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Awanika Anand

A bright, flamboyant and ambitious student of ILS law College, Pune.

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Awanika Anand

To address the ever deplorable economic situation of rural India has become the foremost priority of the government. There is a need for structured development in these sectors of the country. The aim is to eradicate poverty, illiteracy and hunger from the face of rural India. Various poverty alleviation schemes have been suggested by the government for this purpose. However, the paucity of funds has proved to be detrimental to the implementation of such schemes. Microfinance is one of those measures that can go a long way in poverty alleviation. It is a financial service scheme wherein the government, NGOs, and other financial institutions introduce several welfare schemes and activities to reduce poverty. A synergy is required among the MFIs, banks, NGOs and the government for the practice of good microfinance. In India a substantial portion of the micro finance system was based on self-help groups. It has been further suggested that NGOs should direct or teach the poor to invest their money through the MFIs into entrepreneurial development programs. These programs help in better savings and returns thereby facilitating their purpose.

Origin in India and the Urge behind it

The Indian microfinance scheme has been mainly inspired by the revolutionary movement that was started in Bangladesh by Mr. Muhammad Yunus. Both these movements have basically been adopted from the German and Dutch rural credit system called the Raiffeisen Model.

Thus the first issue to be addressed is as to why the need for micro financing was felt in India. Micro Credit is defined as the extension of very small loans to the poor and thus aims at spurring entrepreneurship. It is a part of micro financing. Banks are not able to extend credit to the extremely poor masses in the country because poor lack collateral, steady employment, verifiable credit history and these disqualify them from obtaining traditional credit.

In the mid-19th century, the benefits of micro finance were stressed upon by individualist anarchist Lysander Spooner. He was of the belief that it would help alleviate poverty by supporting entrepreneurial activities. Idea of Micro Financing was also mentioned in the Marshall plan at the end of World War II. Thus it can be easily assumed that Micro Finance is a not a new concept. It is just that the need for it has arisen now. The non-traditional methods of money lending have proved to be non-beneficial to the poor man. When we say old nontraditional money lending methods, it includes-money lenders, loan sharks etc.. To do away with such methods of money lending the concept of micro lending had to be introduced to promote actual growth among the poor. Rural finance stresses on savings and promoting self help groups who in turn promote savings.

Efforts in vain Towards Implementation

Since independence, various Governments in India have experimented with a large number of grant and subsidy based poverty alleviation programs. These programs were based on grant/subsidy and their credit linkage was through commercial banks only. As a result, these programs became unsustainable, perpetuated a dependent status on the beneficiaries and depended ultimately on the government employees for delivery. This not only led to misuse of both credit and subsidy but also as non-bankable and hence not profitable and commercial.

Potential and Scope

With 75 million poor households potentially requiring financial services, the micro finance market in India is among the largest in the world. Estimates of household credit demand vary from a minimum of Rs. 2,000 to Rs. 6,000 in rural areas and Rs. 9,000 in urban settings. Given that 80 percent of poor households are located in rural areas, total credit demand ranges between Rs. 255 billion and Rs. 500 billion. However, only Rs.18 billion of this amount has been generated so far. The reason for this is that a major portion for rural crediting has been from the informal sector and this is at a very high interest rate, thus reducing the volumes of such credits, and by far has been less for investment purposes (13%) and more for family emergencies (29%) and social expenditures (19%).

Reasons for Failure

There are a number of factors why rural crediting by the formal sector has not taken place so far.

 1.         High fiscal deficits have meant that Government is appropriating a large share of   financial savings for itself.

2.         Persisting interest rate restrictions reduce the attractiveness of lending, particularly to small, rural clients.

3.         Flexible repayment options are absent.

4.         Convenience and frequency with which such loans can be accessed is minimal.

5.         Less reliance on collateral is not encouraged

Even if the banks try, they are unable to provide loan to the extreme poor population in our country. We know that bank loans involve high transaction costs, long procedures and lengthy processing. On the other hand if we look at the financial condition of the poor, the banks are reluctant to entertain requests for loans from them as they have no regular income. The poor are unable to organize themselves and they lack the capacity to save.

Micro Financing – A Blessing In Disguise

How micro financing is helping the poor come out of the clutches of extortionary financial agencies (e.g. money lenders) is something that has to be brought into the picture. It is easy to conclude that a poor individual cannot possibly provide collateral for any kind of loan. To fill this gap self help groups are formed where social capital is leveraged, by creating a joint liability, for a loan .This also ensures regularity of repayment. We are all aware that globalization has led to developments in technology. With development in technology the need for human resource is decreasing everyday. This is leading to lesser job opportunities for the poor illiterate masses. Micro-Finance, although not the final solution, helps that category of people uplift themselves and do something with their lives.

Micro-Credit has proved to be a lifeline for the poor. Micro finance institutions raise resources in two ways:-

1.  By issuing bonds in which other BFI’s (Banks And Other Financial Institutions) invest and

2. By taking direct loans from these BFI’s.

These resources act as a raw material for these MFI’s. However, Banks involved in micro-credit are free to structure their products in the way they want. These loans can be given both for productive and non-productive /consumption purposes.

The “Supply Led” approach

The “Supply led” approach was applied in rural financing which in turn have created various concerns. By “supply led” we mean that the lenders are keen to lend and in their keenness they are ignoring the due diligence required to assess the viability of a borrower. Quiet similar to this is the sub-prime mortgage scheme devised by the banks in the US which resulted in a huge financial debacle back in 2008. The loan package[2] so devised failed to identify its appropriate clientele. Under normal lending conditions financially viable borrowers could get loans. However, during the sub-prime lending spree, when lenders were eager to expand their portfolio, the standards for evaluating the viability of a borrower were lowered. As a result of this even otherwise unviable borrowers ended up getting mortgage loans. A similar approach in rural finance undermined the viability of institutions because of the ever increasing loan delinquency. They were also not able to replace the usurious money lenders (prime cause of exploitation of the poor) from the rural finance scenario.

The “Financial System” approach

A new approach called the “Financial system” approach has been applied to rural financing now. In this new approach, apart from expansion of micro credit, the viability of lending institutions is also given importance. In other words directed lending and directives on interest rates are no longer preferred. The new approach believes in working with discretionary interest rates. However, banks do not enjoy the freedom envisaged under this new approach because of the government directives. On the other hand MFIs were allowed to benefit from this which resulted in their mushrooming in such areas and sectors. As a consequence, banks are increasingly shying away from rural lending as well as rationalizing their branch network in rural areas. However, the SHG-bank linkage program, which emphasizes on full cost recovery, turned out to be an attractive proposition for the banks. There has been constant emphasis on the fact that the poor need timely and adequate credit rather than cheap credit.

Impact Assessment

Another major concept that has been emphasized in this SHG-bank linkage is impact assessment. Mainstreaming of impact assessment is required as a necessary design feature of the program. It has also been rightly pointed out that there are various other issues concerning rural financing besides institutional viability. The SHG-bank linkage programme had no explicit social or economic benchmarks for inclusion of members in the groups. These efforts have not proved to be beneficial because poor have no experience of managing their finances properly.

How are interest rates charged?

Now let us see how interest is charged from the beneficiaries. MFIs quote flat interest rates on their loans. This can be very misleading in the sense that the actual interest rate[3] could be almost double the flat rate. For example an MFI offers a loan of   Rs 2400 at 1% Flat interest rate per month. Thus the repayment of each month for a 12 month repayment period will be of Rs 200 (principal amount) and Rs 24 monthly interest. Even though the monthly interest paid is on the entire sum of Rs.2400   the average sum available to the borrower is approx. Rs1466 only. It is clear from this that if interest is charged in this manner it becomes usurious. The equivalent interest rate on reducing balance method, which we also call the annual percentage rate (APR), assuming the same monthly repayment of Rs.224, is 19.05%. Thus actually the interest being charged is 19.05 % and not 12%.

How do Banks work?

Banks cover four types of costs when they make loans:-

1) Cost of Funds

2) Cost of Capital

3) Cost of Operations

4) Loan Loss Default

To this is added the profit premium to arrive at the final interest rate. This profit premium is that part of the interest rate which goes into the bank’s profit. By adding these costs the banks are liable to get back more of what they lend. Such profit premium is required because banks run with a profit motive. On the other hand micro-finance institutions claim to cover only three types of costs when they make micro-loans i.e cost of funds, cost of loan loss default, transaction costs (cost of operations). However, they fail to include the cost of capital which is in a way a necessity as they have to give returns to the providers of capital. Since they have quoted only three costs it means that the cost of capital and profit premium is part of either the transaction cost or cost of money.

How do the loan loss provision and transaction costs get included when calculating the interest rate can be explained by an example:

Illustration:-  A micro-finance institution borrows Rs 100 from an investor at an interest rate of 10%. He then lends that same amount to a micro-borrower at 11% (cost of capital+ loan loss default).Here the cost of money is 10% and the loan loss default  is assumed to be 1%. In addition to this, these institutions include the transaction costs which are involved in every loan.

Securitization Of Cluster Loans To Women

“MFIs in India are increasingly looking at securitization of women cluster loans to raise capital as traditional fund channels like banks and private equity has restricted lending to the sector.”[4]

In securitization MFIs sell a bundle of loans linked to women as one single loan to another investor to raise funds. Through such funds they create another cluster of loans and follow this procedure of securitization for expansion of micro credit. With this the MFIs are increasing liquidity and coverage.

Why such securitization is linked to women borrowers is because they maintain the repayment rates as high as 99.5%. They have better credit ratings because of their high repayment rate percentage as compared to men.

Andhra Pradesh Ordinance

The ordinance passed by the Andhra Pradesh government restricting the functioning of micro finance institutions in that area is a regulatory backlash against aggressive lending and collection practices. The MFIs were blamed for coercive practices which led to farmer suicides. The ordinance has imposed several restrictions such as they cannot ask for security against a loan, they have to display the interest rates they are going to charge, they cannot recover any amount in excess of the principal amount, and they need to take prior approval before advancing loans to SHG’s. These were a few examples from the ordinance promulgated by the AP government. However, we know that micro finance institutions are not going to be wiped out totally as no other finance model has been devised yet which has had a similar success rate . As quoted by Ibrahimpatnam from Reuters “however, given the lack of alternatives in a country where hundreds of millions of people remain outside the banking sector, the country’s for-profit micro-finance industry will survive, albeit with tighter regulations, fewer players, slower growth, and narrower margins.”[5]

The ordinance was the result of the crisis that broke out in Andhra Pradesh. It was alleged that the Microfinance organizations were  charging exorbitant interest rates of 20% and higher. Apart from high interest rates these institutions were also involved in the practice of forced savings. They applied the ‘flat rate method’ and other charges over and above the annual interest rates which further aggravated the costs. All of this leads to an overall increase in the cost of borrowing for the poor masses. In addition to this, these institutions lacked transparency with regard to their interest rate practices, thereby transferring various costs on to the gullible borrowers. They were also blamed for extortionary ways of recovery of loans which made them no different from the money lenders. The main aim of microfinance was to do away with these evil moneylenders who extorted money from the poor. However, these institutions indulged in similar methods of recovery by confiscation of title deeds, usage of intimidating and abusive language, and combining various products like savings and insurance etc to ensure prompt recovery. Poaching from government and banks, in order to capture their borrowers, has also been one of the strategies  of the micro finance institutions in Andhra Pradesh.

COMMERCIALIZATION and its Dire Need in the Present Scenario

Commercialization is a concept which should have been introduced in the case of micro financing way earlier than today. The micro-finance institutions cannot survive for very long on the charitable nature of the donors. Professionals, lately, have been stressing on the fact that market based principles (investments) should be applied to micro finance. The market based principles will help these institutions achieve sustainability and provide efficient services. Commercialization allows the MFIs bigger opportunities to fulfill their social obligations by providing the poor with increased access to credit. The micro finance draft bill of 2011 proposed by the Indian government covers very basic aspects of the functioning of these institutions. The bill should provide for a two-phase development of micro-finance institutions, wherein in the first phase they start of as mere providers of credit to the poor by the money raised out of benefactions and the later phase should allow compulsory commercialization of these institutions.

There is a need to go a level higher by calling for international investments like that of ‘Sequoia’ in SKS micro-finance of 11 million dollars. Dependency of these institutions on donors and government funding should be done away with. Commercialization will enable micro-finance institutions to grow. The development of MFI’s should not be time bound and should not be completely shut from any outside investment. Our gasconades of how these institutions reach to the meager levels of the society will just remain on paper. A necessary provision for compulsory commercialization of MFI’s as the second phase of development should be provided for. Commercialization helps in expansion of credit at relatively cheaper interest rates. Due to this, loan advancement to the poor can become easier. It is not just the involvement of banks that are important but also that of other sectors that can prove to be greatly beneficial for such institutions. There is a need to tap international capital markets for raising capital as this scale of financing is way larger in scope than expected. NGOs dealing in microfinance are seeking to convert themselves into NBFCs (Non-banking financial corporations) in order to pool in more capital i.e increase their funding.

 CONCLUSION

The rural population in India constitutes about 70 percent of the entire populous. Development as we speak aims at its overall impact in the country today. Is Microfinance the need of the hour is a critical question which shall remain unanswered for a very long period.  However the ongoing attempts to prefect this concept is a commendable effort on the part of the institutions. Let not the rich have everything appears to be the motto of this effort. Freedom to achieve should not be restricted, as we must be prepared to extend it to everyone around us, whether rich or poor. Thus microfinance whether a boon or not is a question unanswered.

 



[2] Sub-Prime Mortgages

[3] calculated on reducing balance method

[4] Microfinance institutions use women cluster loans to raise capital, Shailesh Menon May 3, 2011, 05.50am IST

[5] reuters june 2007,2011, ibrahimpatnam


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