What has played out in the Micro-finance Industry over the last few months is increasingly looking like a ‘Theatre of the Absurd’- being enacted on the financial services landscape of India. What one is witnessing is a disjointed, repetitive, emotional, and intellectually dishonest discourse with a plot that lacks a realistic or logical assessment.
- A sector, which was the darling of investors till 2010 (remember the excitement/frenzy with the SKS IPO and others including I-bankers and starry eyed investors wanting to jump in!) has overnight turned into a pariah. MFI’s are struggling with a severe liquidity crisis as banks have turned shy of lending and investors are rushing for the exits. The much flaunted credit loss rates of 1% have exploded to double digits and more, all in a span of less than 6 months!
- A sector which hired more than 10000 employees in 2010 fired over 2000 employees in 2011.
- Lending has dipped sharply and Top Micro-Finance companies, commanding exorbitant valuations some over 25-30 X are having their bank loans restructured under CDR.
- A motley tribe of “experts”, politicians, associations and bankers with a myopic outlook and ivory tower viewpoint are making an already bad situation worse with their actions and pronouncements. The present crisis in fact reminds me of ‘the elephant and the seven blind men’.
So let’s take a look at the reasons being cited for the current crisis -Exponential growth without the right systems to support the growth, over-indebtedness of borrowers, lack of credit bureaus, over-reliance on costly debt and commercially oriented Private Equity investors with high value expectations. All this added together with lack of the trained human resources and proper governance for a rapidly growing industry. Critics say the industry grew too quickly for its own good, with little regulation. That fostered a breakdown in lending discipline, with multiple loans to overextended borrowers, and allowed some unscrupulous players to thrive. Some say that remarkable growth prompted a backlash from vested political interests. Whilst the post mortem is partially correct it’s time we dig deeper and went beyond obvious. Two broad issues to be addressed at the outset are:
(A) Incorrect Positioning of the sector: In the Indian context most have been led to believe that Micro Finance is a ‘Not for profit business’ and is in the realm of “Social entrepreneurship” and meant purely for the upliftment of the poor, however for most part that has not been the case, albeit for, a small percentage of MFI’s/SHGs and NGOs. The Lion’s share of this “Business” has been dominated by a few large MFIs which were commercial in their orientation but did don a fig leaf of having noble agendas with respect to these customers. Having said that frankly the reality is that scale and sustainability in this area cannot be achieved unless there is a commercial drive behind these enterprises.
Given the number of underserved in India, if you can’t bring scale in this industry, you are doing a huge disservice to the mass of humanity that is not financially included. The industry leaders, however, have done a terrible job communicating this simple fact while obfuscating the business paradigm by masquerading as social entrepreneurs with a cloak of social mumbo jumbo.
Microfinance literally started off as a ‘cottage industry’ in the 90’s, and then some of the enterprising players were able to scale up. Keep in mind there was already a huge customer base, not serviced by large public and private sector banks as the cost structure of the banks did not support servicing this segment, and that’s where some of the Micro Finance players stepped in to service a large underserved segment of the Indian Populace.
The larger MFI’s were able to scale up their operations because of the availability of capital and Private Equity investments, driven by commercial considerations. These investors brought in a semblance of Modern systems and scientific management practices. There was quite definitely a profit motive, and then some promoters and management teams cashed out when the going was good, this needless to say caused heartburn and dissonance with some in the industry, politicians and others have given this sector was perceived to be altruistic and primarily driven by financial inclusion objectives.
My take is that all stake holders would be well advised to ignore the theatrics and accompanying distractions and focus on the core issues. Keep in mind Poor people do make choices every day and are willing to pay for services and more importantly competitive forces over a period of time drives down the prices in any case. For example are the same borrowers not paying telecom players commercial rates for prepaid calling cards or private health care services for that matter? M0re importantly why are some, largely urban intelligentsia being judgmental about the subject -Who is defining the ‘poor’ and are MFIs only servicing the poorest ? In reality a lot of these loans have also been extended to small retailers, farmers, small enterprise owners and people with an entrepreneurial bent of mind, wanting to do something productive with the money lent to them. The only venture capital accessible to them!! Besides full service MFIs have also been selling Micro Insurance and other financial products and services that are in great demand by this segment.
(B) Incomplete understanding of the ‘credit cycle’ and faulty ‘Valuations’: At the heart of the problem are various stakeholders of the industry who have not witnessed a full-blown credit cycle. To understand this better, we need to connect the dots in terms of the vested interests of various stakeholders.
Let’s start with the people who run MF companies- enterprising people with social and equally commercial motives wanting to find a fortune at the bottom of the pyramid. Let’s make no bones about the fact, that there has been a commercial angle to this business that in good measure led to its exponential growth in recent years. Most stakeholders never understood the full impact of a credit cycle and in fact one of the issues with the MFIs is that most of them are woefully underprovided in terms of their credit loss provisions in their balance sheets. The talk about high interest rates is not fully accurate as this is indeed a risky business and you have to price to risk given the unsecured nature of the loans.
The story sold to investors was that micro finance investments make phenomenally great returns. Actually, micro finance business over a full credit cycle does not make supernormal returns, for the simple reason, the revenues are ‘front-ended’ and credit costs come with a ‘lag’. If you take the average over the full credit cycle, the returns are relatively optimal; ROEs should be in the range of 18-20%, and since the full costs have not hit the book, a large part of the investor community started believing that this is a 40%plus ROE business.
Somehow the perception of employees, investors, and the regulators, together with the valuations commanded and cash outs by few promoters, have misled the public at large. However, over a period, you will discover that, not only because of the AP ordinance, when costs normalize and are higher than historical levels, even with the current so called high pricing, this is a business with not more that 1-2% ROA, which in itself is not a supernormal return, in fact reasonable from a sector, which is inherently ‘risky’. If it were not risky, the public sector and other banks would have rushed in.
Therefore most MFI promoters have leveraged the ‘first full-blown credit cycle, ‘riding only the crest’; with valuations and profit projections made basis past performance ignoring hidden and potential losses that would surface in the future. To quote Naseem Taleb, the Andhra imbroglio is but a small ‘black swan’ event, which has pricked the bubble and what you have now is a train wreck in slow motion.
Banks are yet to begin fresh lending to MFIs due to high risk of defaults in Andhra Pradesh, where the biggest MFIs are based. The RBI-constituted panel under Y H Malegam has come out with recommendations such as capping the MFI lending rate at 26 per cent and margin caps of 12% among others.
As much as the regulators are trying to salvage the situation however literally mandating the terms and conditions of the loan program for the entire industry is throwing the baby out with the bath water. This is bound to lead to asymmetries that will be difficult to resolve in the future and it must be said that perhaps inadvertently the new guidelines favor the larger MFIs over the smaller ones and equally large numbers of marginal borrowers will be cut out of the institutional programs pushing them back into the clutches of the local money lenders. So, now in a country with 1/4thr of the geography affected by Maoists, the promise provided by MFIs to provide ‘capital’ for the poor people is getting lost. The investors don’t want to invest in MFIs; banks are shy of lending and thanks to self-inflicted wounds around valuations, and the entire industry is contracting.
So where do we go from here?
A lot of issues have been mixed up in the last few months. So here are three suggestions for the rebuild of this industry (in response to Malegam Committee recommendations):
(1)Avoid Interest rate capping - The heart of the issue is that most have not fully understood the ‘profitability model’ of the Microfinance Industry. Based on experiences in other countries both developing and developed, it would reasonable to assume that this sector would give loss rates in the range of 4-6 %in the long term. This along with the real expenses of running an MFI I suspect has not been fully factored in the recommendations. The debates around usury in the last few months seem more like “Value judgments” rather than backed by real numbers. Keep in mind a lot of banks charge interest of over 35% on their unsecured card loans and justify this on grounds of making only miniscule returns even at that rate. One must take note that financial services must always work on the paradigm of ‘risk based’ pricing. The moment we talk of rate caps there will always be a segment which gets marginalized defeating the very objective of financial inclusion and in turn these borrowers end up going to the ‘local moneylender’. Rate caps create asymmetries in the market, and give an unfair advantage to the players who have already scaled up. The higher barriers to entry created by regulations may also mean that commercially orientated MFIs will be less likely to target smaller or more geographically remote market segments - due to the capped margins and higher operating costs required to serve these segments. So the ‘rate cap’ will actually reduce competition, which is not really good for the consumer.
(2)Bring the entire industry under the supervision of the RBI: It is suggested that an MFI regulatory desk be created. I agree that regulations, relatively speaking have been weak, although views pronouncing, that they are non-existent is not true. In fact, most of the large micro finance players are registered as NBFC’s with all the right kind of regulations relating to Code of Conduct for collections, financial reporting, and transparency in loan agreements, etc. The same set of rules with tweaks and amendments must be applied to all players. Priority sector status for bank loans extended to MFIs is a welcome step and other similar initiatives good breathe life back into the industry.
(3) No state should have the authority to supervise or enact regulations related to MFI, if every state starts enacting laws; we will have an infructuous set of rules and regulations, which will be dysfunctional for the industry at large. Some rules already exist within the RBI guidelines for the NBFC sectors and other new ones have been proposed. The key is implementation and strict monitoring of the existing rules and not having multiple sets of rules and supervising bodies that can potentially choke the sector.
In the end, we should let the market forces take care of the inefficiencies, allow the industry to self-heal as the players are likely to do their own ‘Manthan’ ~ weeding out the poison, till they find the ‘nectar of life.' The entire industry should not be made to suffer for the actions of some players or misguided politicians; lest we end up creating ‘PEEPLI Live’, in real life.