Personal & psychological
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Economic Impact[/b]
Economic impact can be at level of economy itself. A large MFI reaching hundreds of thousands of clients may expect or aim at impact in terms of changes in economic growth in a region or sector.
One MFI may seek outcomes at the level of enterprise. If so, it will look for business expansion or transformation of the enterprise as primary impact.
Another may seek net gains income with in a sub sector of the informal economy.
Another may seek impact in terms of arrogate accumulation of wealth at the level of the community or household.
Another may seek positive impact in terms of income or economic resource “protection”.
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Sociopolitical or Cultural Impact[/b]
An MFI may seek a shift in the political-economic status of a particular sub-sector.
A project aimed at credit for tricycle rickshaw drivers may hope that the drivers increased business will enable them to move collectively to formal status, either forming an association or by being able to change the policy in their favor.
An MFI in a remote rural area may expect to help shift rural people from barter to a monetarised economy.
Another may hope for changes in power relationship.
Another may seek primary impact, the redistribution of assets at the household level.
Another may seek changes in children’s nutrition or education as the result of a microfinance activity aimed at their mothers.
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Personal or Psychological Impact[/b]
Microfinance can impact borrower’s sense of self. These impacts are the other half of empowerment effects. The first half people achieve more power in the household community as a result the result of financial services. The second half is internal and has to do with persons changed view of self.
Product & services of Micro Finance Institutions[/b]
There are four broad categories of services. That may be provided to micro finance clients. They are
Financial Intermediation i.e. the provision of financial products and services such as Saving, Credit, Insurance, Credit Card & Payment system.
Social Intermediation i.e. the process of building the human and social capital required by sustainable financial intermediation for poor.
Social Intermediation includes group formation, leadership training and co-operative learning.
Social Intermediation may require subsidies for a longer period than financial intermediation, but eventually subsidies should be eliminated.
Experience shows that microfinance can help the poor to increase income, build viable businesses, and reduce their vulnerability to external shocks. It can also be a powerful instrument for self-empowerment by enabling the poor, especially women, to become economic agents of change.
Poor households save for a variety of reasons. They save for ceremonies, marriages; they save to repay loans in many cases. Large amounts of savings are precautionary for medical purposes. So there are many purposes for saving. It is also important to realise that households save in different forms. Poor households save in bank deposits maybe with credit unions or cooperatives, or local financial institutions which they have access to. Many save in the form of grains still.
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Evolution of Micro Finance in India[/b]
Successful microfinance interventions across the world especially in Asia and in parts of India by NGOs provided further impetus. NABARD’s search for alternative models of reaching the rural poor brought the existence of informal groups of poor to the fore. It was realised that the poor tended to come together in a variety of informal ways for pooling their savings and dispensing small and unsecured loans at varying costs to group members on the basis of need. This concept of Self-help was discovered by social-development NGOs in 1980s. Realising that the only constraining factor in unleashing the potential of these groups was meagreness of their financial resources, NABARD designed the concept of linking these groups with banks to overcome the financial constraint. The programme has come a long way since 1992 passing through stages of pilot (1992-1995), mainstreaming (1995-1998) and expansion phase (1998 onwards) and emerged as the world’s biggest microfinance programme in terms of outreach, covering 1.6 million groups as on March, 2005. It occupies a pre-eminent position in the sector accounting for nearly 80% market share in India.
Today, microfinance plays a major role in the development of many African, Asian, and Latin American nations. Its impact is substantial enough to have warranted acknowledgment by the United Nations who declared 2005 The international year of microfinance, reminding people that millions worldwide benefit from microfinance activities.
DEBATES:[/b]
In this context it is important to understand the various debates on this industry and the current signals in India to regulate the industry.
There is, however, criticism towards microfinance institutions. In 2001, a Wall Street Journal article raised questions about the Grameen Bank, including repayment rate, collection methods and questionable accounting practices.
On a larger scale, some argue that an overemphasis on microfinance to combat poverty will lead to a reduction of other assistance to the poor, such as government welfare.
Research on the actual effectiveness of microfinance as a tool for economic development remains slim, in part owing to the difficulty in monitoring and measuring this impact. Questions have arisen regarding whether microfinance can ever be as important a tool for poverty alleviation as its proponents and practitioners would submit.
One key debate within microfinance has been whether donors and practitioners should focus on impact, i.e. improved living standards for the poor or financial sustainability. The former approach has been called 'poverty lending' or 'the welfarist approach', whereas the latter is sometimes termed 'the institution-building' or 'financial system approach'. Whereas the welfarist approach often supplements financial services with other services such as education and health, institution-builders focus solely on financial service.
The arguments for this approach are:
If poor people are willing to pay to use the institution, it must be offering them value
Only by ensuring financial sustainability can the huge demand be met
Donors are best to direct subsidies to other services like education and health through separate non-profit organizations.
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RISKS OF MICROFINANCE[/b]
Some MFIs target a segment of the population that has no access to business opportunities because of lack of markets, inputs and demand. Productive credit is no use to such people without other inputs.
Many MFI s never reach either the minimal scale or the efficiency necessary to cover costs.
Many MFIs face non supportive policy frameworks and daunting physical, social and economic challenges.
Some MFIs fail to manage their funds adequately enough to meet future cash needs and, as a result they confront liquidity problem.
Some MFIs develop neither the financial management systems not the skills required to run a successful operation.
Replication of successful models has at times proved difficult due to differences in social context and lack of local adaptation.
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Further the following factors considerably influence the Microfinance sector
Risks in the Microfinance Industry[/b]
Ownership and governance
Management Risks
New industry
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FINANCIAL SECTOR POLICIES AND Legal enforcement[/b]
Interest rate policies (Usury Laws in West Africa)
Government mandated credit allocation.
Legal enforcement of contractual obligations and the ability to seize pledged assets (Alexandaria Business Association- Legal sanctions)
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Economic and social Policy environment[/b]
Economic and Political Stability
Inflation
Growth rate
Transition and Political unrest ( Kenya)
Poverty levels
Investment in Infrastructure and Human resource development
Government view of the sector
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Thus in the current context in India many experts argue that we need a regulatory regime that checks malpractices while encouraging the positive aspects of microfinance. In this context it is to be noted that the Government of Andhra Pradesh has passed an ordinance that significantly enhances regulatory control on MFIs in the state, reflecting the concerns regarding what the provincial government perceives are high interest rates being charged by the MFIs, and the coercive means of recovery they adopt.
Thus, according to experts regulation is required to
Avoid a financial crisis and maintain the integrity of the payment system.
Protect the depositors
Encourage financial sector competition and efficiency.
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It is also pointed out by some of the policy makers that the key considerations when regulating MFI’s are
Minimum capital requirements
Capital adequacy
Liquidity requirements
Asset quality
Portfolio diversification.
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But will a regulation alone can keep check on the performance of this industry. Studies have shown that any good institution should have the following attribute
Characteristics of good and strong MFIs
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Good institution has three attributes:
It provides services to the relevant target group
Its activities and offered services are not only demanded but also have some identifiable positive impact on the lives of the customers.
It is strong, financially sound and stable.
Global experience shows that the following factors are important to access the performance of Microfinance institutions.
Accordingly any MFI has to take care of the following key parameters while managing their institution.
Performance Indicators of MFIs
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It can be organized into six areas
Portfolio Quality
Productivity & efficiency
Financial viable
Profitability
Leverage and capital adequacy
Scale, outreach and growth
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Performance Management
The effective financial management of MFI requires an understanding of how various operational issues affect financial performance. The performance management addresses main three areas
Delinquency
Productivity & efficiency
Risk, including liquidity and interest rate risk, foreign exchange risk and operating risk
A worried government has put on fast track the proposed bill to regulate micro-lenders, as it seeks to ensure that over-regulation by states does not kill the sector that is envisaged to play a big role in furthering financial inclusion.
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CONCEPTS AND WORKING MECHANISM OF A MICROFINANCE INSTIUTION:
MECHANISM OF MICROFINANCE INSTITUTIONS
Traditionally the poor are considered too risky because they lack collateral; the banks lack information about them, which leads to a variety of problems, which in economics we call the asymmetries of information. The problems related to asymmetries of information, which are categorised as adverse selection and moral hazard.
The idea is that because banks lack adequate information about clients, it’s very difficult to assess the riskiness of a particular borrower, which we term as the adverse selection problem, when the bank, or the lender, does not know the type of the borrower. The innovation that have been used by microfinance institutions, the first being group lending, is that the lender does not know the type of the borrower, but if borrowers come together and they can assess the riskiness of each other, collectively they are not as risky as individual borrowers are to a lender. The idea is that they do a lot of screening amongst each other before they come to the bank.
The second problem in asymmetry of information is related to the moral hazard problem, which is a problem which occurs due to lack of information once the lender has given the money to a borrower. This problem is basically because as a lender you don’t know what the borrower is doing with the money. Are they putting in the right amount of effort to use this money fruitfully? This is the problem of moral hazard.
Now, group lending overcomes this problem because within a group you monitor each other because access to capital, or access to credit of individual members within a group depends on whether the previous member has repaid or not. So besides group lending, microfinance uses other forms of collateral substitutes. Some examples are dynamic incentives, which is you begin by giving a small amount of loan to a borrower, and if the borrower successfully repays it, the lender increases the amount. What this does is it’s good for the lender because you can assess the riskiness of the client early on. It’s good for the borrower because he’s able to assess his own risk well and take just the right amount of loan which he can adequately use.
There are also certain complementary incentives which are of different kinds, and one is that microfinance institutions target women because they make for good clients, they are good borrowers. They insist on frequent repayment installments so as to gauge the early warning signals – if any – within the system. They also insist on public repayment. The basic idea being when people gather and they have weekly meetings, there’s a lot of cross reporting of borrowers across the group, and the lender is able to judge the situation of the borrower very well. So in the event of a default, or when a borrower is not able to repay an installment for a particular week, re-negotiation and bargaining is possible if the situation really demands
Moral hazard
It occurs when a party insulated from risk behaves differently than it would behave if it were fully exposed to the risk.
Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to hold some responsibility for the consequences of those actions. For example, a person with insurance against automobile theft may be less cautious about locking his or her car, because the negative consequences of vehicle theft are (partially) the responsibility of the insurance company.
Economists explain moral hazard as a special case of information asymmetry, a situation in which one party in a transaction has more information than another. In particular, moral hazard may occur if a party that is insulated from risk has more information about its actions and intentions than the party paying for the negative consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.
Moral hazard also arises in a principal-agent problem, where one party, called an agent, acts on behalf of another party, called the principal. The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent. The agent may have an incentive to act inappropriately (from the viewpoint of the principal) if the interests of the agent and the principal are not aligned.
Information asymmetry models assume that at least one party to a transaction has relevant information whereas the other(s) do not. Some asymmetric information models can also be used in situations where at least one party can enforce, or effectively retaliate for breaches of, certain parts of an agreement whereas the other(s) cannot.
In adverse selection models, the ignorant party lacks information while negotiating an agreed understanding of or contract to the transaction, whereas in moral hazard the ignorant party lacks information about performance of the agreed-upon transaction or lacks the ability to retaliate for a breach of the agreement. An example of adverse selection is when people who are high risk are more likely to buy insurance, because the insurance company cannot effectively discriminate against them, usually due to lack of information about the particular individual's risk but also sometimes by force of law or other constraints. An example of moral hazard is when people are more likely to behave recklessly after becoming insured, either because the insurer cannot observe this behavior or cannot effectively retaliate against it, for example by failing to renew the insurance.
CGAP (Consultative Group to Assist the Poor) is an independent policy and research center dedicated to advancing financial access for the world's poor. It is supported by over 30 development agencies and private foundations who share a common mission to alleviate poverty. Housed at the World Bank, CGAP provides market intelligence, promotes standards, develops innovative solutions and offers advisory services to governments, microfinance providers, donors, and investors.
In 1995 a group of donor agencies including the World Bank launched CGAP, initially oriented primarily to improve the quality of microfinance programming. During the early years, CGAP played a pivotal role in developing a common language about microfinance, catalyzing the move toward best practice performance standards, and building consensus among its many and varied stakeholders.
As CGAP's membership grew to the current 27 bilateral and multilateral donors, and its small investment fund became more visible, many in the microfinance community initially thought of CGAP as another donor in the fray.
As microfinance continues to transform into a cohesive industry, CGAP has undergone a metamorphosis itself: from a donor-type organization to a service center to the fledgling industry.
Objectives of CGAP:
CGAP’s mission is to improve poor people’s access to convenient and affordable financial services so that they can improve their living conditions and build a better future.
CGAP has five core areas of work to help make our vision of permanent access to affordable and client-responsive financial services a reality.
Developing and strengthening a wide range of institutions and means, both financial and non-financial, that deliver financial services to the poor
Improving the quality and availability of information about institutional financial performance
Establishing supportive legal and regulatory frameworks
Improving aid effectiveness
Reaching poor and unserved clients and ensuring impact on their lives
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NABARD (NATIONAL BANK FOR AGRICULTURE AND RURAL DEVELOPMENT) is set up as an apex Development Bank with a mandate for facilitating credit flow for promotion and development of agriculture, small-scale industries, cottage and village industries, handicrafts and other rural crafts. It also has the mandate to support all other allied economic activities in rural areas, promote integrated and sustainable rural development and secure prosperity of rural areas. In discharging its role as a facilitator for rural prosperity NABARD is entrusted with
Providing refinance to lending institutions in rural areas
Bringing about or promoting institutional development and
Evaluating, monitoring and inspecting the client banks
Besides this pivotal role, NABARD also
Acts as a coordinator in the operations of rural credit institutions
Extends assistance to the government, the Reserve Bank of India and other organizations in matters relating to rural development
Offers training and research facilities for banks, cooperatives and organizations working in the field of rural development
Helps the state governments in reaching their targets of providing assistance to eligible institutions in agriculture and rural development
Acts as regulator for cooperative banks and RRBs
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NABARD's 'SHG Bank Linkage' program
This model has attracted attention as a possible way of delivery microfinance services to poor populations that have been difficult to reach directly through banks or other institutions. "By aggregating their individual savings into a single deposit, self-help groups minimize the bank's transaction costs and generate an attractive volume of deposits. Through self-help groups the bank can serve small rural depositors while paying them a market rate of interest."