Hemalatha (C) and other loan borrowers show pass books given to them by a micro finance company at Ibrahimpatnam, on outskirts of Hyderabad, May 19, 2011. Reuters

Microfinance — an approach to financial inclusion based on providing small loans and other financial services to poor people, primarily women-has generated considerable enthusiasm, not just in the development community but also at political levels In the last decade and half microfinance institutions (MFIs) in India have struggled to gain legitimacy as credible institutions even though they have demonstrated the ability to deliver financial services to unbanked low income households sustainably. Serious doubts on their modus operandi, high interest rates, governance, client treatment and transparency continued to bedevil the sector.

Microfinance has lately been facing trouble because of what observers apparently feel is the dilution in the purity of its mission. When it started, microfinance was a financial tool being used for social good. Now it has increasingly become a social tool used as a way to generate money, which is why it has lost a lot of its original sheen. This is one reason why microfinance often runs into heavy weather and hits periodic roadblocks and default crisis. A number of rigorous field studies have shown that even when lending programmes successfully reach borrowers, there is only a limited increase in entrepreneurial activity — and no measurable decrease in poverty rates.

Farmers from Tamil Nadu display skulls, which they claim are the remains of Tamil farmers who have committed suicide, during a protest demanding a drought-relief package from the government, in New Delhi, March 22, 2017. REUTERS/Cathal McNaughton
Farmers from Tamil Nadu display skulls, which they claim are the remains of Tamil farmers who have committed suicide, during a protest demanding a drought-relief package from the government, in New Delhi, March 22, 2017. Reuters

The sector’s biggest shock came seven years ago in India’s southern state of Andhra Pradesh: after a spate of suicides by highly indebted borrowers there, local authorities banned any collection on private microloans. Around $1.2bn in debts was eventually written off, leaving behind ruined institutions and dismayed investors.

The industry has seen a dramatic turnaround and a number of measures have led to a creation of an ecosystem for responsible lending. But the aftermath of demonetisation not only put a brake on growth but it actually put the sector through a rocky patch and the industry has been experiencing a chill since then. In states like Maharashtra and Uttar Pradesh the sector is gasping on account of a vitiated credit culture driven by populist politics.

Experience the world over has consistently shown that whenever microfinance suffers a crisis particularly on the client front, the politicians stoke it, leading   sometimes to large conflagrations. It has much to do with India’s socialist history and popular politics. The poor is a constituency politicians see as a very sensitive turf. Anything which leads to greater empowerment of the poor makes them insecure. Demonetisation was a big jolt for the poor whose financial lives were badly rattled leaving MFIs lurching with poor recoveries. To add to the woes of the collecting agents, politicians poured the alluring but explosive political gasoline inciting borrowers with loan boycott exhortations.

Indian politicians need to be better informed about financial markets. Most politicians still do not know much about the mechanics of microfinance, particularly about how loan pricing is done. They still don’t know that millions of poor women have built amazing credit histories that serve as passports for accessing credit, and by demonising microfinance, politicians are abetting a crisis which can deprive these women of the only reliable financial lifeline.

“These crises happen when the microfinance sector gets saturated, when it grows too fast, and the mechanisms for controlling over indebtedness is not very well developed,” according to Elisabeth Rhyne, one of the founding leaders of microfinance and   author of the famous book, Microfinance for Bankers and Investors. “On the political side, politicians or political actors take advantage of an opportunity. When they see grievances, they go, ‘Wow, we can make some hay with this’ ”, she says.

Political leaders must realise that hope and rhetoric are great for burnishing one’s electoral credentials but not for figuring out what to do. They make good politics but bad economics and much less good sense. The poor are no longer quiescent; they can distinguish populism from   genuine concern and demonstrate it through suffrage. Politicians may be right when they say that MFIs must practice microfinance responsibly. But they must also ensure that they are allowed to practice it sustainably.

The politicians are under an illusion that they scored a political victory over the microfinance industry in Andhra/Telengana in the 2010 crisis. But they are wrong. The worst sufferers of the crisis   have been the low-income households. With the veritable exit of microfinance institutions (MFIs) from the region, availability of microfinance has dramatically reduced and money-lenders are thriving again and are having a wonderful time.

Fixing one point on the economic continuum won’t make much difference unless all parts of the continuum improved at the same time. What the politicians need to do is to focus on the crippling economy which can barely breathe in an environment of suffocation created by   the severe currency crunch. What the rural population actually needs, and what can help MFIs, is more of economic oxygen.

A customer of a micro finance institution strings beads into necklaces at a workshop in a slum area in Mumbai February 17, 2007. Reuters
A customer of a micro finance institution strings beads into necklaces at a workshop in a slum area in Mumbai February 17, 2007. Reuters

Poor households, in particular the rural poor, are exposed to unsteady flows of income. The reasons are many, including seasonal unemployment related to the agricultural labor cycle, sickness or death in the family or weather shocks among many others. Given the variability and vulnerability of their income, they value formal microfinance   because it is more reliable, even if it is often less flexible than their other tools to manage their cash flow. Banks offer cheaper credit but are mired in thickets of red tape.

Microfinance provides loans to poor individuals, who are illiterate, have no credit history and live in villages with no roads or infrastructure the majority of whom have never had a bank account and certainly would not be considered suitable borrowers by mainstream banks. Banks will never cater to them. But microfinance companies, including commercial ones, will.  They have no assets, no collateral, so the banks’ doors are shut to them.

Granted, there are problems: a husband confiscates the cash and uses it to buy a bottle of homebrew, a woman buys a goat that then dies, a borrower uses a loan not to invest but to pay for a doctor’s visit for a child, and so on. In those cases, the borrower’s family is indeed worse off, but I think those are unusual. Socially responsible finance, delivered responsibly, enables poor women to accomplish a number of useful purposes for her family.

Emergency loans are equally important. When children fall sick, parents do not have the time to apply for a loan from a state-owned bank (perhaps the only alternative source of loans for the poor other than the moneylender). Usually, the bank takes months to process the application . The micro-financier, confident of being repaid, is willing to extend the emergency loan quickly and with little bureaucracy.

There is still lot of illiteracy on issues relating to loan defaults and how they can be handled. A deferment of repayment of loan installment, which borrowers and their representatives usually clamour for in such events, doesn’t give any real benefit to the borrower; it is not even a palliative. A loan holiday or deferment is actually just a postponement of a liability on which the borrower will continue to incur cost by way of the accruing interest, thus actually increasing his financial burden. Politicians would be doing a service to the borrowers by advising them to pay their installments on time.

There  is no doubt that poor clients themselves value microfinance , as evidenced by their strong demand for such services, their willingness to pay the full cost of those services, and high loan repayment rates that are motivated mainly by a desire to have access to future loans and demonstrates their desire to progress and become financially  independent.

Indeed, it is no wonder that some 200 million people around the world borrow from microfinance institutions — 200 million people who were, in all likelihood, not eligible for any sort of formal credit before microfinance started. In order to provide a more balanced perspective on the microfinance industry compared to other kinds of financial-services providers, MFIs need to do more to measure and explain their social and economic value.

In India, most MFIs are essentially hybrids with business and social goals; but with the passage of time, the order in which the two parts are mixed has been flipped. When it started, microfinance was a financial tools being used for social good. In the classical avatar, the pioneer MFIs operated as non-profit, non-governmental organisations with a strong social focus. Now microfinance   has increasingly become a social mission used as a way to generate money which is why it has lost a lot of its original sheen. It began to focus on growth of the institutions rather than transformation of the clients.

Such “mission drift” — with the quest for profits taking precedence over social welfare goals —has been at root of all microfinance repayment crises. The claims of doing well by doing good have been neutered by some painful realities revealed by several studies that challenge microfinance myths.

But the failure to differentiate between profit-seeking and profiteering does not mean that sustainable microfinance should not yield returns above costs. The business of providing financial services to the poor requires commitment. Without profits, MFIs are unable to invest in the talent and product development needed to serve people for the long term.

The first step to ensure both safe and sustainable microfinance is better regulation. Much of microfinance in India is still not regulated Microfinance institutions (MFIs) come in many forms — mainstream banks, specially licensed banks, non-financial companies, finance and leasing companies, non-governmental organisations, cooperatives and trusts — and follow a variety of business models. All of these intermediaries must be recognised and regulated according to the needs of the economies in which they operate.

Clients who are facing default may very well be in the most precarious financial position of their lives and they need empathetic guidance in climbing out of the trap. The elements of a humane approach seem intuitive: Do not shame or intimidate people. Speak to them gently in privacy and with respect. Do not deprive them of their basic survival needs or tools of work. Be flexible. And help defaulters to rehabilitate themselves over time.

Microfinance needs a relook and has to undergo a soul searching. When it comes to microfinance it is very important to think outside of the borrowing box. It will have to move beyond its traditional roots. Recent evidence suggests that relatively simple tweaks to microcredit products — including flexible repayment periods, grace periods, individual-liability contracts or the use of technology — may change their impact for both clients and institutions.

Women wait for a volunteer to distribute their loan money collected from a microfinance agency. Reuters
Women wait for a volunteer to distribute their loan money collected from a microfinance agency. Reuters

More than micro-loans, what the poor need are investments in health, education, and the development of sustainable farm and non-farm related productive activities. Microfinance has matured and sobered over time; it is undergoing changes and several microfinance organisations have now transformed into small banks. These institutions are leading the development of new kinds of products and services that, while based on the fundamental roots of the microfinance tree, branch out into many new directions to serve low-income individuals and communities. Beyond more conventional products in savings, credit, payments and insurance, their offerings also address needs in such areas as housing, energy, agriculture and small enterprise.

Today, the frontiers of microfinance go well beyond microcredit, to include savings, insurance, money transfers and other products that the poor need just as much as the rich to manage their financial lives. These financial services are important tools that help individuals manage their businesses, cope with unpredictable cash flows, build assets, and afford lump-sum expenses, like health emergencies and school fees.

Despite huge growth, microfinance reaches only a tiny fraction of the billions whose lives would be better with access to these basic services. We have much more we need to do, but continuing to discredit microfinance by magnifying some of the unintended consequences of microcredit, which is just one of its many functions, is distracting us from the far more.

The growing use of mobile phones, digital services and mobile money accounts is beginning to fill that vacuum. Mobile operators are teaming up with banks, financial tech (fin-tech) companies, and data analytics specialists to use the data they have on customers to gauge their credit risk and offer microfinance products to some who would otherwise lack any proof of their capacity to repay a loan. For the microfinance industry, such systems represent an important opportunity, as they enable borrowers to apply for, receive, and repay loans on their mobile phones, using a network of local agents to deposit and withdraw cash.

Since they know how much consumers are spending on airtime and are able to infer other relevant information, such as whether a subscriber has a job, mobile operators can gauge how affluent an individual is and what size of loan they can afford. If the customer is a regular user of a mobile money transfer service, the operator may also be able to assess how much disposable income they have. In fact, mobile operators’ data can be good enough to lower the lender’s risk significantly, enabling interest rates to fall and making microfinance a more attractive proposition for small businesses and individuals alike.

In the past two years the sector has been growing at a frenetic pace. But observers acknowledge that not everything is well with the sector. Microfinance is now becoming a potential site of a coming repayment crisis. It has much to do with the broader issue of excessive credit and over-indebtedness. Buoyed by rapid growth and huge returns and easement of regulatory norms, the MFIs went into an overdrive and microfinance became a car without brakes.

Critics say the industry has grown too fast, creating multiple loans to overextended borrowers. India isn’t the only country where micro customers have become overextended. Indebtedness has also been a problem several other countries. A study on indebtedness in microfinance by   Institute for Financial Management and Research (IFMR) a not for profit research organisation, has found that 23% of the MFI clients in its sample were over indebted. The study also found that the drivers of over-indebtedness include low of unstable income, multiple borrowings, high loan sizes, poverty levels, use of loans and cross borrowings.

A customer of a micro finance institution strings beads into necklaces at a workshop in a slum area in Mumbai February 17, 2007. Reuters
A customer of a micro finance institution strings beads into necklaces at a workshop in a slum area in Mumbai February 17, 2007. Reuters

Excessive indebtedness has certainly much to do with aggressive growth targets for the credit officer, which stretches him to add more portfolios and thus to recruit more clients and sometimes to put push more credit in already saturated geographies. It happens in two ways — borrowers take multiple loans from same or different institutions or borrow large amounts beyond the repayment capacity.

Until lately, the sector has been all about growth, a goal made easier by the country’s economic boom. Now that some markets are getting saturated, the focus must shift to putting the brakes on the industry, to look more at quality of what you’re giving than just expanding the numbers.

A research commissioned by ACCESS, India’s most respected resource support for the sector, several clients had loans outstanding from over five sources. In several cases 60% of the fragile, uncertain income is being spent by borrowers in paying off loans. In the quest to meet their growth targets, loan officers often sell loans to clients already indebted to other organisations. And in regions where there are more than one microlender competing for clients, observers are concerned that the poor are being encouraged to take on more debt than they can bear.

The findings are a “wake-up call to the industry about the need to focus more on the growth of our clients’ businesses than on the growth of the institutions that provide them financial services.”

Several MFIs endorse smart microfinance being espoused by the Smart Campaign but it is important that it is practiced on the ground. What is smart microfinance? Microfinance industry leaders from around the world came together in 2008 to launch a campaign to establish the Client Protection Principles. These principles are: appropriate product design and delivery, prevention of excessive indebtedness, transparency, responsible pricing, fair and respectful treatment of clients, privacy of client data, mechanisms for complaint resolution

To put the principles into action, the Smart Campaign was launched in October 2009. Today, it is a global effort with over 4,000 signatories, a wealth of tools and resources, and an ambitious action agenda. One of the campaign’s fundamental mantras is: “Protecting clients is not only the right thing to do; it’s the smart thing to do.”

When these features are weak or missing, even well-intentioned lenders feel pushed into harsh practices. When word gets out that a lender is soft, mass default can quickly infect the whole portfolio.

Consumer protection in microfinance is not just about fair treatment and safeguard of clients’ individual rights, but also proper  governance of microfinance institutions. The industry must be in a position to achieve its fundamental social mission of poverty reduction, while ensuring sustainability of operations. Microfinance institutions must deliver demand-driven, quality services to these clients, to low-income people and develop the industry in a health way.

The hard truism is that microfinance has been saddled with misplaced expectations, and we have lost a sense of its more modest, even though critical, potential. It is actually a tool in a broader development toolbox, but in certain conditions, it happens to be the most powerful tool. It will make the poor a little more resilient, but it is not the answer on its own It has all to do with how we are using it and how we are defining the outcomes.

“Microcredit is not a transformational panacea that is going to lift people out of poverty,” says Dean Karlan, Professor of Economics at Yale University and Founder of Innovations for Poverty Action, who studied the phenomenon in the Philippines. “There might be little pockets of people who are made better off, but the average effect is weak, if not non-existent.

The practical question is not whether microfinance should continue, but how it can play to its   strengths without damaging its social conscience. Before pundits and politicians reduce the questions and solutions posed by the occasional crisis down to sound bites and slogans, we must realise just how positive the effects of microfinance can be, for both financial inclusion and livelihood promotion, if handled correctly.

Microfinance is actually a tool in a broader development toolbox, but in certain conditions, it happens to be the most powerful tool. It has all to do with how we are using it and how   we are defining the outcomes. It needs to shape a more responsible capitalism.  It is certainly not an easy choice by any means, but a right choice for wise investors and society alike. Similarly, politicians should be wary of the bad consequences of their narrow populism. They should not overstep and attempt to throw the baby out with the bath water. This will be to the detriment of all.

Moin Qaziis the author of Village Diary of a Heretic Banker. He has spent more than three decades in the development sector.

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