Tuesday, December 7, 2010

Microfinance - Part 1

Everything is for helping the poor. As is Microfinance. The story goes like this.  The poor farmer whose wife is having a complication during child birth rushes to the money lender to borrow to save her life. Or to get his daughter married. Then ends up working for the rest of his life just to keep up with the interest payments. If it were a Hindi film, the moneylender would probably be having malicious designs on the wife or daughter. It's enough to make you weep.


A lot of it is true as well. However, moneylenders do perform a useful function, that of lending money to the poor in times of need, especially to those who are outside the pale of formal banking systems and who do not have any security to offer.


The obvious question then arises "Why cannot  banks offer microfinance – finance in very small amounts, to the poor?" The banks cannot do it – they do not have the reach and their cost of servicing loans is very high due to high salary and overheads. They would rather make 10,000 loans of Rs. 10 lakh each than 10 lakh loans of Rs. 10,000 each. They also do not have the mechanism to make collections on a weekly basis at the customer's doorstep – most of the beneficiaries would be people earning daily wages who will find it impossible to save up to pay once in a month.


However, there is a huge arbitrage here which cannot be ignored. The lending rates of banks are in the range of 12 to 18 percent, while the lending rates of moneylenders  could vary anywhere upwards of 60 percent, and in several cases even exceed  100 percent per annum. This was a big opportunity for an institution or institutions to step in to bridge the gap. If the institution could manage to borrow from banks or from entities abroad at 12 percent levels and lend it out at, say, 25 percent levels… that is what is called an untapped opportunity in entrepreneurial parlance. Such a model to be successful would need to have the following:

                Low-cost disbursal and collection mechanism

                Ensuring no defaults – a real challenge when the borrowers are small and numerous

                Scale in terms of sheer number of loans


Grameen Bank of Bangladesh has a tried and tested model which has been extremely successful in that country. They lend to the poor who do not have any collateral and ensure repayment through groups formed at the local level. Peer pressure is used to ensure that people pay – the group is also useful in inculcating good savings habits and spreading financial literacy among the people. The Grameen Bank works primarily for upliftment of the rural poor; its lending rates are in the region of 20 percent. The bank has been in existence for more than 25 years now. It acquired international recognition when it was awarded the Nobel Peace Prize, along with its founder Mohammad Yunus, in 2006.


In the last few years, several microfinance institutions set up and started expanding in India following the "Self Help Group" model. The Group is held responsible for timely repayments, and systems are institutionalized where they meet regularly. The Group this ensures repayments through peer pressure. Some of these institutions grew really big. The one that is in the news recently, SKS Microfinance, founded by Vikram Akula, is the biggest, with millions of borrowers across India.


As they began and started expanding, the repayment record of these institutions was very good. They boasted of loan repayment rates of 99% or above. How much of this is due to evergreening of loans (the practice of lending fresh money to repay the old dues) is not clear; there is reason to believe that at least in the initial years when the whole movement took off, the rates of repayment were genuinely high, but 99% repayment from poor borrowers is something that stretches credulity.


The story for the consumption of the general public was that these institutions were doing a lot of social good. They were lending at rates far lower than the money lenders – this is like saying that you are celibate since you sleep around less than Tiger Woods – and aiding in social development by "enabling" the poor. Enablement implied that they could use the money to start their own business or stand on their own feet, or avoid a debt trap – actually it's a bit vague what it meant.  A couple of microfinance institutions realized that true enablement occurs due to a combination of factors that includes access to education, easy access to health care facilities, availability of power and infrastructure, etc.; money needs avenues to be deployed productively and the ecosystem that creates those avenues needs to be built up first.  These few institutions realized that focusing on rural development initiatives along with providing credit was required and started focusing less on growth of the loan book and more on provision of loans coupled with NGO type work in developing social infrastructure.


Following the pioneers, several microfinance companies entered the arena. All of them wanted fast growth in terms of number of loans and aggregate loan portfolio, which has a parallel to the early days of telecom. When a new market is being established for the whole category in general, the early movers want to capitalize on their advantage by going for topline growth. This has multiple benefits.  You move in before others even realize the market is out there waiting to be tapped. You crate entry barriers for the new entrants. You try to reach the "tipping point" after which people buy your product because everyone buys your product. And most important, you create valuations. Any PE investor looking to invest will look at the current "numbers" in terms of number of loans, number of connections, or whatever; what is the expected growth, for which, in true equity analyst style, a graph showing the last three years' trendline will be extended infinitely into the future; and not look at the "bottomline" since the market is still nascent. This gives an incentive to ignore the bottomline, increase costs, provide duplicate connections or multiple loans as the case may be. The internal systems and processes are also not strong at this point. A lot of sins can be hidden in a system which is growing furiously.


In case of microfinance, several institutions started playing this game. One suspects that in this process, there are a lot of bad loans that have been created. Also, the companies started lending to the same borrower in the pursuit of growth.  There are several cases where the same borrower has five or more loans, all with different institutions! Several of the borrowers would probably have accounted that  money as revenue rather than as loan! How do we know the strength of the loan book in case of all these companies who have lent crores of rupees to lakhs of borrowers? The only thing an investor hopes for, as the companies themselves do too, is that the growth in numbers would still make the percentage of bad debts look small.


The companies got PE funding – for example, Akula got some funding from Narayana Murthy's venture fund as well. All PE's as we know, look for profitable exits. So the IPO becomes essential. In any case, how does the promoter become wealthy if not from "unlocking" value through an IPO? Any comparisons to Grameen Bank at this stage would be ridiculous, since all these companies departed from that model long back. Grameen Bank did not try to list, and profits are distributed among the participants.


So the IPO of SKS Microfinance happened. Investors, including of course large institutional ones, jostled each other in the queue in their eagerness to subscribe. It was a compelling story. India is a large untapped market. It has a large base of people without access to formal banking systems.  They now have an alternative to the moneylender. They are willing borrowers at 26 percent per annum. The companies that do the lending have mastered the art of collecting the money back along with a low-cost model. They borrow in turn either from local banks or from abroad at 12 to 14 percent. Even allowing for a cost of operations of about 6 percent, including bad debts, it yields a margin of 6% on the asset base, which when translated into return on investment, becomes a very high number. This growth would of course, continue. The valuation as we all know is nothing but a discounted value of future expectations. Expectations were high; the issue was a success. Akula took home a lot of money. So did several others.


The first indications that something was wrong came when there were reports complaining of coercive tactics for recoveries, and of course, the favorite, borrower-suicides.  (At a certain level I do not have any objections to coercive tactics for recoveries – if I have borrowed it is my duty to pay up or face the consequences – but I shall skip that line of thought since it is not a politically correct line of thinking!). Andhra introduced a bill (still to be passed) putting severe strictures on microfinance companies. There is an inside story here that we shall never know. Andhra already had a successful microfinance model where money was being lent at absurdly low rates, subsidized by the government. This is run from the major towns, and local politicians and bureaucrats are involved. One can imagine the huge patronage network that is already in place, and the vested interests that have been created, which will be threatened by these new developments. The system is running amok because of too many institutions trying to enter the fray, there are noises about coercion and suchlike, and the halo around the social development objectives seems to be slipping especially after the successful IPO – what better time for these lobbies to strike? So the word has gone out in Andhra that loans taken from microfinance institutions need not be repaid. The recovery rate has plummeted from the earlier claimed 99% levels. Suddenly, the whole edifice that was built on assumptions of exponential long term growth, and assured repayments, has started looking weak. SKS Microfinance which after listing shot up, plummeted to below offer price.  When valuations are built on future expectations and hype, any prick to the balloon can cause the entire balloon to deflate.


In the meanwhile, two months after a successful IPO, Akula sacked his CEO Gurumani, who by the way, was  an ex-banker who was brought in at a salary comparable to foreign banks. No one knows what the problem was, but the whole episode does raise serious issues on corporate governance. 


Akula's discomfort was compounded by his divorced wife going public over matters public and private – under the backdrop of a messy post-divorce child custody case, she accuses him of bad governance in his institution – he is not exactly portrayed in saintly light.  Actually, that should not matter so much. With the money he has, he can buy a sainthood anytime!


And Sheikh Hasina in Bangladesh is of late making noises about Grameen Bank lending at very high rates, and the tax department is investigating Grameen Bank for possible tax evasion. I am sure the politicians of Bangladesh are not very pleased at the success of Yunus but they could not touch the one with the halo; now the climate seems right for muddying the waters the bit – why would they lose the chance? It is no different from how our politicians would act!


Being the first microfinance company to grow so big, and being the first one to list, unfortunately puts the spotlight a little too strongly on Akula's venture. There are several other microfinance companies waiting in the wings to make their IPO's, all of whom have deferred their plans for the time being. The whole edifice of banking is built on the principle that the borrowers, at least a large mass of them, want to repay; and the depositors will keep their moneys with the bank. If either of the two assumptions breaks down, there is a systemic crisis. What is being engineered by the politicians now by encouraging people not to repay is a systemic crisis that could have long-term repercussions.


Talking of long-term repercussions, it is actually good that the microfinance juggernaut has slowed down and people are talking of placing curbs on it. There was (and still is) a real danger of this going the way of the sub-prime crisis, with similar moral hazards, similar unbridled growth of debt, etc. We shall go into that in the next part on microfinance.




SG said...

What an end-to-end analysis! This article truly captures the holistic view of microfinance

Joseph Abraham said...

Brilliant and incisive commentary on the microfinance scene in India, what I especially liked is where you talk about the vested interest's at work ... the best way ahead is to bring all microfinance institutions with the RBI framework and let RBI build a framework for regulation, rather than individual states bringing in legislation and shackling this new sector and making it unviable and unprofitable. Dinesh, also looking forward to reading your views on "Gold Loans”, which were in the past being run by small time operators in Kerala , unofficially called "blade" for obvious reasons.. and now being launched on large scale across India by NBFC like Mutooth Finance and also mainstream banks...

Dinesh Gopalan said...

Gold loans from banks or institutions like Muthoot seem to be ok - if you have to borrow, you might as well do it at the lowest possible rates - I believe these could be in the region of 12% give or take couple of %. I have not enquired personally at any of those outlets, but from what I read, it seems to be fairly above board.