Future of Microfinance in Andhra Pradesh and India

CONNECTING THE DOTS…

By Sirish  Dhurjety

(The  author  of  this  article,  Sirish  Dhurjety,  is  currently  pursuing  his  Doctoral Programme  focusing on impact investments in India. He is also the cofounder of a boutique investment bank – Capital Logic , based out of India. The views expressed in the below article are personal. Feedback can be sent to sirish@capitallogic.net )

India’s once- booming Microfinance industry has fallen into the crosshairs of the country’s  murky politics. Will the industry survive and what could be the industry’s possible contours going forward?

Clients of SKS Microfinance ring the bell at the BSE on listing day.Img-credit:AFP

Microfinance has been very much in the news lately. The financial markets led by savvy Private Equity funds, started taking notice of and investing in the industry’s rapid growth a few years back, culminating in the highly successful first ever IPO of an Indian MFI in August  of  this  year.  Unfortunately,  the   industry’s  fortunes  have  steadily  plunged downhill thereafter. This paper connects the dots of the MFI industry scenario with other key economic and political factors playing out in the country. The views discussed in this paper are strictly non-political, but are an effort to link various situations leading up to a holistic case for the future.

On the  one  side,  most  of  the  post  crisis  headline  news  on  Microfinance  (i.e.  from September 2010) has been negative. ‘Getting it right on Microfinance’, ‘Microfinance in India is like subprime lending’,  ‘Anatomy of a crisis’, ‘Are MFIs showing Shylockian streak?’, ‘What’s wrong with Microfinance Institutions in India?’ to name a few, paint a picture  of  an  industry  struggling  to  survive.  On  the  other  side,  there  is  increasing coverage and focus on Inclusive Growth in India – meaning mainly financial inclusion, which could be a starting step for some interesting developments in the midst of  the growing political controversy.

To begin with, MFI industry fortunes can only be understood with an appreciation for the effect this rapid industry growth has had, where it has increasingly impinged directly on the agenda of state and federal level politics in India.

Background of the situation

One of  the  key  mandates  of  our  current  government  is  Inclusive  Growth  –  mainly Financial Inclusion. Unfortunately, our national leaders have been spending more of their time in handling/ responding to the several multi- billion rupees scams and digesting poor electoral performance in a few  key states in the country. The recent controversies in

Andhra Pradesh politics – dispute within the state, Chief Minister quitting, former Chief Minister’s son  rebellious act and the MFI saga – has led to some opposition parties playing the political card by urging borrowers not to repay their loans to MFIs. Andhra Pradesh accounts for around 30% of the MFI loans in the country and has witnessed an alarming number of suicides by some debtors, purportedly due to harassment from MFI agents over repayment.

The Indian MFI industry which has close to Rs 30,000-crore in outstanding loans to 30 million borrowers is going through a rough tide and has been challenged ever since the SKS Microfinance IPO. Major Indian Public and Private Banks – State Bank of India, Bank of India, Indian Overseas Bank, Punjab National Bank, Andhra Bank, SIDBI, Axis Bank and ICICI have amongst the maximum credit exposure to MFI firms, estimated to be close to 70% of the total credit outstanding to the industry.

Some of the figures lent to MFIs by banks, according to data from a rating company, are as follows-

Source: CARE rating

In addition to their direct lending to MFI’s, most of the public and private banks have purchased loan  pools  for  millions  of  dollars  from  MFIs.  These  loan  pools  are  also expected to be under pressure, as the securitization mechanism exposes the investors to the ultimate borrowers and a drop in repayment rates will subsequently affect them.

Public Sector —————————- Private Sector

Source: Morgan Stanley Asia Pacific Report through Moneylife

THE RESULT

Stocks of banking companies, mainly the private sector have been under pressure lately after having outperforming the market over the last few months. Banks with the highest MFI exposure have witnessed the sharpest fall in their share price in the last week. Shares of Yes Bank fell by around 10% in the three trading sessions last week, while those of Axis Bank and Oriental Bank of Commerce fell by 9% each. But even though the impact on ICICI Bank and HDFC Bank is somewhat similar to that on Axis Bank and Oriental Bank of Commerce, their shares fell at a lower rate of 6% and 3.4%, respectively.

One of main concerns of the investors is the asset quality of microfinance institutions (MFIs),  which  is  under  pressure  after  measures  taken  by  the  Andhra  Pradesh  (AP) government to tighten regulations governing the industry which challenges the existing business model – banning of the weekly collections from the borrowers. This has resulted in a sharp decline in the repayment of loans across AP and the trend is spreading across the country mainly in areas such as West Bengal, Madhya Pradesh, Orissa and Karnataka.

Source Microfinance exposure takes toll on banking stocks through Livemint

Latest Developments – the dots…

In spite of the current crisis, many MFIs have approached banks for emergency funds amounting to Rs  10,000 Cr, admitting to suffering a severe liquidity crisis. As some banks in some states have stopped lending to MFIs, many are worried that the crisis could deepen and threaten a collapse. As per Vijay Mahajan, one of the pioneers of the Indian microfinance industry in India and the President of  Microfinance Institutions Network

(MFIN), the MFI industry will collapse and will be finished as early as first quarter of the coming year in case the banks decline to support and lend to the microfinance institutions because of the current environment in the MFI market.

Amid all the chaos, some of interesting developments in the economic and political environment are:

• The Union Finance Minister clearly indicating not to “strangulate” the industry and to finalize  the regulatory architecture for microfinance institutions and the

‘Microfinance Bill’ by early next year

• MFI  bill  introduced  in  Andhra  Pradesh  assembly  and  Karnataka  government planning  to   establish  a  state  funded  microfinance  institution  like  Andhra Pradesh’s SHG-based SERP programme
• MFI regulation panel proposed by Orissa state government

• Nation’s largest lender  – State  Bank of  India announced its 750-million euro (about Rs. 4,650 crore) five-year bond issue and also awaiting government’s nod to  come  out  with  a  Rs.  20,000-crore  rights  issue  improve  its  capital  base sometime in late December or early next year
• Union Bank’s direct entry in the MFI business

• Axis bank’s top management’s apprehension in relation to huge exposure to the

MFI sector

• Major PSU Banks – Bank of Baroda and Indian Bank sign contracts with MFIs to rein interest rates, ensuring  MFIs  do not charge interest rates beyond a certain ceiling from their borrowers
• Corporation bank management’s   mooted thought of   converting the debt from

MFIs to equity, for safeguarding risks in case of default

• Indian Banks’ Association proposal for roping  in “Bollywood” film stars for spreading the message of financial inclusion – to educate rural masses about the benefits of bank accounts and other financial services
• One of the leading NBFC’s from the South, Muthoot Pappachan Group has tied up with Accion of US to boost lending in microfinance sector and also in the final stages of acquiring a leading MFI player in the North

The way forward – …Connecting the dots

The microfinance industry which was considered to be an instrument in realizing the goal of financial inclusion, as they serve a segment of the population without access to banks, will certainly face regulatory  headwinds. The issue is primarily whether the proposed regulations will be supportive of an industry that has emerged as a global frontrunner in combining social and economic  goals –  or whether  they  will  land up throttling the industry with unviable requirements.

Snapshot of the Microfinance Industry

* Depending on nature of regulation that emerges

Going forward, the MFI promoters as well as for the Investors might not have the best news – at least not to the extent they would have imagined couple of months back.  In case  the  same  trend  continues-  borrowers defaulting,  very limited  access  to  capital, regulatory risks, ratings with negative implications and political resistance, MFI’s would be faced with both solvency and liquidity challenges. An IPO exit would remain a distant dream for the players, as well as their private equity investors.

Analyzing and evaluating the sequence of events strategically, along with some crystal ball gazing, the following might be the way forward for this industry

Potential  Convergence  between  Banks  and  MFIs:  Although  current  regulations maintain a clear demarcation between scheduled commercial banks and MFIs (the large MFIs are mostly regulated as  NBFCs), the mutual advantages to each other are fairly obvious. MFIs can significantly lower their  cost  of funds, and also remove potential hazards of dependence on institutional liquidity through conversion to a banking model; banks can get into the financial inclusion game through best practices from MFIs.

The convergence needs to be initiated through regulatory changes from the RBI, and the resulting activity could either be organic or inorganic. Though the business model is different between  Banks and MFIs, there could be some interest from the Banks to acquire MFIs given their exposure to the industry and also which could give them access to new and rural parts of the country. SBI raising funds (may be part of it is to acquire MFIs), Union bank entry into this business and Corporation’s bank intention to acquire stake in MFIs might be early signs from Banks intending for consolidation in financial services space.

It might be premature to discuss the modalities of partnership at this point in time, but this idea should  certainly be explored by Y.H. Malegam and team, a sub-committee appointed by RBI to study the industry and recommend ways to better its practices. This could be a win-win situation for banks,  regulatory bodies and mainly the customers – provided  the  banks  give  a  decent  valuation  for  the  MFIs.  From  the  government’s perspective, this could be a one of the best strategies to fulfill the  Financial Inclusion objective as well as to get the situation politically correct.

Partnership with Regional Rural Banks (RRB):  As per the data till last financial year, there were 82 RRBs (with a network of 15475 branches spread over 619 districts in 26

States and 1 Union Territory), of which only 3 RRBs out of 82 RRBs were incurring losses. In addition, the RRB’s were given a target by the Finance Ministry to open 2000 branches by March 2011  with the right banking technology platform as part of their financial inclusion strategy.   Partnership  with MFIs could be one of the routes which could be explored by RRB’s to have better access to similar client base and to fulfill their mandate of financial inclusion

Consolidation within the MFI industry: Consolidation amongst existing MFI players could come about, in the situation that present stressed conditions continue for a further quarter or two. Larger  MFIs  with good balance sheet, with appetite for risk till the regulatory framework is worked out and also having the capacity digest an acquisition in this environment might look to buyout other small/medium MFIs for their customers and loan books, at distressed valuations. However, the challenges in this case as mentioned earlier remain – borrowers defaulting, very limited access to capital,  regulatory risks, ratings with negative implications and political resistance.

Investments by Microfinance Investment Vehicles (MIV’s) / Impact Investors in the Indian MFI space

Investments done by Financial Investors in Indian Microfinance companies

The above tables give a brief overview of the VC/ PE investments in the Indian MFI landscape. Indian MFIs have raised more than $450 million across 66 deals from private equity investors  since  2006,  according to  VCCEdge.  Investors in  the  sector include international DFIs like IFC, Silicon Valley Bank to venture capital firms Sequoia Capital and Canaan Partners, social VC firms like Aavishkaar and  Elevar to hedge funds like Sandstone Capital and Tree Line Asia.

Most of the marquee domestic and international investors  had done multiple  deals /  investments in  the  Indian  MFI.  Being a  capital intensive business, MFIs demand for capital is no-doubt very high. The investors were very optimistic  about the growth trends and the MFIs needed more money to scale-up which resulted in multiple borrowings – both through debt and equity till September this year.

In the current environment, consolidation amongst the existing MFIs might not be a bad idea for MFIs wanting to operate on a standalone and the investee companies of same fund can explore the possibility of partnering together.

For instance, Matrix Partners – a financial investor which has invested in an NBFC (Muthoot  Finance) and an MFI (Bhartiya Samruddhi Finance Limited) might look at closing an internal deal amongst its portfolio companies for their exit (Muthoot buying stake in the MFI).

The other possibilities could be Muthoot Finance acquiring Swadhaar FinServe or Saija Finance in which Accion has invested in the past. Muthoot has recently tied up with Accion to boost lending in microfinance sector, in case we were to go by the latest developments and the given situation in the market. Muthoot Finance is planning to raise at least Rs 800 crore ($178 million) from an initial public offering (IPO) soon.

Emergence of Cross – border (inbound) acquisitions / strategic partnerships: Global microfinance had around $12bn in cross-border investment by the end of 2009, up from

$4bn three years ago according to CGAP (The Consultative Group to Assist the Poor, a World  Bank   linked  group).  The  first  table  above  lists  specialized  microfinance investment vehicles (MIVs) like IFC, Oikocredit, Hovos, Micro Ventures and Incofin to name a few, which have investments in multiple MFIs across the globe, which may very well turn out to be the drivers for cross-border consolidation and strategic partnership so that best practices across the globe are shared and MFIs move towards higher bargaining

power in countries like India where they are currently at the mercy of politicians and bureaucrats. In addition, major international MFIs like Compartamos – a listed Mexican player may be open to exploring strategic options in India. Globally, there have been few interesting cases of cross-border acquisitions and given the current environment, Inbound M&A deals could emerge as a new trend in the Indian MFI space.

Development of  non-institutional  funding  base: MFIs  have  in  some  cases  moved beyond  institutional sources of funding (primarily banks and MFs) to securitization of loans. As the current crisis demonstrates, dependence on institutional sources of funding can be a significant risk in times of stress. Going forward, larger MFIs may need to raise the bar through innovation in developing a retail  bond/deposit market for raising their funding.

New Bank / Larger NBFCs and the MFI model – More than a decade after the Reserve Bank of India issued the last of the two banking licenses to private sector entities; the government has again started  the process of allowing non-banking finance companies (NBFCs)  to  graduate  to  full-fledged  banks.  The  ordinance  for  issuing  new  banking license will be considered on the thrust given to financial inclusion. The business model could be required to clearly articulate the strategy and the targets for achieving significant outreach to clientele in Tier 3 to 6 centers (i.e. in populations less than 50000) especially in the under banked regions of the country either through branches or branchless models

– which indeed could be good fit for them to invest/ partner with existing MFI’s – though the model is  different from banking, the partnership could create a base by providing better  understanding  of  the  market  and  have  live  business  from  the  starting  point. Reliance Capital, Mahindra, Religare enterprises, Cholamandalam and Tata Finance have already expressed their interest in acquiring a banking license, of which Reliance Capital has already invested in MFI space in India.

Pure Political Card aka Prepare for More Regulation! – This could be the best part and the might  be the best weapon for the existing government to win hearts and gain votes. The cynical view is that the ground situation in AP could very well move towards

waiver of MFI loans as a means of creating a vote bank for parties – and that      the politician / bureaucrat nexus in the state would not mind killing the MFI industry for its own benefit. Last year, the government announced farm loan waiver of Rs. 72,000 crore during the budget and this  year it might be to waive off the MFI loans which will certainly form a solid platform for the  general  elections in 2013. In this case we are discussing about close to Rs 30,000-crore in outstanding loans for 30 million votes. In addition, the objective of Financial Inclusion is fulfilled – sounds like a good deal to me. Borrowers or Aam Aadmi (which means “Common Man” in Hindi) is safe and situation is politically correct. Thus proving the philosophy that most of the politicians who run this  country follow “As long as the general public is given what they want, we (politicians) get what we want”

Thankfully sanity might prevail at the federal/national level,and through recommendations from the Malegam committee. What cannot be escaped is that the industry will be regulated more tightly – maybe in the form of interest rate caps, stronger criteria and diligence for disbursement, less aggressive collections methods. At the end of the day, what is required is a set of regulations that reasonably protect the borrower/consumer, and at the same time ensure continued growth and innovation in an industry that  has  emerged  as  a  global  leader  in  combining  societal  and  community  impact objectives with commercial and entrepreneurial drive sourced from the corporate world.

(Send your feedback and comments on the above article to sirish@capitallogic.net )