There has been quite a bit of noise in Andhra Pradesh in the past several weeks about microfinance institutions’ (MFIs) business practices and interest rates charged by them. It might help to think about this issue a bit logically, rather than emotionally, legally, and politically, and steer the debate in the right direction.
1. Microfinance Interest rates:
This is perhaps the most contentious issue in this whole debate. It has been reported in the media that MFIs charge between 26-60% p.a. effective rates. The truth is MFIs do charge higher rates than banks and very few, if any, charge more than 36%, all-inclusive. Someone who is doing it at more than 40% is probably not the MFIs as we know them. It would be good to check the credentials of these entities just to be sure if they really qualify to be a part of the industry or just wearing MFI hats to get away with their exploitative businesses.
Having said that, let us put these interest rates (26-36%) in perspective. In order to do so, it is important to start with a comparison to loans that are available to relatively well off people. Keeping aside the intended purpose for a moment, a credit card loan can probably be considered the closest comparative to a microfinance loan.
Average credit card balances are typically smaller than other loans and, most importantly, unsecured. You pay anywhere between 24-36% effective on these loans. One could still argue that poor people should have access to this service at a cheaper price compared to the rich. In theory, it sounds good but in practice, we are yet to see a viable and scalable model that can achieve this. Several industry experts touched on this subject and tried to explain why MFIs charge high rates and why indiscriminate subsidies do not go a long way in serving the needs of the poor. Read this for instance. Notwithstanding high operating costs in delivering loans at clients’ doorstep which primarily drive the interest rates to the levels mentioned above, let us try and understand in simple terms what these interest rates really mean for cash flows of the poor:
MFIs in India lend an average of Rs. 10,000 ($200) per borrower and charge 12% – 15% flat rate + 2-3% upfront fees (translates into 26-36% effective rate). Without bothering about how much is it in terms of effective interest rate, let us understand how these rates translate into the absolute amount and how that could affect the borrowers. 15% flat rate literally means Rs. 1,500 ($30) interest on a Rs. 10,000 ($200) loan because the interest is computed on the disbursed amount and not declining loan balance. It is perhaps safe to assume that an upfront fee of 2-3% i.e., Rs. 200-300 ($4-$6) is good for covering initial group formation, loan processing, and disbursement costs, considering the number of trips (4 to 6) a loan officer makes to the client location before the loan is issued.
One should also note (and make sure) that the borrower pays nothing else to obtain or repay the loan, not even a visit to the MFI office except on the disbursement day. Most MFIs collect loans in 50 weekly cycles. Rs. 1,500 ($30) interest literally means Rs. 125 ($2.5) per month or Rs. 30 ($0.75) per week. From MFIs’ standpoint, Rs. 15 ($0.38) of this weekly interest collected is remitted directly to banks in the form of interest on borrowed funds, it costs at least Rs. 11-12 ($0.30) to deliver the services at the clients’ doorstep, if managed efficiently, and Rs. 2 ($0.05) is set aside to cover for possible defaults leaving Rs. 1-2 ($0.05) as margin. Not much of a margin really. This does not mean to say though that there are no greedy players in the industry. They are however exceptions than the norm.
Profit is good for any business but profiteering is not. If we consider credit as a service similar to any others such as phone, cable, electricity, and so on, it is not unusual for someone of the profile of an MFI client to be buying a talk time of Rs. 125 ($2.5) or paying for electricity in a similar amount in a month. We know that these services offer great value and intended to improve the quality of life of clients and their families in addition to making profits for the provider. Similarly an Rs. 10,000 ($200) loan goes a long way in meeting the working capital needs of a small shop or a dairy unit or a small farm or treatment of a sick family member or fees for a college student.
Now, let us assume that MFIs reduce the interest rates to 7.5% flat (half of the original rate) which translates into approx. 15% effective rate, close to commercial bank lending rates. The interest obligation ends up to be Rs. 62.5 ($1.25) per month or Rs. 15 ($0.38) per week. So, it sounds like the argument is essentially about the difference of Rs. 62.5 ($1.25) per month or Rs. 15 ($0.38) per week per average MFI loan. It is hard to believe that someone would end his/her life for less than Rs. 100 ($2). Even for someone with 5 loans of similar nature total interest obligation does not seem worth one’s life. Based on this logic the real problem seems to lie somewhere else, certainly not in interest rates per se.
2. Multiple lending and over-indebtedness
It is not unusual that poor households borrow from more than one source, formal as well as informal. In fact AP leads in this statistic with an average of 4 loans per family, 86% served by informal sources. In principle, having access to multiple sources of any service is indeed a good thing since healthy competition helps in keeping exploitative tendencies of monopolies at bay and clients would have a wide choice to work with. However, excess supply, especially of credit, to ill-informed clients and by poorly trained staff driven by perverse incentives often leads to disasters. Andhra Pradesh stands out with respect to the availability of a variety of lenders, thanks for proactive government programs and aggressive microfinance initiatives led by for-profit MFIs, in addition to super-active traditional informal sources.
The trend is fast spreading to other states too. Aided by the push from all quarters it is quite possible that some households end up borrowing beyond their means. The effects started showing up in the form of deteriorating repayment records of government-sponsored SHG-bank linkage programs.
MFI repayments thus far remained unaffected primarily due to the robust operating model. Signs of excessive MFI growth did become apparent though in other forms such as occasional complaints of loan officer misdemeanor, increasing frauds, the proliferation of ring leaders, and sporadic political outbursts. Some MFIs became too large and began to threaten government-led SHG programs. Lack of proper communication between the two parties only added to the problem. Some MFIs have grown into mammoth corporations hungry for business and profits, and supported by private equity investors. Buoyed by the trend commercial banks joined the bandwagon by offering unprecedented amounts of loans to these MFIs, all this resulting in some situations where one family has as many as 10 loans, from various sources, at the same time.
However, it is hard to believe that someone has ended his/her life solely because of MFI loans. It is certainly plausible though that some of the bereaved families have borrowed large sums from informal sources too and the total obligation of payments exceeded their capacity. Since it is difficult to gather information about informal sources and more often than not most of these lenders enjoy political clout, it is not surprising that MFIs, an isolated and exponentially growing industry, got the short end of the stick in the recent crisis. Having said that I do think MFIs should have behaved more responsibly and contained the excesses as much as they could.
3. Coercive collection practices:
Most MFIs conduct business with groups of women who meet in weekly intervals for making repayments and applying for new loans. Such meetings are usually held in open places in the presence of 20-40 women, and often men and children watch over. In a scenario like this, the scope for applying strong-arm tactics seems like a remote possibility. As noted above since many households in the state have access to about 2 or more MFIs it is unlikely that a client would put up with any such coercive actions exhibited of an “x” MFI, nor could “x” MFI resort to such practices openly, else they lose business to the competition.
So, it sounds like a distant likelihood that anyone would have to resort to suicide as a respite from MFIs. On rare occasions though peer pressure could lead to someone resorting to such extreme end. Having said that one cannot completely rule out the possibility of misbehavior by an ill-trained loan officer on a rare occasion and such situations should be condemned and checked right away through proper training, orientations, and internal controls. Incentives of loan officers perhaps demand a fresh look too.
4. MFI as an entity:
The question would then lead to “how would an organization identify itself as an MFI?” There is no regulation or national definition of MFIs. Anyone who lends money in the villages or urban slums can get away by calling themselves MFIs. As microfinance grew popular and acceptable among communities it should not come as a surprise if informal money lenders and fly-by-night finance companies present themselves as MFIs in the front-line, making it difficult to distinguish between different private players.
So in a diverse population of several recognized and unrecognized players operating across the state, it again sounds unfair to put the blame squarely on the microfinance industry as a whole instead of finding out unscrupulous players and dealing with them directly. That goes without saying though that even a recognized MFI found to be resorting to any strong-arm tactics should be dealt with appropriately. Moreover, the responsibility also lies with everyone in the industry to keep a watch for fake and rogue entities.
Based on the above analysis, it doesn’t seem completely far-fetched that some isolated incidents of distress might have occurred due to over-indebtedness coupled with coercive actions. But, it sounds very unfair to lay the allegations solely on MFIs without even verifying the facts or consulting with anyone from this key group. While it is undeniable that there exist several loopholes in MFI operations, as with any other fast-growing industry, all the concerned parties, including government, should own the responsibility for the state of affairs. A consultative approach to public policy is a good way to address such issues rather than a one-sided iron-hand solution. The latter would only do more harm than good to everyone.
MFIs and banks will lose money in the form of defaults, poor households will find it difficult to access much needed financial services and eventually the government will attract public criticism for cutting off the only legitimate source of adequate credit in most communities.
MFIs must consider this as a wake-up call and look inside for deficiencies including operational methodologies, incentive structures, product offerings, governance, management capacities, MIS, and public relations. On the other hand, the government should devise policies and programs that promote transparency, healthy competition, client protection, financial literacy, public-private partnership, and responsible lending. The differences must be resolved and gaps filled at the soonest in the larger interest of the society. The longer it takes the harder it gets to restore normalcy and, as always, the innocent poor will be the biggest losers at the end of the day.
The views expressed in the above article are those of the authors and do not necessarily reflect the views of their employers or IMBN.