Ramesh S Arunachalam
Rural Finance and MSME Practitioner
The proposed draft micro-finance bill in India is very welcome and in fact, chapter 35 of my recently released book, The Journey of Indian Micro-Finance, does propose a similar option along with two other alternatives.
That said, while the bill is indeed welcome, in the light of what has happened in Andhra Pradesh (outlined in this blog and also chapters 2 to 17 of the book) and also the general lessons learned from the present micro-finance crisis (chapters 18 to 28 in the book) and regulatory lessons (chapters 29 to 34 in the book), the bill, which does not have the required safeguards, runs the serious risk of implementation failure. Make no mistake about that!
Stepping back from the bill, without question, it is clear that policy (and/or lack of it) has also played an important role in the disorderly growth of MFIs and the challenges arising therein. I shall look at this in detail here and outline the implications for the proposed bill! I would like the concerned stakeholders to take it in the right spirit and again, let me reiterate that the idea is to strengthen the bill rather than undermine it. Thank you Ladies and Gentlemen for a patient reading…
A first crucial aspect is that laws will have to follow policies and the point to note is that we have no serious national micro-finance policy in India, as on date, despite the acknowledged importance of the subject. Therefore, before (and/or at least simultaneously along with) the bill, it seems important to draft a policy in a democratic manner and this policy will have to outline various aspects including the following:
1) What is the proper scope of micro-finance, given the Indian context? What specific problems and issues will it be expected to address?
2) Which institutions (stakeholders) are providing such MF services, through what delivery channels and to whom? What key lessons with regard to these different models are discernible and especially, in the light of the recent micro-finance crisis? The aspect to be noted here is that while past policy pronouncements have been well-intentioned and talked of a range of financial services that the present bill is also talking about, in reality, micro-finance has been somewhat limited to the delivery of large scale consumption credit (and perhaps some small production credit) to low income people. Therefore, the bill cannot assume that a wide range of financial services will indeed be delivered. This difference between intended and realized strategies on the ground, is an aspect that needs to be factored in thoroughly and this leads to the next question.
3) What is expected of micro-finance over the next 3 years? 5 Years? 10 Years?
4) Given the above, what should the scope of regulation/supervision be? Who should be the regulator (s)? Supervisor (s)? and other aspects as required
OK, that said, I see three major reasons for (having) a bill of this kind and Chapter 35 of my book delves into this fully and I summarise the key aspects here:
a) To provide legitimacy and a proper regulatory framework to MFIs (Legitimacy For Micro-Finance Institutions and Players) and others involved in delivery of financial services to low income people
b) To ensure that MFIs indeed satisfy the broader objectives for which they have come into being (in the first place) and also that they operate and function in a sound and legal manner, in accordance with norms and standards required of such (pro-poor financial) institutions (Regulation and Supervision of Micro-Finance Institutions and Players), and
c) To protect clients from MFI bad practices as well as institutions that operate legally and correctly from usury laws (Protection of Micro-Finance Clients and Institutions)
The proposed bill, which addresses the aspect of providing legitimacy for MFIs, has indeed made a great beginning. This is something that Dr Thorat and I argued in a paper, way back in May 2005. It also looks at the aspect of protecting institutions from State level usury laws and that is a trifle scary because only those institutions that operate within the ambit of the law must be (so) protected. Institutions that engage in multiple, successive, and/or ghost lending and use coercive recovery practices must surely not be legitimized. Likewise, those institutions that have improper governance (as prof Sriram notes in his EPW, June 12th 2010 paper) and fraudulent systems again must not be protected. What is worrying here is that, from the face of the bill, the ability to distinguish between not-so-legal and good institutions (MFIs) is not clear, in any significant measure. Further, the aspects of regulation and supervision of MFIs (in terms of the real provisions) are not known. Also, the mechanisms for client protection and redressal are perhaps not adequately addressed. So, in the absence of these, with all due respect, the bill is indeed incomplete and there are serious ramifications indeed as the following example will illustrate.
For example, the bill proposes under section 23 that
These are huge tasks and admittedly, while the bill says that the Reserve Bank can either do it directly and/or delegate these to other institutions, several key questions arise: a) how are these tasks to be structured at the RBI (assuming that they would be done by RBI in the first place)?; b) Does the RBI have sufficient capacity to effectively and efficiently manage the various tasks including supervision?; c) In case the RBI delegates these tasks, what about the alternative institution and its capabilities with regard to these tasks including supervision?; and d) several other aspects
The above questions are very relevant and cannot be ignored. The idea here is not to find fault but rather to highlight serious practical issues that would need to be considered first before the bill is passed. Therefore, I try and look at supervisory issues from the present micro-finance crisis using the example of NBFCs and banks {with regard to their own (NBFC) and priority sector lending (PSL) micro-finance portfolio} and raise the important question of whether or not, the RBI and its concerned departments indeed have the wherewithal to ensure that the implementation of the provisions of the proposed draft micro-finance bill (that has been put up on the Finance Ministry website). Read on…
First, let us get some basic issues right…
The dominant MFI model in India is the commercial model where the MFI is registered as an NBFC with RBI and taps commercial funding (debt and equity) through different means. This model is based on fast track growth and generally carries a standard loan product-delivered to clients through joint liability groups and/or agents-based on weekly repayments and having loan related insurance. The emphasis is on-efficiency, standardized processes, large outreach and enhanced profitability–all elements of hardcore commercialization, strongly supported by agencies such as CGAP.
While there could be some modifications to the above model to suit different contexts; the above description is true, by and large, of most NBFC MFIs. The dominant NBFC MFI model is also based on the notion that, to reach and include vast number of unreached and excluded people (including the poor), MFIs must tap commercial funding in a big way from lenders and investors – Mr Vijay Mahajan’s[i] statement to this effect, when SKS was to tap the capital markets, strongly resounds in memory. To do this successfully, the model also believes that commensurate (market) returns must be provided to the commercial investors. It is important to note that much of the basic tenets of this (commercial) model have evolved from the global development of new wave micro-finance – which was spearheaded by several stakeholders including CGAP, especially since 1997 onwards[ii]. As noted in the earlier posts in this blog and also in the book, the fastest growing MFIs, who have perhaps contributed to the present crisis situation in India, are primarily NBFCs MFIs that come under the purview of the Department of Non-Bank Supervision (DNBS), RBI. These NBFC MFIs themselves grew at a phenomenal rate, adding several million clients and dollars to the gross loan portfolio over the period April, 2008 to March, 2010. Thus, the following basic facts are discernible from the data:
· 13 of the top 14 MFIs (ranked on the basis of active clients and gross loan portfolio added from April 2008 to March 2010) are NBFCs
· 6 of them are Andhra Pradesh headquartered NBFC MFIs and they constitute the largest chunk within this group of 13 NBFC MFIs. 9.76 million clients were added by these 6 Andhra Pradesh headquartered NBFC MFIs from April, 2008 to March, 2010 whereas the 8 other state NBFC MFIs added just 4.52 million clients (this is less than 50% of the outreach of Andhra Pradesh headquartered NBFC MFIs). Likewise, these 6 Andhra Pradesh headquartered NBFC MFIs increased their gross loan portfolio by 2.076 billion US $ during this period whereas the 8 other state NBFC MFIs recorded a growth of just an additional 703 million US $ (which is less than 1/3rd of the gross loan portfolio of Andhra Pradesh headquartered NBFCs)
· All of the 13 NBFC MFIs (including the 6 Andhra Pradesh headquartered NBFC MFIs) file quarterly papers with the department of non - bank supervision (RBI)
· As the graphs below indicate, there was phenomenal growth in gross loan portfolio (GLP) and active clients for 10 of these top 14 NBFCs during the year April 2008 – March 2010
Please note that the phenomenal growth spurt was led by 5 large Andhra Pradesh headquartered MFIs (SKS, Spandana, Share, Basix and Asmitha), who added 2049 million US $ and 9.59 million clients between Apri,l 2008 and March, 2010 – which is very significant indeed.
This is equivalent to each of these 5 large Andhra Pradesh headquartered NBFC MFIs, adding a gross loan portfolio of Rs 78.55 crores (Rs 1 crore = Rs 10 million and exchange rate assumed is Rs 46 per dollar) per month, month after month, quarter after quarter, year on year for the 24 months in question.
And as noted in box 1 below, please also recall that the department of non-bank supervision is supposed to supervise every NBFC that has a loan portfolio of over 100 crores closely and each of these 5 MFIs were adding almost 78% of that threshold value of (Rs 100 Crores portfolio) every month, quarter on quarter, year on year for the 2 years in question – Apri,l 2008 to March, 2010.
Off-site surveillance of NBFCs involves scrutiny of various statutory returns (quarterly/half yearly/annual), balance sheets, profit and loss account, auditors’ reports, etc. A format for conducting the off-site surveillance of the companies with asset size of Rs.100 crore and above has also been devised.
In numerical terms, this is equivalent to each of these 5 large Andhra Pradesh headquartered NBFC MFIs adding almost 79916 clients every month, quarter on quarter, year on year for the 2 years in question – April, 2008 to March, 2010. This translates to adding about 2664 (fresh) active clients every day, month after month, quarter on quarter, year on year for the 2 years in question. This is a huge task indeed.
In the past, it has taken many MFIs, several years to reach the figure of 75,000 clients and/or portfolio size of Rs 75 crores which is why the RBI specified that NBFCs with asset size greater than Rs 100 crores are systemically important/significant and need to be closely supervisied.
Clearly, these are trends that should have grabbed the attention of anyone, let alone the regulators/supervisors but, for some reason, they perhaps did not. Thus, there appear to be several issues and challenges with regard to NBFC supervision and these are highlighted below.
The first issue here is, whether or not this huge and unnatural growth - quarter on quarter during the period April, 2008 – March, 2010 - raised any alarms within the department of non -bank supervision, RBI, especially with regard to the following:
· What is the motivation of these MFIs to grow at this never before seen pace?
· How were they growing[iii] in terms of market development strategies (client acquisition etc)? · What is their business model and is it in accordance with the RBI NBFC regulations and the RBI code of conduct?
· Where and how were they getting the resources (debt, equity etc) for this burgeoning growth? Where exactly were these resources coming in from (India, Abroad etc)? Please read India Today (June 6th issue) which states that terrorist, Dawood Ibrahim, is involved in both secondary and primary equity markets, under the guise of foreign institutional investors. Under these circumstances, I am sure, it would be important for the regulator/supervisor to know about the antecedents of the various foreign institutional investors. Again, I am not sure whether the department of non-bank supervision was aware of the burgeoning equity investments (including their antecedents) in Indian micro-finance, especially during the years, 2006 -2010
· What is the current and likely future impact of this burgeoning growth on the low - income clients?
· Are the RBI NBFC and other codes of conduct being followed in letter and spirit? Do the NBFCs have sufficient governance and systems to manage this turbo charged growth and, more importantly, not to violate any of the provisions in the law and the code of conduct?
· Is appropriate and required KYC documentation available?
At this juncture, it seems pertinent to look at what Dr Rangarajan and others have had to say about the business model of the NBFC MFIs and also apply the same to this analysis.
"The business model of microfinance institutions is faulty. They must revisit the model to support the income earning ability of the borrower," Prime Minister's Economic Advisory Council chairman C Rangarajan said at an event organised here by Skoch Consultancy. Rangarajan said multiple lending done by MFIs is inconsistent with the very repayment capacity of borrower. He said MFIs have been indulging in multiple lending and large parts of the loans are given for consumption purposes and this model of business has landed them in trouble. "Income earning capacity must be criteria for granting loans... The provision of credit for consumption must be a small part of the total loan," Rangarajan said“[iv] Others have tended argue for the same and I reproduce a quote from Dr Al Fernandez’s post on the CGAP blog. As Mr Fernandez argues,
“The State of the Sector report 2010 (N. Srinivasan) indicates that out of 60 MFIs which reported on profitability, six had ROAs over 7%; thirty five had ROAs over 2%. In contrast the public sector banks in 2009 had average ROAs of 0.6% with the best being 1.6%, while the best private bank had ROAs of 2%. The yield on portfolio confirms this picture; in the case of 23 MFIs it was above 30 % (the highest being 41.29%). The report also says that economies of scale have not led to lower interest rates or lower yields. This implies that MFIs maximized their profits and competition did not decrease rates as it was expected to. The largest MFI recorded a 116% jump in net profit at Rupees 81 crores ($18 million) in the second quarter ending September 2010 as against the corresponding period last year. “
The cornerstone of this argument is essentially this:
Many MFIs engaged in multiple lending for consumption purposes often granted loans without assessing the loan absorption capacity of the clients. Implied in this statement is the fact that MFIs have pushed loans indiscriminately to low-income clients for consumption purposes without any sensitivity to their debt servicing ability and tried to grow (very fast) in this manner and make unnatural profits. Again, as with the above, it seems more and more clear that MFIs grew to attract capital at high valuations (see below) and, thereafter, had to justify these high valuations by providing better returns to investors. And investors likewise, as they had paid huge premiums, wanted to recover their investment fast and hence, were perhaps pushing the MFIs to grow faster. Hence, as diagrammed in figure 3 below, there appears to have been a mutually reinforcing cycle of multiple/over/ghost lending, fast growth, high profits, very high share valuation, equity investments, faster growth, greater profits, more returns, turbo charged growth and so on.
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Now, the key question here is whether the department of non-bank supervision at RBI spotted any of this?
Second, it is during this period (April, 2008 – March, 2010) that the NBFC MFIs (including the above 13 NBFC MFIs among the top 14 MFIs) received equity worth several million USD and this again should have been disclosed as per the filings with the RBI. The data in table 1 suggest the following two basic facts:
· This group of NBFC MFIs can be categorized into 2 groups, on the basis of the equity investment they received (please see table below). As a group, 5 of the 6 equity leader NBFC MFIs who received a large inflow of equity were among the top 6 Andhra Pradesh Headquartered NBFC MFIs and they were also part of the 13 NBFC MFIs in the top 14 NBFC MFIs.
· In fact, as noted above, these 5 Andhra Pradesh headquartered NBFC MFIs (SKS, Spandana, Share, Basix and Asmitha) grew at a phenomenal rate adding the equivalent of Rs 78.55 crores per month in gross loan portfolio and about 79916 clients per month, making them systemically very important.
Again, given the above, it would be useful to know whether or not, this unprecedented and sudden inflow of equity, into select NBFC MFIs, raised any alarm bells for the concerned department at RBI, especially in terms of the following questions:
· Why has there been a sudden inflow of equity into micro-finance and, that too, at a scale not seen before at all?
· As Ms Naina Lal Kidwai argued at the Sa-Dhan March 2010 National Micro-Finance Conference and similarly, as Mr. N Srinivasan wrote in the State of the Sector Report (2010), we surely need to understand what made micro-finance so attractive to equity investors, especially, during a period of serious global economic crisis? · What kind of MFIs are receiving this equity inflow; at what valuations and why?
· Who is investing in these MFIs and what are their expectations in terms of returns etc? What returns, if any, did the investors actually get?
· Where is this equity money coming in from, in terms of countries? This is especially critical given the fears about not–so–legal money from (from people like Dawood Ibrahim - Please refer India Today, June 6, 2011) coming into the stock market via foreign institutional investment.
· Is there anything abnormal with the operations of these MFIs in terms of growth or profits or earnings per share or promoter and management compensation etc?
There is some very interesting data - on the last point with regard to these 5 Andhra Pradesh headquartered MFIs - in the recent Intellecap (Inverting the Pyramid[v]) report. As the Intellecap report[vi] notes, “Indian MFIs are receiving the highest valuations in the world. A recent report by the Consultative Group to Assist the Poor (CGAP) and JP Morgan[vii] shows that the median price to book value (P/BV) multiple is 5.9 in India, thrice that of global multiples. Some have been quick to call this “irrational exuberance” on the part of investors. Analysis shows that while the leading large MFIs have been able to command very high premiums, valuations vary across the sector based on investor type, MFI class and stage of investment. The vast market potential, demonstrated growth of the sector and positive macro-economic outlook contribute to relatively higher valuations in India.
In addition, the number of investors (see below) chasing deals with the few large, high growth MFIs has driven up their valuations considerably. These MFIs are able to command valuations upwards of 10 times their projected profit after tax (PAT). Early stage MFIs are, on the other hand, typically valued lower, at between one and three times the book value[viii]. Across the sector, the drivers of value are primarily growth and returns, both demonstrated and potential. Thus, to put Indian MFI valuations in perspective, it is instructive to compare the return on equity (RoE) and PAT growth of the leading MFIs with other financial service business, banks and NBFCs. As shown in table 2, leading MFIs outperformed Banks and NBFCs on both counts. On average, MFI Roe is 32.1%, a full 12 percentage points higher than that of Banks and NBFCs. MFI profits grew over three times that of the sample banks’, and five times that of the sample NBFCs’ between 2006 and 2009. The closest comparable, in this sample, to MFIs in terms of business model is Mannapuram General Finance[ix], as their clientele is similar to that of MFIs and loan sizes are relatively low (INR 20,000), although their loans are backed with collateral. Despite the company’s RoE and PAT growth being lower than those of MFIs, its P/BV is at 8.4, higher than average for leading MFIs. Thus, given the enormous market potential, the ambition of leading Indian MFIs, and their demonstrated high growth, prudent cost management and thus high returns, the current valuation levels are not surprising.”[x]
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The above makes it reasonably clear that one of the major reasons for MFIs to grow, in the manner they did, was to attract capital at higher valuations.
Again, the key question here is whether the department of non-bank supervision at RBI spotted this?
A third issue is also relevant here. The amount of (priority sector) debt leveraged by these 13 NBFC MFIs (in top 14 MFIs) and other NBFC MFIs is obviously huge and that would be clear from the filings made by them to the department of non-bank supervision. This would also be clear from the filings made by banks to the DBOD. In numerical terms, the growth of debt for MFIs from commercial banks and SIDBI is given below and this growth is best described as phenomenal:
As Mr N Srinivasan says in the 2010 State of Sector Report,
“Bank loans to MFIs did not exhibit any overt signs of increased risk perceptions towards the microfinance sector. The total loans extended to MFIs and outstanding at the end of March 2010 is estimated at Rs.15085 crore.[xi] Public sector banks have taken to MFI financing in a big way. Public sector banks (not including SIDBI) had an exposure of Rs. 4737 crore to MFIs in comparison to private sector banks' exposure of Rs. 4133 crore. Foreign banks had outstanding loans of Rs.1994 crore and FWWB had increased its exposure from Rs. 295 crore last year to Rs. 360 crore. SIDBI almost doubled its exposure to Rs. 3808 crores during the year. At this level SIDBI had a share of more than 25 per cent of the market.” Again, the key question here is whether or not, the concerned departments (of non bank supervision (DNBS) and DBOD) felt alarmed about this burgeoning growth of priority sector lending (PSL) funds from Banks to NBFCs in terms of the following aspects:
· Is there any cause for alarm given the huge growth of (PSL and other) funds from banks and DFIs to MFIs?
· How and where are the MFIs investing these priority sector loan (PSL) and other funds?
· For what specific loan purposes are these PSL and other funds being used?
· Which banks/institutions are providing these PSL funds to different MFIs? What do the growth trends say?
· Is there any reason to believe that these priority sector loan funds may be used for non-priority sector purposes? If so, what are the reasons and what are the ways of addressing this?
· Have any of the institutions provided loans from their PSL funds to their promoter, senior management and/or board members? If so, for what purposes?
All of the above questions need to be looked into by the RBI because even some interest from the concerned department and/or any of their local offices, in cautioning the MFIs, might have, after all, prevented this crisis and/or mitigated the damage to a large extent measure.
This becomes even more significant when one considers the fact that during the period in question (April, 2008 to March, 2010), the top 6 Andhra Pradesh MFIs grew at a phenomenal rate, were able to receive significant equity infusion and perhaps used this equity to leverage PSL funds in larger measure. And it must also be noted that all of this happened in the backdrop of the Krishna district crisis, which the RBI was able to successfully intervene in and resolve.
Therefore, it is imperative that the RBI looks into all the regulatory and supervisory aspects highlighted above for, as much as the micro-finance industry is a sunrise sector as claimed by several industry experts, it is also a very sensitive area that requires careful handling from a client perspective. And this is especially true given the fact that MFIs are trying to sell what is perhaps the most attractive product on the face of this planet to a very vulnerable set of people. It would also be interesting for the RBI to look at whether the department of non - bank supervision and the RBI department that deals with supervising priority sector lending to banks (the DBOD) were in fact even talking to each other on something unusual happening in the micro-finance industry. These will certainly provide valuable lessons for design of future supervisory arrangements.
In summary, I leave you with these key questions:
1) Did the department of non-bank supervision miss these (significant) trends? If so, why? What lessons can be learnt from this with regard to supervisory arrangements in the future (especially those given in the proposed bill)?
2) If not, having spotted these happenings in the first place, why did it not take necessary corrective action? Again, what lessons can be learnt from this with regard to supervisory arrangements for the future (especially those given in the proposed bill)?
3) If the concerned RBI departments could not monitor 12 to 13 NBFC MFIs that were supposed systemically important, then, how can they be expected to set up supervisory mechanisms for several hundred MFIs as per the proposed Micro-finance bill? Without sufficient supervision, none of this will work on the ground. I believe that the Malegam committee arrangement was very good because it ring fenced the large NBFC MFIs. This bill however clubs all of the MFIs together and this means that some several hundred (or even thousand) organisations (including coops) may have to be regulated/supervised and no single regulator/supervisor may be able to achieve this effectively.
That is certainly some food for thought and let me reiterate that India is a great country for legislation but the implementation record is rather poor in many cases. We certainly require a micro-finance bill to provide legitimacy to the micro-finance sector and that is a noble objective indeed but we cannot and must not stop with that. Rather than being a paper tiger, the bill should have the teeth and mechanisms to ensure orderly growth of the sector and for this, the most critical aspect is to look at the supervisory capacity of the RBI (and/or other organizations) and evaluate it to see what needs to be done to ensure ground level implementation.
I leave you with these questions and thoughts and hope that the concerned people and powers that be, pay attention to these critical issues. I will flag more issues in the coming days and again, the objective here is not to undermine the capacity of concerned people or the good work being planned. The objective, solely, is to assist in enabling the development of better regulatory and supervisory mechanisms that can work on the ground towards the benefit of large numbers of low income people, who continue lack access to quality financial services at the grass-roots.
[i] Mr Vijay Mahajan is Chairman, BASIX, Chairman, MFIN and Chair, Executive Committee, CGAP [ii] This is a description of the commercial model as I understand it. [iii] Green field client acquisition vs. other strategies (including sharing of clients, takeover of SHGs/other MFI JLGs etc), market skimming (first time loans to new clients), financial deepening/multiple lending to older clients and several other strategies. [v] Inverting the Pyramid (Third Edition), Indian Microfinance Coming of Age, Published by Intellecap, (2010) [vi] Inverting the Pyramid (Third Edition), Indian Microfinance Coming of Age, Published by Intellecap, (2010) [vii] CGAP, JP Morgan, occasional Paper: Microfinance Global Valuation Survey 2010, March 2010 [viii] Analysis by Intellecap. [ix] A listed NBFC that provides gold and vehicle loans, amongst other services. [x] Inverting the Pyramid (Third Edition), Indian Microfinance Coming of Age, Published by Intellecap,(2010) [xi] Footnote is cited from, State of Sector Report, Micro-finance in India, 2010 by N Srinivasan, Sage Publications. The original footnote states that the statistics are ‘based on provisional data made available by NABARD and further information collected by the author (N Srinivasan) individually from some banks.’
