Lessons from the Indian microfinance crisis, an open letter to Andrew Mitchell

December 16, 2011 


Ramesh S Arunachalam

Two crucial aspects in microfinance—client origination/targeting and loan appraisal—have been neglected in favour of unprecedented growth (caused by a desire to fully commercialise microfinance and rapidly enhance access/outreach of such services) and this has resulted in the present crisis

An open letter to the right honourable Andrew Mitchell, UK International Development Secretary, on lessons from the Indian microfinance crisis

Respected Sir,

Good afternoon! I am delighted that The UK Department for International Development (DFID) is launching SAMRIDHI (a programme promoting microfinance and impact investment in India)  in partnership with SIDBI in your esteemed presence (Sir) at 6pm today, the 16th December (Friday) at the British Council Division, Kasturba Gandhi Marg, New Delhi. Much as I wanted to attend the same, I am unable to do so and hence, this open letter Sir for your kind consideration and necessary action.

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Subjectivity and inconsistencies in microfinance code of conduct assessments

Ramesh S Arunachalam

While there are many contradictions, inconsistencies and subjective interpretations in the CoC assessments which seem to draw the attention away from the real issues, we hope the sponsors and developers of the SIDBI-World Bank COCA tool recognize the fact that it far from being a reliable and valid psychometric measure of code of conduct assessments

While previous articles looked at the award of free points in the code of conduct assessments (COCA) reports and the peculiar findings arising therein, this article looks at issues of subjectivity and inconsistency in CoC assessments with tangible examples.

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The award of free points in microfinance code of conduct assessments

Ramesh S Arunachalam

It is meaningless that the COCA tool rewards mere existence of policy and/or management statements of policy implementation when it should be really looking at solid evidence in support of implementation of the voluntary codes of conduct on the ground

An earlier Moneylife article (Have sophisticated thermometers ever reduced the temperature?) raised the issue of how the fastest growing NBFC-MFIs received higher (better) code of conduct assessments (COCA) scores in relation to the lower growth and not-for-profit counterparts. This peculiar finding has necessitated a close analysis of the eight SIDBI-World Bank sponsored code of conduct assessments found in the public domain (http://www.sidbi.com/micro/codeofconduct.html)

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Have sophisticated thermometers ever reduced the temperature?

Ramesh S Arunachalam

The hype of the moment in microfinance is undoubtedly to subscribe to all kinds of code of conducts, client protection principles, social performance and other self-regulating initiatives. To set the record straight, had all the stakeholders really subscribed to these in the first place, there would have not been such a crisis in Indian microfinance

The ongoing Microfinance India Summit has a special session titled, ‘Client protection and Code of Conduct: From principles to practice and compliance’. The session is to be held on 13 December 2011 (1.30 - 3.00 p.m - Breakout Sessions). As the session introducer notes:

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Reasons For Use of Agents in Indian Micro-Finance: Three Major Explanations From The Field…

Ramesh S Arunachalam

Rural Finance Practitioner

As I continue my field visits and learning in the crisis ridden micro-finance industry, I fondly remember what Prof Malcolm Harper has always said to me – failures and crisis teach you a lot as well and I am determined to make the most of the learning from the present crisis. And of course, I am trying my best to share it with all of you!

As I have been interacting with various types of agents and especially, center leader/group leader turned agents, I think I have begun to understand the evolutionary process with regard to use of agents and I attempt to describe these below. Read on…

Desire of Many MFIs To Rapidly Build Scale: First, at least initially, the desire to use center or group leaders as agents seems to have emanated from the desire of MFIs to build scale quickly in delivery of micro-finance services to low income people. And many MFIs did get carried away without thinking about the kind of impact that these agents could have in the long run. As one MFI staff put it, “We wanted to disburse several crores[i] of rupees on a daily basis and there was a lot of pressure from the senior management and also bankers/equity investors. We were told that if we show exponentially increasing disbursements, we would be able to attract more equity capital and also go in for a large IPO. Of course, stock options had by then become the standard way of compensating staff and this skewed the incentives all the more…”

Consistent Pressure on MFIs to Reduce Interest Rates: A second reason seems to be the pressure to reduce interest rates and this is something that I have always been saying – ‘servicing the last mile is costly in micro-finance and any attempts to force interest rate reductions will cut out important controls and may even force MFIs to adopt short cuts’. And that is exactly what seems to have happened. The drive for artificial interest rate reductions and the constant pressure on MFIs to achieve this seems to have resulted in several things: a) omission of important client level and other controls at the last mile; b) the proliferation and use of the decentralized model in its ultimate form – the agent led model of micro-finance; c) further reduction of engagement with client (which was a significant one even in the original Grameen adapted to use in India); and several other aspects that favoured decentralization of micro-finance operations.

Adoption of The Profit/Value Maximization Syndrome by Many MFIs: A third reason appears to be the preoccupation of MFIs with the efficiency and value maximization syndrome - as part of the commercial micro-finance movement over the last 4 years – where cost leadership (at scale), profit maximization and shareholder value enhancement became the order of the day, courtesy equity investors and others including bankers. According to one senior manager at an MFI, “We started to look at ways to increase case load of staff significantly and this meant that we reduced the duration of center meetings, where we conducted these directly. Then, we realized that we could do better by outsourcing it with some quality checks and that is how the center/group leader agent came in. As these efforts expanded, in some cases we faced serious delinquency problems and to counter that in an effective manner, we used local opinion leaders and these strong men/women later became agents themselves. And then, there was no real exit and loan after loan had to be made and as long as the problems did not show up, we were not bothered. The use of agents soon was picked by many MFIs and in fact, that used to be the strongest and fastest way to the rapid burgeoning growth that the micro-finance sector in India wanted. Multiple lending and high indebtedness became natural phenomenon in the agent led model of Indian micro-finance.”

Thus, while there could be other reasons for use of agents, the above aspects of “building scale quickly”, the “pressure to reduce interest rates” and the “desire to be a cost leader and maximize profits and value to shareholders” look like the major ones that seem to have pushed the Indian micro-finance industry to – using agents in a decentralized model – the brink.

While the question of whether and how the Indian micro-finance industry can be rescued from its present use of (notorious?) agents[ii] always remains, it is also very clear that the industry is currently on a pathway towards long term disaster…And let us hope that the concerned stakeholders begin to introspect with integrity and quickly attend to rapidly spreading agent related problems on the ground. And the eternal optimist that I am, I do believe that the Indian micro-finance industry has the innate character to change its current course and rise like the phoenix…will the so called industry leaders stand up to this issue please, to be counted…

Have A Nice Day!

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[i] 1 US $ = 46 Rupees and 10 Million Rupees = 1 Crore

[ii] I really hope that the RBI conducts a national study in several states to actually determine the scale and size of the agent problem, which appears to be growing in size, with each passing day…. I have personally met over 100 agents in small geographies during the last few months.

Introducing a Self-Regulatory System For Micro-Finance in India: PROCESS Issues for Consideration of The RBI and The Malegam Committee

Ramesh S Arunachalam

Rural Finance Practitioner

While the earlier post looked at the substantive policy issues with regard to regulatory reform, significant process issues must also be considered, as outlined below:

Design risks: The authorities should articulate the key drivers for changing the current approach to regulation (say for example, introducing self-regulation as has been done in the Malegam Committee Report which uses the SRO/industry approach as one of its pillars) and should assess the importance of achieving the objectives of reforming the system. Those objectives should be compared to the risks involved in designing changes to the system. Major changes carry risk, and the broader the scope of the planned changes, the greater the risk of problems or even failure. The major risks are:

·         Increased conflicts of interest

·         Ensuring that the SRO/industry association operates with real and effective independence

·         The potential for “regulatory capture” of the SRO/industry association system by regulated MFIs or by one powerful segment of the industry (say for example NBFC MFIs or large MFIs etc)

·         Disruption of standards of regulation and supervision during the transition period because of organizational conflict and uncertainty

·         Reduced standards of regulation and supervision under the new system

·         Overloading the SRO/industry association system with new responsibilities that it does not have time to build the capacity to address. This has to be also seen in the light of the past track record of the SRO/industry association.

·         Excessive interference by the statutory regulator in the governance and operation of SROs/industry associations

·         Failure to design the new system properly, leading to excessive duplication of activities and cost and the like

Transitional risks: Transitional risks are temporary risks that arise from the process of implementing changes in the case of regulatory systems, among a group of organizations. Whenever structural changes are made to a regulatory system (as has been proposed in the MCR), important transitional issues must be addressed. These include ensuring that:

·         Regulatory processes continue uninterrupted, especially supervision of the micro-finance industry players and intermediaries. I am not sure of what is happening in the present period

·         Regulated entities/persons remain within the legal jurisdiction of a regulator at all times.

·         The transition to new institution is as seamless as possible.

·         Dispute resolution mechanisms are agreed to address any unforeseen issues that arise during the transition period.

If major changes are contemplated, the industry and the authorities might consider taking an evolutionary or staged approach to implementation so they minimize the transitional risks involved. I am not sure if any of these aspects are being addressed currently.

Stakeholders’ views: In considering any changes to the present system of regulation, it is important to understand and consider the views of various stakeholders. Stakeholders include a broad range of participants:

·         Intermediaries (banks, MFIs and others)

·         Clients of the above institutions

·         Retail and institutional investors

·         Government and statutory authorities,

·         Existing SROs

·         Stock Exchanges, if applicable

·         Industry associations

·         Other Related regulators

This is indeed a critical issue and I am not sure of what is the degree of support for the changes proposed compared with the resistance to change? Building consensus among the various stakeholders on a “common vision” for the regulatory structure with regard to micro-finance is highly desirable and I hope the RBI/MCR engage and take this process forward quickly

Legal and regulatory risk: If institutions’ regulatory responsibilities are changed in the new structure, plans to minimize legal and regulatory risk are needed. Transfers of responsibilities will likely require (1) transfer of rules from one body’s rulebook to another’s, (2) transfer of responsibility for supervision programs, (3) transfer of experienced officers and staff, and (4) transfer of infrastructure including information

All of the above process issues will also have to be considered and dealt with by the RBI and the Malegam Committee before finalizing the regulatory and supervisory arrangements for Micro-Finance in India…

Introducing a Self-Regulatory System For Micro-Finance in India: SUBSTANTIVE POLICY Issues for Consideration of The RBI and The Malegam Committee

Ramesh S Arunachalam

Rural Finance Practitioner

The Malegam Committee Report (MCR) has proposed a self-regulatory mechanism, through SROs/Industry Associations, as part of its four pillar approach. While the idea is fundamentally a good one, when ever one considers introducing a new self-regulatory system (or for that matter, reforming such an existing system), a number of important issues must be addressed. These are highlighted in the present post and hope the RBI and/or the Malegam committee looks into some of these issues.

Basically, the concerns include both (1) substantive policy issues on the design of the self-regulatory system and (2) process issues that arise in implementing self-regulatory reform. We take up the former in this post and look at the latter (process issues) in a separate post.

And policy makers should consider the following substantive policy issues in addressing whether self-regulation is appropriate for the concerned micro-finance markets and, if it is, how the system should be designed.

National Strategy for Development of Micro-Finance: What is the government’s (and prime regulators) strategy for developing the nation’s micro-finance industry? Any strategy should consider the structure and competitive position of the micro-finance industry, nationally, regionally and internationally. A strategy should encompass the following:

·         How to ensure that the industry best supports economic development?

·         How to enable the industry to foster market development, competition, and innovation to better meet the needs of clients in micro-finance?

·         How to alter/raise/revise standards of regulation and conduct to ensure that clients and other stakeholders (including investors and other participants) are treated fairly?

·         How to improve integrity of the micro-finance market in general?

·         How to achieve an appropriate cost level for regulation of the micro-finance industry?

• How to ensure that the MFIs, FIs and various stakeholders have the business focus, competitive positioning, systems, and governance standards required to succeed in their missions?

·    Commitment to self-regulation: Do clients, investors, lenders, MFIs and other stakeholders have a sufficient degree of confidence in self-regulation to make the system viable, both today and going forward? Are the members of the SROs/industry associations committed to the concept of self-regulation, and are they prepared to invest the requisite time and resources? Do the regulatory authorities believe that use of self-regulation in the micro-finance industry is indeed appropriate?

·    Size and complexity of micro-finance industry: Does the micro-finance industry need, and can it support, multiple layers of regulation as has been proposed in the Malegam Committee Report?

·    Effective and efficient regulation: What approaches, according to the authorities and industry stakeholders (including clients), are likely to deliver the most efficient and effective regulation of the micro-finance industry? Do the benefits of self-regulation outweigh the potential extra costs and disadvantages? What about the issue of regulatory efficiency and costs - is it likely to be significant? Finally, can the conflicts of interest that arise be managed appropriately?

·    Regulatory priorities and key risks: The authorities, MFIs and other stakeholders should determine and agree on what regulatory issues and risks (the MCR lists several risks and provides some suggestions to tackle them) need to be prioritized. Does the existing system adequately address those issues and manage those risks? If not, how should the system be reformed to respond more effectively to the issues, and what role should SROs/industry associations play? This should particularly look to address in practical and feasible manner, some of the key issues that have caused the present day micro-finance crisis. With all due respect, it is the blog writer’s humble opinion that some of the proposed solutions in the Malegam Committee Report do not meet the criterion of practicality and feasibility.

·    Fairness and consistency: In choosing a particular SRO/industry association structure, the fairness and the consistency of regulation for different segments of the micro-finance (for profit, mutual benefit and not-for-profit) and larger financial services industry need to be maintained. This means that players in different segments of the industry that offer similar services should be treated equally. This is critical and the omission of not-for-profits and other legal forms in the MCR can perhaps be addressed at the SRO/Industry association level, even if the banking regulation act cannot absorb regulating these legal forms. This again requires close analysis and redressal perhaps

·    Funding: Who should pay for the cost of regulation? While industry players may fund government regulators to a significant degree in many countries, can MFIs and other stakeholders do that in the present context? Which groups of MFIs/stakeholders should fund a self-regulatory system, and how should the costs be allocated among groups or members of a group? Those issues are invariably contentious but need to be addressed as well and this is again something that has not been exhaustively dealt with in the MCR

·    Legal framework: Does or will an SRO/industry association have sufficient powers to perform the responsibilities allocated to it? If not, is changing the applicable/related laws possible in practice and feasible from an implementation sense?

First, in many contexts, most SROs/industry associations often have the statutory authority to perform their regulatory responsibilities, but they can also obtain or reinforce jurisdiction by specific contracts with its members. Second, because SROs/industry associations are private bodies, the countries’ civil code legal systems will also need to be examined for any limits that they may place on SRO’s/industry associations rule-making authority or regarding the extent to which the regulator can delegate activities to an SRO/industry association. Both of these need to be looked at by the MCR in the present context and addressed accordingly.

Some obstacles may however be addressed rather easily: (a) by relying on SROs/industry associations mainly to supervise compliance with regulations (this is a critical aspect of regulation versus supervision); (b) by designing effective working agreements; and/or (c) through MOUs to clarify the role and working relationships of SROs/industry associations with the regulator.

·    Supervision of an SRO/Industry Association: Does the regulator have the powers and the capacity to effectively oversee an SRO/industry associations operations? In some cases, a more limited role for self-regulation may be appropriate; for example an SRO/industry association that is mainly made responsible for supervision of compliance with regulations set by the regulator.

These and other issues will have to be looked at by the RBI and the Malegam Committee before finalizing the regulatory and supervisory arrangements for Micro-Finance in India…

PS: The above paper is based on various ideas and resources available and there are far too many resources to mention here but they are all gratefully acknowledged

Making Micro-Finance Associations More Effective as Self-Regulatory Organisations: Lessons From The Indian Experience

Ramesh S Arunachalam

Rural Finance Practitioner

A lot of questions have been raised about the effectiveness of micro-finance associations as Self-Regulatory Organisations (SROs). While it is true that these associations may have tried hard, the fact of the matter is that this self-regulation has not worked and here are some reasons why. It would useful for the RBI and The Malegam Committee to look at some of these aspects and address them, as the Malegam Committee Report (MCR) does provide a fairly important role for micro-finance associations as SROs. The various reasons are briefly highlighted below:

(1)   To be effective, MF associations that act as SROs must have a common set of public policy objectives including the enhancement of market integrity, market efficiency and client/investor protection with regard to micro-finance;

(2)   They must be actively supervised by government regulators and in the present instance by RBI, IRDA and other such regulators;

(3)   They must have (official) statutory regulatory authority and/or authority delegated by the government regulator(s). This would give them the much-required legitimacy and this is a very critical aspect because, then the SROs will act (on behalf of the government regulators and also) along with them in maintaining decorum and order in the micro-finance industry

(4)   They must establish simple and practical rules for MFIs and individuals to follow and this must be subject to their official regulatory authority and it should also be in line with the objectives in the larger regulatory framework;

(5)   They should monitor compliance with these rules, without any conflict of interest and irrespective of whether the member MFI is a pioneer, founder, largest MFI and the like;

(6)   They must have the official authority and more importantly, administrative will to discipline MFIs and individuals that violate these rules. Clearly they must show intent to self regulate rather than provide a lip service;

(7)   While they should have industry representatives on their Boards and also ensure that industry representatives have a meaningful role in governance, the board must have the equivalent of independent directors from civil society and/or official regulators. That alone will make them more accountable; and

(8)   They must maintain structures, policies and procedures intended to ensure that all conflicts of interest between their membership (commercial) and regulatory activities are appropriately managed.

Along with the core characteristics outlined above, MF association SROs also need to carry out a variety of other activities that are consistent with their mandate to enhance market integrity, market efficiency and client/investor protection. These activities would need to include the provision of: (1) Consumer redressal services for the end user clients; (2) Dispute resolution services for and among their members; (3) Client literacy and education for end user clients as well as educational services for staff of their members in special areas like gender etc; and (4) Reliable and valid market data for their members and other market participants.

Within the above broad continuum of services and characteristics, MF associations as SROs can then start to occupy a unique position and play an important role, using their official regulatory authority as well as their special relationships with government regulators and their members. I hope that the RBI and Malegam Committee look at this aspect closely and work out the relevant details…

Have a nice day!

Sa-Dhan Members (Re) Adopt The Code of Conduct in Andhra Pradesh: A Positive Step but what is the Guarantee for Implementation this time around?

Ramesh S Arunachalam, 
Rural Finance Practitioner 

I came across this very interesting piece of information:

“November 2^nd 2010, the Government of Andhra Pradesh and bankers declared full support to the Code of Conduct developed by Sa-Dhan for the Microfinance sector which was adopted by its members from AP. Sa-Dhan organised a one-day meeting of its member Microfinance institutions, financing banks and the representatives of the Government of AP on the ongoing crisis in Microfinance at NABARD regional office, Hyderabad. This was attended by Principal Secretary Rural Development Mr. R. Subramanyam, Mr. Mohanaiah (CGM, NABARD), SIDBI and senior officials of major banks financing the sector.

The meeting was organised with the objective of bringing together all MFIs, bankers and the state government in a bit to find a solution to current impasse in the sector and reiterate the commitment to the Code of Conduct of Sa-Dhan. It was attended by Sa-Dhan members including NBFCs as well as NGO MFIs namely  Spandana, Share, Basix, Asmitha, Saadhana, Pragathi Seva Samithi, Indur MACS and others, numbering 28 MFIs and 25 banks .

Sa-Dhan Microfinance institutions wholeheartedly adopted the Code of Conduct and declared their commitment for its vigorous implementation within a self regulatory framework. This Code of Conduct puts high emphasis on protection of poor borrowers in rural and urban areas and strengthens transparency and governance of MFI’s operations in the state. Implementation of the Code will help the MFIs in AP to comply with the provisions of the Ordinance issued by the State Government recently. The Code of Conduct of Sa-Dhan is supported by the Ministry of Finance, Government of India and RBI and received positive acknowledgement by the AP government.  Strict enforceability is ensured by an Ethics and Grievance Redressal Committee of Sa-Dhan comprising of eminent and independent personalities. Mr. Subramanyam said encouraging words towards the efforts of Sa-Dhan members in providing access to financial services to the poor. However, he emphasised the need to improve transparency as well as collection and lending practices and to comply with the Ordinance.” – Sa-Dhan note being circulated by e mail

That the Sa-Dhan Code of Conduct (CoC) is being (re) endorsed by various stakeholders is a positive development. There are several issues however with regard to implementation of the Sa-Dhan Code of Conduct and these are articulated hereafter.

First, the AP micro-finance crisis of 2005/6 did result in the Sa-Dhan CoC being framed in the first place. According to the Sa-Dhan CoC document on the Sa-Dhan website, the voluntary code was to be operational as per quotation given hereafter:  “This code comes into effect from 18 January 2007 unless otherwise indicated.”

This raises the question that despite this code of conduct that was supposedly operational, how did the Kolar or present round of AP crisis occur? Indeed, it is a fact that MFIs did not practice the Sa-Dhan voluntary code (or for that matter, the MFIN Code of Conduct) in reality. Otherwise, the Kolar or present AP crisis would not have occurred at all in the first place.

Therefore, is becomes relevant to understand the following:

1.    Why did many of Sa-Dhan’s member MFIs commit to the voluntary code of conduct in letter and spirit but shied away when it came to actual implementation?

2.    What are the key lessons learnt with regard to the so-called implementation of Sa-Dhan’s voluntary code of conduct (or lack of it) over the last three years? 

3.    How does one ensure that codes of conduct are indeed adhered to and/or are enforced on the ground?

4.    What were the key challenges and impediments to implementing the Code of Conduct last time around and how are they proposed to be overcome now?

5.    Have the codes of conduct been framed in a manner that compliance can be objectively measured and assessed?

Second, as the brief Sa-Dhan report on the November 2^nd workshop notes, “The workshop was attended by Sa-Dhan members including NBFCs as well as NGO MFIs namely Spandana, Share, Basix, Asmitha, Saadhana, Pragathi Seva Samithi, Indur MACS and others, numbering 28 MFIs and 25 banks”.

This is indeed a welcome development but again, it raises some practical issues. Many of Sa-Dhan’s members are also members of MFIN (another MFI network) and some of these NBFCs are said to have been represented at the 1 day workshop.

Therefore, it becomes crucial to understand the following:

1.    Would these NBFC MFIs (who have dual membership) follow Sa-Dhan’s Code of Conduct or MFIN’s Code of Conduct or both?

2.    If these NBFC MFIs are to follow both, then, are there any apparent contradictions between Sa-Dhan’s and MFIN’s codes of conduct (and their underlying philosophies) and how can these be reconciled during actual implementation?

3.    What about the RBI fair practices code and how does it relate to the above two Codes of Conduct?

4.    Would the presence of several codes become an excuse for some MFIs to not follow any code?

5. Overall, how can we assure ourselves that the proposed self-regulatory measures (Sa-Dhan and other Codes of Conduct) will INDEED work this time around?

All of these issues must be seriously looked into by Sa-Dhan and action taken accordingly! Again, not to sound like a broken record, but I sincerely hope that too many Codes on Paper will not provide an excuse for many to not follow any code at all on the ground.

Third, it seems strange that there are two mainstream associations (and several other networks) which perhaps do not seem to communicate with each other despite common goals, vision, members and operational areas.

I think it makes a lot practical sense for Sa-Dhan and MFIN to sit down and iron out any differences between their respective codes of conduct and also agree to share information as associations. It would also be important for both associations to make a statement that they are together for the ushering in a new era of ethical, legal and sustainable micro-finance ‘that is fair to every stakeholder – the MFI’s, their clients, staff, bankers, investors, various other partners, governments and larger community.’

One last point or rather a caveat is in order: Since, in my opinion, the growth story of Indian micro-finance seems to be one of multiple lending, shared clients and common JLGs, I begin to wonder whether at all it is practical to implement any of the Codes of Conduct on the ground, unless the fundamental issue of shared clients and JLGs is sorted out. Let us hope that the (false) synergies created can be unwound so that people oriented (rather than investor driven) micro-finance gets to be implemented in India soon.

Watch out for the Zaheera Bee and other Case Studies, likely to be up in the next few days and posts on several other interesting issues in Indian Micro-finance.