Rural Finance Practitioner
Is the micro-finance like India’s sub-prime? This is a very legitimate and genuine question that several people have been asking…and a question that we certainly need to answer…even as the RBI board sub-committee is looking into the present micro-finance crisis and The Planning Commission is formulating an approach paper to micro-finance delivery in India (presumably for the next plan period)...
And according to Dr Y V Reddy, ‘the former Reserve Bank of India governor - credited with saving the nation’s financial system from the 2008 meltdown - microfinance is India’s subprime[i].’ “Ultimately, its something like subprime lending,” Mr Reddy told Economic Times[ii] in an interview ahead of his book release. “The same incentives are operating here... it was securitisation and derivatives that operated in the US. Here it is the priority sector lending by banks.”
“Yes, I agree with Mr Reddy when he says a lot of perverse incentives got aligned,” said Vijay Mahajan, chairman of BASIX, a micro lender, and head of Microfinance Institutions Network. “Here perverse incentives got aligned like in the US and in two years the sector went from helping the poor to preying on the poor.[iii]”
So, what is Subprime lending? Basically, subprime lending refers to loans extended to people with poor repaying ability that ultimately led to defaults. And as the same ET article notes, ‘the similarities do not end there: Indian micro-finance and The US Sub-Prime have a lot more in common including opaque practices, high salaries and commissions inducing unethical business, leverage and several other issues.’
“Even before the global financial crisis, in September 2005, CGAP[iv] observed that ‘the increased attention to microfinance could attract lenders/investors who might not care as much about development objectives, and might even engage in predatory lending practices that take advantage of poor clients.’ (See Box below).”[v]
In his paper, Mr Ajay Tankha notes that, “there are, however, other serious concerns related to the quality of MFI lending to the poor. These include:
• Microfinance interventions are essentially supply-led, offer limited products and do not take cognizance even of existing knowledge about client needs.
• The graduated increase in loan size for repeat clients is the growth strategy for most MFIs. Clients tend to access larger loans without a prudent consideration of their repayment capacity.
• MFIs overlap some in geographical areas resulting in multiple loans and high-client-level risks
• Some MFIs by chasing rapid growth - the "too big too soon" phenomenon - may be overstretched affecting the quality of financial services provided by them
• Leverage of external and commercial funds could contribute to compromises in the original wider social objectives of the NGO-MFIs
The Andhra MFI crisis of 2005, among others, raised lasting questions about consumer protection and the transparency of MFIs in their dealings with clients. It is accepted that a major contributory factor to the crisis was the aggressive …lending operations through ‘partnerships’ with the large for-profit NBFCs. In recent years the financial penetration of rural areas and increased outreach of MFIs has been facilitated by less than responsible lenders. The poor are affected by this not only through diversion of loans to larger borrowers (’mission drift’ through pursuing breadth rather than depth of outreach) but through an unsatisfactory and risky pattern of progressive minimalist lending. The latter creates unwarranted indebtedness among poor clients which could carry a heavy price. The retreat from the social mission of transforming MFIs is another critical feature of the ‘drift’ from the point of view of the poor. These constitute perhaps the most disquieting features of financial services delivery through MFIs."
“Rhyne[vii] (2008) argues that the sub-prime lending abuses that fueled the U.S. housing bubble demonstrate the dangers of financial services to the poor done wrongly. The sub-prime industry’s core failures in consumer protection – (i) tempting low-knowledge customers into over-indebtedness, (ii) ignoring capacity to repay in making loan approval decisions, (iii) failing to clearly disclose and explain loan terms – are the fruits of intense competition and ineffectual regulation.
Some of the above appear to be issues in the present Andhra Pradesh and Indian micro-finance crisis as well as Rhyne[viii] argues today…“The blame for this unfortunate situation falls most squarely on the microfinance institutions, or M.F.I.’s, that failed to restrain aggressive growth even as the market became increasingly saturated. Microfinance leaders in India are now working intensively to put measures in place that would hold back multiple lending. Investors must also swallow a big spoonful of blame. Because they paid dearly for shares in the M.F.I.’s, they need fast growth to make their investments pay off. Regulators share some responsibility, however. The public-sector policy environment has treated microfinance institutions as orphan children of the financial sector rather than helping them to build solid foundations.”
Therefore, while experts are slowly but surely getting to identify conditions that could result in micro-finance as being heralded as India’s sub-prime, it is about time that we explore this question – Is micro-finance India’s sub-prime? – in a detailed and objective manner. We attempt to do this in a series of successive posts where we raise the questions such as (but not limited to) the following and examine whether indeed micro-finance could be called as India’s sub-prime:
Ø Are clients having multiple loans and do they appear to be (over) indebted? Are they in a position to repay loans from their known (legitimate) sources of income/cash?
Ø Have institutions (for whatever be the reason) provided successive loans (one after one another), despite knowing that the concerned clients cannot repay existing (multiple) loans from the known (legitimate) sources of income/cash?
Ø Have clients used one loan to repay another a loan? Is periodic refinancing is required to provide sufficient liquidity to enable the client to service another/existing loans? Has an additional loan been provided mid way through an on-going loan and especially, on easier terms? Have there been a series of delinquent payments and one equalising payment (often from another loan) and has this pattern been repeated?
Ø Have coercive repayment practices been used to ensure better repayment? Has there been a lack of transparency with the product terms and the like, especially, in terms of the effective interest rates as well as other issues?
Ø Has growth of institutions been unusually large and has it been supply led? What are the motivations for the concerned institutions (MFIs) to grow this rapidly? To show better operating results? Have greater returns? Pay higher salaries and commissions to staff/management? Get better valuations? Tap capital markets at a premium etc?
Ø And most importantly, has there been policy as well as regulatory/supervisory failure, in one sense or another?
And I leave you with these questions so that you can ponder on whether (or not) micro-finance could be called as India’s sub-prime…and make no mistake, if it turns out to be India’s sub-prime, then, a lot of stakeholders including regulators, will have to (satisfactorily) explain to the Indian public on why this happened…and of course, regulation would no longer be able to use a hands-off approach to micro-finance…which has indeed been treated as an orphaned child (in a regulatory sense) for several (long) years now…
[ii] Same as i
[iii] Same as i
[iv] CGAP Portfolio 3, Issue 3, September 2005
[v] Quoted from Jan, Postmus (2010), “Micro-finance at Cross Roads”, Unpublished Working Paper.
[vi] Quoted from Tankha, Ajay (2009), “Microfinance Institutions and “Mission Drift”
[vii] Elisabeth Rhyne, Standards for Microfinance Growth, American Banker, December 17, 2008