Why should RBI immediately disband newly appointed Committee on Financial Inclusion?

Ramesh S Arunachalam

Many of the past crisis situations can be linked to lax and laissez-faire regulatory and supervisory frameworks that had either been developed by industry insiders with commercial interests and/or been created with significant input from such insiders - both with a view to benefit the overall industry concerned!

Conflict of interest is an area of significant importance to regulatory ethics and this is something that the Reserve Bank of India (RBI) needs to note with urgency because there are significant conflicts of interest in the both the recently appointed financial inclusion committee as well as the banking selection advisory panelⁱ. If not eliminated, they could spell disaster for the larger Indian financial sector. And this article is a means to record the above warning publicly!

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A workable microfinance & financial inclusion policy: How can it be formulated?

Ramesh S Arunachalam

India needs a microfinance policy that is holistic, futuristic and yet practical in terms of satisfying unmet ground-level financial needs of low-income and excluded people. It should be developed through a truly bottom-up and democratic process with widespread stakeholder input and consultations

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Re-engineering financial inclusion in agriculture is key to promoting inclusive growth

Ramesh S Arunachalam

Proper financing of agriculture must enable and facilitate a wide range of innovative solutions that will strengthen the primary producer that is critical for fighting poverty in Bharat

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Financial inclusion of sugarcane farmers in modern-day India

Ramesh S Arunachalam

In some ways, financing arrangements today penalise the small producer for mistakes of other parties. There is an urgent need to make financial products for low-income people client-sensitive and responsive

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Does India Need a Micro-Finance/Financial Inclusion Policy?

Ramesh S Arunachalam

Rural Finance Practitioner

There has been a lot of talk about microfinance and financial inclusion in India, especially during the last few years. Especially during the last 6 months, the discussions have centered around having an appropriate regulatory framework for microfinance, scaling up financial inclusion, the need for a sole microfinance regulatory and the like.

As before, every one (and this writer included) have been talking about these aspects, often providing their rather divergent and diverse views. But, it seems to be that, we are again running off, without serious thought to:

·        What we see as part of financial inclusion and/or micro-finance in India and why?

·        What has worked on the ground with regard to financial inclusion and/or micro-finance in India and why/why not?

·        Going forward, what is our vision with regard to the various financial inclusion and/or micro-finance services in India?

·        What do we hope to achieve with scaling up financial inclusion and/or micro-finance in 5 years, 10 years, and 20 years and so on?

·        And Other Questions as Appropriate

Unless, we have a clearly defined national micro-finance/financial inclusion policy answering the above and other questions, our responses to delivering/scaling up low-income financial services will continue to be knee jerk and piecemeal. Interim solutions are undoubtedly necessary as life has to go on but we need to critically look at medium and long term issues as well

Therefore, even before we look at building a PERMANENT regulatory architecture for micro-finance/financial inclusion (through some mechanism and/or a bill etc), let us first look towards devising a national policy for micro-finance and financial inclusion - a policy that is holistic, futuristic and yet practical (in terms of satisfying unmet ground level needs of low income and excluded people) and developed through a TRULY bottom up and democratic process with widespread stakeholder input and consultations. The aspect of having a bottom up and democratic process is very critical to create strong ownership for the policy and adherence to its vision during implementation.

Further, such an approach cannot be a mere document – designed in Delhi or Washington (with all due respect) and - produced through field visits by few important consultants/agencies to select field areas. It has to be truly national in character and must be backed by public interactions with low income people in all parts of the country apart from district, state, regional and national level consultations among various stakeholders. It has to be comprehensive enough in terms of bringing together different and competing models with alternative aspirations. And last but not the least, it must be grounded in reality so as to make a SOLID difference to the lives of the people, for whom it is being framed in the first place…In other words, it just cannot be a writing exercise…

It is about time that we follow the lead of many (other and especially, smaller) countries that have genuinely tried to frame appropriate micro-finance/financial inclusion policies through a proper process. That alone can ensure the orderly/sustainable growth of the Indian micro-finance/financial inclusion sector and simultaneously enable low income people to become a REAL part of the inclusive growth story…The key question here is whether we have the commitment and courage to undertake such an important and urgently required task, in a voluntary and selfless manner…Time alone will provide the answers…

Jai Hind!

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Inclusive Finance As The Backbone For Inclusive Growth: Some Critical Issues for Policy Makers, Central Bankers, Donors and Other Stakeholders…

Ramesh S Arunachalam

Rural Finance Practitioner

Inclusive growth has always been seen as the imperative for achieving the equity and equality objectives. While that point is well taken, the experience of the last few years and especially during the global financial crisis suggests that inclusive growth is perhaps essential to even sustain the overall growth momentum. There are several good reasons[i] as to why a REAL inclusive growth paradigm will facilitate this in a rapidly emerging economy like India (and other similar environments). Read On…

First, in many of the emerging market economies like India, a huge proportion of the population (over 60% at least) is based in rural areas, where agriculture is the primary source of livelihood. And any further (substantial) increase in demand for manufactured goods and services will have to come primarily from this large rural population[ii], which mainly depends on agriculture and allied sectors. And barring a couple of years (2005/6), by and large, the performance and growth of agriculture has been rather indifferent.

Indeed, what has become more apparent with this kind of skewed growth is the dualistic nature of the Indian economy - where the gaps are indeed deepening and widening across various sections of the society. The classic manifestation of these gaps and the failure of the economy to re-adjust and ensure equitable economic opportunities for wealth creation, especially in relation to the work and inputs, can hardly go unnoticed –one manifestation is suicides by small and marginal farmers, at the grass-roots. That several farmers have committed suicide in the last few years tells us that the causes of these problems are not short-term – they are, mainly due to serious structural weaknesses in livelihoods systems of low-income people that require urgent and systematic attention.

Why is this happening? What are the consequences in a country like India, where over 60% of the population is engaged in agriculture and related activities? The key point to note here is that this case of farmer suicides is neither a cotton specific problem nor a paddy crop germane issue. Rather, it concerns, fundamental problems[iii] associated with one of India’s largest livelihood sectors, agriculture and allied activities – a sector where over 600 million people and a majority of India’s low income and poor[iv] people earn their living. More importantly, it is a sector without whose produce/products, we can neither eat nor survive in the long run. Therefore, without question, agriculture and allied areas as sectors and the low income people dependent on it for their livelihoods must be “included” in the overall growth paradigm. That is an urgent imperative in India today…

Second, as noted above, from the perspective of supply-side management, growth in agriculture is very vital for keeping manufacturing prices under check, ensuring food security and keeping inflation under control. India knows this better from its own experience of the last few years. Price stability is not merely important as an anti poverty measure but also as an instrument to ensure stable and sustained growth. Again, the lessons of the last 5 years should not be forgotten and especially, with regard to prices of essential food items as well as from a food security perspective. That the farmers who grew these commodities hardly got returns/rewards commensurate with their effort, investment and risks taken can hardly go unnoticed and this again point to very fundamental weakness in the structural aspects concerning agriculture and low income livelihood systems.

Third, higher growth in agriculture and rural areas coupled with demographic dividend (i.e. growing proportion of population in the working age group of 15-65) should result in a rise in the savings level, which, in turn, should facilitate financing the increasing level of investments required to maintain the overall momentum with regard to growth. This is again a very crucial aspect and the role of local and small savings should not be discounted in any serious measure. Its potential to support inclusive growth is phenomenal and appropriate incentives must be provided in this regard to encourage local/small savings as a resource alternative in the new growth paradigm

Fourth, the limitations on increasing production and productivity in agriculture are forcing people to migrate to urban areas and this results in increased population pressure in urban areas as well as larger numbers of urban poor. And this burgeoning urbanization has several important consequences for low income people, who tend to migrate and live in slums. As an NSSO survey revealed (a few years ago), nearly 40 per cent of farmers claimed that would like to quit farming, if they have the option to do so. Unfortunately, there is little option for them except moving into urban slums[v].

Thus, in reality, migration to urban areas primarily implies greater growth of urban slums, which hold a lower quality of life for the poor, many of whom have migrated from rural areas in search of better livelihoods. This growth of urban slums, typically, is associated with greater unemployment for the poor living there, harsh living conditions, enhanced crime, greater negative impact on health and several aspects including environmental degradation[vi]. Therefore, the major point to be noted is that the infrastructure in urban areas is simply not enough to cater to the growing needs of these migrants. Huge and appropriate investments are therefore needed in housing, sanitation, water, lighting and power, solid and other waste management, education, health, and so on and so forth. Therefore, we need “inclusive and enabling investment” in the above areas to deal with the huge and increasing numbers of low-income population in urban areas. This also calls for a paradigm shift in urban planning which must also become more inclusive.

Fifth, in countries such as India, the growth process is essentially knowledge-based and primarily services led. These new growth areas that continue to have a lot of potential going forward. Hence, the requirement of skilled labour is rather huge in comparison to the current levels of availability. Therefore, in order to ensure availability of adequate supply of labour skilled to tackle opportunities in new growth areas mentioned above, we also need huge enabling and inclusive investments in areas such as practical education and skill development – so that the vast majority of people who have the latent potential but cannot afford these services – are facilitated to gain access to such practical skills and knowledge, and thereby perform to their potential.

Last but not the least, whenever we talk of rural areas, the sector that comes first to our mind is agriculture. However, there is the (unorganized and informal) non-farm sector which continues to play an increasingly role in absorbing a large numbers of rural people. Make no mistake – taken together, this non-farm sector and value added agriculture enterprises (MSME) sector have huge potential for growth but this again requires investment in “inclusive infrastructure and enabling mechanisms” for ensuring easier/quicker access to assets, skills, appropriate technology, wide range of vulnerability reducing financial services (including credit for post harvest and post production) and fair linkage to various markets and other market development infrastructure (both private sector and government procurement). Without question, such efforts can make these hitherto excluded sectors, an expanding base for wealth creation and generation in a competitive manner in rural areas

Therefore, to reiterate, it is critical to ensure that growth takes place in: (a) agriculture, allied and non-farm sectors as well as secondary and services (enabling) sectors in rural areas; and (b) amongst urban poor so that they have a better quality of life and opportunities for sustainable livelihoods/wealth creation and thereafter, they also serve as a growing market for the goods and services produced by the expanding industrial sector including those produced by various kinds of MSMEs. However, this growth cannot be mere dumping of goods and/or provision of services in rural areas or among the urban poor. It has to be responsible growth and delivered in an ethically sound and transparent manner and this is one of the most important lessons from the present Indian micro-finance crisis/growth story. Otherwise, all the gains will be lost…and we will still be at square one...

To summarise, it is clear that inclusive growth is very necessary for sustainable development and equitable generation of wealth and prosperity. However, achieving this inclusive growth is the biggest challenge in a democratic country like India as it translates to the concern of integrating 600 million people living in rural India and several million living in urban slums into the mainstream economy and facilitating them to create wealth and better quality of life at the grass-roots. And that is a task in which a new paradigm of inclusive finance must take the lead in and show the way forward such that sustainable growth and wealth creation opportunities are available to all excluded sections of the society and in all neglected sectors of the economy and parts of the country.

And this requires that we let go off our narrow conceptualization of inclusive financial services and broaden the paradigm to ensure that financial services play a very vital role in addressing two critical supply-side issues: (i) by creating an effective and fair ecosystem for delivery of a wide range of (financial and related) services to facilitate productive and enabling investment in largely excluded but employment impacting sectors such as agriculture, value added agriculture, MSMEs etc as well as hitherto excluded (geographic) areas and for enabling low income and excluded people (living in rural India and urban slums) to realize their latent untapped potential; and (ii) by driving large scale investment in inclusive infrastructural facilities and enabling mechanisms like watersheds, irrigation, rural/urban reconstruction, social infrastructure such as health care, education and sanitation and the like.

Without question, mere credit[vii] to low-income people can do very little for inclusive growth as has been consistently argued by many proponents of the narrow inclusive finance paradigm. Only a new, braod and enabling paradigm of inclusive finance as mentioned above can help usher in an era of real inclusive growth in India…

Have A Nice Day!

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[i] This post draws from several resources including: Inclusive growth – the role of banks in emerging economies by Mrs Usha Thorat and other web based resources as well as papers by this author

[ii] And this issue becomes even more critical when one considers the fact that the average monthly per capita consumption expenditure (MPCE) in urban areas in India is near double that of rural areas. And in some States (like in Central or Eastern India), these disparities are even more glaring.

[iii]  “Farming is both a way of life and the principal means of livelihood to 65 per cent of India's population of 110 crore, Our farm population is increasing annually by 1.84 per cent, The average farm size is becoming smaller each year and the cost-risk-return structure of farming is becoming adverse, with the result that farmers are getting increasingly indebted. Marketing infrastructure is generally poor, particularly in perishable commodities. The support systems needed by farmers, like research, ex-tension, input supply and opportunities for assured and remunerative marketing are in various stages of disarray. Small farmers are forced to borrow money from money-lenders at high rates of interest, since less than 60 per cent of the credit requirements of farmers is met by institutional sources.” (Dr M S Swaminathan, Chairperson, National Commission on Farmers, 2006).

[iv] Despite significant progress made by India during the last decade or so, about 30 – 35% of the total population still lives below the poverty line.

[v] INDIA has always been considered a country that lives in its villages. But increasingly rural Ind1a is moving towards the town and the City. The 2001 Census established that almost one- third of India's population, an estimated 285 million people, lived in urban areas. By 2020, half the country's population is expected to be city-based.

[vi] In fact, as the data suggest, almost 50% of country’s population and a large majority of the poor are likely to reside in urban slums in India by 2020. And Noted environmentalist Chandrasekar confirms the above trends and summarises the issues with rapid urbanisation, “Although on paper all cities have some kind of development plan, the actual development follows no particular pattern except that dictated by expediency, patronage and privilege. As a result, every city in India is the epitome of urban chaos - lacking in adequate water and sanitation, affordable housing, all weather roads, decent public transport and clean air. Cities generate wealth but increasingly Indian cities have become home to the urban poor. Every city is marked by the informal settlements where the poor are forced to live without access to basic services like water and sanitation. City administrations are unable to check the flow of poor people into the city and have failed to build affordable housing where the poor can live. As a result, in some cities like Mumbai, for instance, half the population lives in slums. And in Maharashtra, India's most urbanised State, 61 cities and towns have slum populations that together makeup over 27 per cent of the total urban population and a third of the total population of the State. Indeed, the slum has now become an inescapable part of the Indian urbanscape” (The Hindu,).

[vii] Several factors like market imperfections and other factors (like poor infrastructure and production practices etc) severely constrain these low income people in their efforts to build sustainable livelihoods and enhance their economic security - as a result of fragile livelihoods, they often go through a cycle of being financially included and excluded at various times.  The key point is that, in the absence of other infrastructure and mechanisms, the use of loans by poor and vulnerable people renders them into greater debt.

Redressing the Imbalances in Power, Information and Resources: The Consumer Protection Legislation Imperative in Micro-Finance…

Ramesh S Arunachalam

Rural Finance Practitioner  

The need for consumer protection in micro-finance arises from a huge imbalance of power, information and resources between consumers and MFIs, with low-income consumers at a great disadvantage. Some specific aspects that contribute to these imbalances are given below:

·         While MFIs/FIs know their products rather well, the individual low income consumer often finds it difficult and/or costly to obtain sufficient and transparent information regarding the various financial products that they access from MFIs.

·         In addition, many of the low income people find MFI financial products naturally complex and/or difficult to assess, even when all relevant information is disclosed.

Imbalances also occur because the entry or exit costs are low for many MFIs, thus allowing (disreputable or fly by night operator) firms to emerge, exploit low income people and vanish. Please recall that industry stalwarts like Mr Vijay Mahajan and others (like Mr Alok Prasad) have often mentioned unregistered fly by night operators as mainly responsible for the present (2010) as well as previous (2005/6) AP micro-finance crisis

Therefore, it is imperative to have consumer protection legislation to help address this (natural) market failure caused by these huge imbalances of power, information and resources. And any such consumer protection law (legislation) for micro-finance should provide clear (non-ambiguous) consumer protection rules regarding the various financial products and services delivered by MFIs/FIs to micro-finance clients.

For this, it must clearly define the scope of micro-finance appropriately and also specify the product and client characteristics apart from specifying models of delivery/institutions and the like. This is very critical and without identifying the scope of micro-finance, neither can products, delivery models, institutions, clients and other aspects be highlighted and therefore, clear-cut (consumer protection) rules cannot be framed

This law must also try to ensure client protection from two perspectives: a) From a product design view point as financial products are services consumed by the client and require their active participation in the production; b) From services delivery perspective as much customer insensitivity can stem from the delivery/institutional model and related aspects.

Last but not the least, the necessary institutional arrangements should be in place to ensure thorough, objective, timely and fair implementation and enforcement of the consumer protection rules. This is a very vital aspect because much of micro-finance is delivered through a dispersed and decentralized model and therefore, institutions tasked with the objective of implementing the consumer protection law must have the wherewithal and resources (physical, managerial and financial) to actually implement the consumer protection law/rules. Otherwise, any consumer protection legislation will also turn out to be as ineffective as the current codes of conduct (regulatory or voluntary), prevalent in Indian micro-finance…

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The Urgent Need For Specialised Consumer Protection Legislation in Indian Micro-Finance…

Ramesh S Arunachalam

Rural Finance Practitioner  

Just after the last Krishna crisis (2005/6), I heard a lot of micro-finance industry stalwarts arguing that codes of conduct along with competition will ensure protection of low income consumers.  However, as the events of the last few years have shown, that has not sadly happened. Two aspects are noteworthy here: (1) Neither has competition between MFIs been able to fully address consumer protection issues on their own; and (2) Nor have codes of conduct for responsible lending (often cited substitute for regulation) been able to improve the business practices of MFIs.

As far as I have seen, in many competitive markets, competition may have been sufficient to ensure that firms succeed by providing consumers with a flood of products and services but practices surrounding the delivery/distribution of these products including access to transparent information has always been under question. Therefore, much more than competition is required to ensure efficient and fair markets and the same applies to micro-finance services for low income people.

Likewise, while codes of conduct were meant to encourage MFIs to follow ethical standards in the treatment of their customers, there are no real substitutes for adequate regulation intended to protect the interests of consumers of micro-finance services. And in the Indian micro-finance sector, self-regulation through such voluntary codes of conduct has been less than effective since institutional capacities of industry associations (MFIN or Sa-Dhan) have often been limited, micro-finance markets are highly concentrated and dominated by a small number of MFIs, the legal framework for micro-finance services is underdeveloped, and available the laws and regulations (like RBI code of conduct for NBFCs) are frequently not effectively applied or enforced. In fact, when the code of conduct was first introduced in 2006, I had a very open mind and felt that it may provide a useful first step, particularly if the regulator (or supervisor) oversees the codes and reports on the effectiveness of the codes. However, that did not happen and it is clear that codes are not sufficient to improve business practices of MFIs and hence, it is imperative for the regulator/government to consider introducing special consumer protection legislation for micro-finance.

The focus of such consumer protection must be on the relationship and interaction between a low income customer and MFI/equivalent delivering similar services. Among other things, such legislation should ensure that MFIs provide low income people (consumers) with:

Ø      Transparent Information - by providing full, plain, adequate and comparable information about the prices, terms and conditions (and inherent risks, if any for the new savings and mutual fund type products) of various Micro-Finance (MF) products and services;

Ø      Choice of Products and Services - by ensuring fair, non-fraudulent, non-coercive, legally valid and responsible/reasonable practices in the selling, advertising and marketing of Micro-Finance (MF) products and services, and collection of payments etc;

Ø      Appropriate Redressal Mechanisms - by providing inexpensive and speedy mechanisms to address complaints and resolve disputes in fair and transparent manner and especially at the local level; and

Ø      Privacy Aspects - by ensuring control over access to personal financial information and its non-use for other (not-so-legal) purposes

In addition, the legislation should also ensure that low income people/consumers have access to programs of financial education that enable them to develop the financial capability and capacity required to understand Micro-Finance (MF) products and services and exercise their rights (and responsibilities) as financial consumers. Such training in financial issues should serve to empower low income people to make wise and informed decisions about their household finances including access to various financial services from various stakeholders and also to plan their financial needs over a lifetime.

However, as the Indian micro-finance experience has clearly shown, financial education and literacy[1] alone cannot, be a substitute for adequate financial consumer protection regulation. While they can help reduce the information and power imbalance of low income consumers with regard to MFIs/FIs that deliver various services, they can do so only to an extent - as they form only a part of the much wider intervention of consumer protection, which needs to be mandated through appropriate legislation. In fact, clear consumer protection legislation for micro-finance is required as Micro-Finance (MF) markets will not work on their own and one needs institutions to regulate and stablise these markets, compensate to losers and provide the safety nets – thus, Micro-Finance (MF) markets can neither be legitimate or, for that matter, efficient, if you don’t have the appropriate regulatory frameworks. And several stakeholders have suggested, the prime justification for regulating financial markets like in micro-finance stems from the need to protect low income people from fraud and misrepresentation, unfair treatment, insufficient information, coercive employees of MFIs, and other things (including the loss of their investments)

Thus, while expanding access to financial services is very critical and is in many ways a fundamental right of citizens in a developing country like India, to help grow the economy in an inclusive manner, both MFIs (as financial institutions) and low income people (as financial consumers) need to be responsible in their use of financial services. That, in a nut shell should be the objective as well as result of any consumer protection and accompanying micro-finance legislation…

Have A Nice Day!

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[1] I plan to post separately on financial literacy and education from a customer protection perspective.

Peculiarities of Micro-Finance Assets and Practical Regulatory and Supervisory Lessons For Governments, Central Banks and Donors Involved in Building Inclusive Financial Systems …

Ramesh S Arunachalam

Rural Finance Practitioner

Micro-finance loan assets have several peculiarities that need to be carefully considered while devising regulation and supervisory arrangements – irrespective of whether MFIs (different legal forms) or Business Correspondents (various types of legal entities) are involved in the last mile intermediation. While much of what I am talking about applies to the Indian context very well, the same general principles can easily be used by governments, central banks and donors in other environments as well…Read On…

Unique Characteristics of Micro-Finance and Associated Problems:

First, MF loan assets tend to be predominantly small in amounts but large in number. Second, while the transactions are also small, they are however numerous (repetitive) and most often, predominantly cash oriented – this makes it difficult to trace the source as well as end use. Third, the geographic diversity is huge and these assets tend to be spread over remote rural areas and/or urban slums that make it rather difficult to physically locate them. Therefore, establishing the identity of the micro-finance borrower and hence, the loan asset becomes rather difficult. Fourth, while many of the lenders ask for KYC documentation, it must be noted that what is provided is far from accurate. Therefore, it is very easy for an MFI to show the same assets for different lenders and re-deploy the (surplus) funds in other activities like real estate and the like. I have solid documentary evidence of this happening in India and a lot of this was highlighted as far back as May 2005, in the (now infamous) paper of Thorat and Arunachalam (2005)

Thus, as noted above, these peculiarities can cause serious problems in supervision of micro-finance assets and especially, those who buy these securitized assets must be very careful as there is a good chance that the may be no real persons at all with the associated assets or the assets themselves may have been hypotheticated or pledged to other lenders

Some Practical Strategies For Regulation/Supervision:

Ensure Exclusivity of Micro-Finance Assets: Thus, the only way to safeguard against the above is to ensure the exclusivity of micro-finance assets to specific lenders and that is something that only the regulator can mandate via regulation and ensure through supervision. As per this, each MFI will have to exclusively earmark certain number of whole branches/units across its portfolio and geographies to respective lenders. And this should not be done on a geographic basis as then it may be unfair to some lenders – rather allocation of branches should be done in a fair manner using stratified (by quality of branches) random sampling methodology to ensure that all lenders get a somewhat equal share of excellent, good and ordinary branches. This will ensure equitable distribution of portfolio at risk across the lenders

Mandate A Consortium Approach For Lending To Large MFIs: Further, the lenders will also have to take a consortium approach to lending to the MFIs (at least for those MFIs that have portfolio greater than US $ 100 Million or Rs 500 crores). This will prevent MFIs from setting off one lender against another and also ensure that the micro-finance market is less of a borrower-dominated market. If one were look at the instances in the years 2007 – 2010, there are a number of cases from India where MFIs set off one lender against another and this led to dilution of terms and conditions, including monitoring and supervisory arrangements. In my opinion, a lot of the present problems in India are due to such aspects.

Again, “consortium lending” is something that only the regulator can mandate via regulation and ensure through supervision. And make no mistake, no lenders forum (even those established through the responsible micro-finance project) can ensure consortium lending because by their very nature, the lenders are fierce competitors for the available large and medium sized MFIs. Therefore, only a regulatory diktat can ensure this on the ground.

While lenders typically use rating agencies prior to sanctioning a loan, in this case it is the consortium that must choose a credit rating agency, which among other things must be REALLY independent in terms of not having any other relationship to the larger micro-finance industry and the MFI being rated – especially, the rating agency must not have a sister concern that is involved in capacity building and/or be a part of a larger Corporate group that has such interests in the micro-finance industry. Also, ratings for the same MFI must be rotated among the mainstream rating agencies so that repeat ratings do not become a wrong incentive (or an incentive for providing a higher rating grade). And raw data collected as part of the ratings must be made available for verification by the supervisors auditor and lenders’ internal auditors, as and when required. This may not at all be used but this has to be provided by the rating agency to the consortium of lenders

Make High Quality Randomised Loan Portfolio Audits Mandatory On An Annual Basis: While many of the banks and lenders are going in for loan portfolio audits and the like (I myself participated in the development of loan portfolio audit toolkit that is prominently used in India and other countries), much of the principles used in all these toolkits will have to be changed significantly, especially, in line with lessons from the present Indian crisis. And mainly, client level sensitivities and the prevalence of decentralized models/agents and their practices will have to be factored in specifically. Further, loan portfolio audits are seldom effective in the absence of a transparent MIS that is integrated across geographies, products and clients groups and that again needs to be ensured on the ground (please see following post with regard to MIS at MFIs: http://microfinance-in-india.blogspot.com/2010/11/understanding-state-of-management.html). Also, loan portfolio audits must be conducted by people who are not only independent evaluators but also seen to be independent in terms of having no other relationship with the concerned MFI (or the larger micro-finance industry), at least over the previous 3 years. And finally, there is a critical need for ensuring statistically valid random sampling of an MFIs portfolio while conducting such an audit and that again needs to be implemented on the ground. All of this can be ensured only by regulation and it is hoped that the regulators will do that and also ensure implementation through appropriate supervisory arrangements. While credit rating agencies could also conduct the loan portfolio audits, they must adhere to the transparent terms set out for portfolio audits above and also that mentioned for credit rating agencies earlier.

Make It Mandatory For MFIs to Provide An Annual MIS and Systems Audit Report: Another issue that needs to be made mandatory by regulators is the requirement of an annual MIS and other systems audit – to be certified after due examination by regulator/supervisor empanelled professionals and I will make a separate post on what process should be followed for such certification to be effective. This must form part of the annual filing of returns along with the aforementioned annual loan portfolio audit certificate

Have One Credit Bureau with A Unique ID Linkage: Lastly, while credit bureaus are very useful, the regulatory authority must own the credit bureau. However, the central database should be available for use (on a lease basis) for the different credit bureau service providers. MFIs can link up to different credit bureaus service providers to submit the data but all of this information will have to go into the regulator established central database. Likewise, all concerned industry stakeholders should be able to access this data at a cost of course, subject to various terms and conditions. And it would be great if the credit bureau architecture piggyback rides on unique national IDs for each individual, accessing a micro-finance loan. Only then, can the micro-finance assets become really traceable and accounted for in the complete sense and the real impact of financial inclusion efforts be transparently and objectively determined…

Have A Great Day At Work!

The Business Correspondent (BC) Model in Indian Micro-Finance: Serious Regulatory Issues for Attention of The RBI and Lessons For Policy Makers Globally…

Ramesh S Arunachalam

Rural Finance Practitioner

Under the proposed BC model, a regulated entity (Bank) is to use a third party (either an affiliated entity within a corporate group or an entity that is external to the corporate group) to perform activities on a continuing basis that would normally be undertaken by the regulated entity, now or in the future – in other words, it would outsource activities to various kinds of business correspondents (other than NBFCs).

Thus, in the BC model, in effect, there is a transfer of an activity (or a part of that activity) from a regulated entity (Bank) to a third party (BC).

There is no doubt that financial services businesses throughout the world have increasingly used third parties to carry out activities that the businesses themselves would normally have undertaken. While industry research and surveys by regulators/others show financial firms outsourcing significant parts of their regulated and unregulated activities, especially because of cost and other considerations, there is no DOUBT in the fact that these outsourcing arrangements are also becoming increasingly complex and as a result, causing significant problems on the ground. The last few years have demonstrated a range of issues that require attention, when financial service businesses outsource activities…and these are highlighted below:

The most fundamental point is that such outsourcing, as envisaged in the BC model, has the potential to transfer risk, management and compliance to third parties who may not be as well regulated and supervised (as in micro-finance and/or the Corporates in the private sector) - especially in line with the financial functions that they may be performing (which certainly calls for an appropriate kind of regulation/supervision). Several concerns arise in this regard:

1.      In these situations, how can the regulator and/or the regulated financial service businesses (banks in this case) remain confident that they remain in charge of their own business and in control of their business/other risks? A look at the recent micro-finance crisis in India suggests that neither the regulator/supervisor nor DFIs/Banks (like SIDBI especially) were aware of any of the ground level problems/happenings in Andhra Pradesh and their REAL causes.

The presence of unscrupulous agents, rampant multiple lending, serious Corporate Governance violations, ghost clients and several other issues including violation of priority sector norms and the like were neither known/anticipated nor dealt with appropriately/nipped in the bud. This is a serious aspect that needs to be recognized by all stakeholders including The RBI and in turn, it calls for appropriate supervision arrangements with regard to the proposed BC outsourcing activities as well. From my limited understanding, I am not sure that these are in place and hence, my cautionary note with regard to upscaling BC type arrangements, especially using corporates. Also, the complete failure of the self-regulatory mechanism with regard micro-finance, over an almost a 5 year period is another aspect that needs to remembered…

2.      How do the regulated financial service businesses (banks in this case) know they are complying with their extant regulatory responsibilities? How can these regulated financial service businesses demonstrate that they are doing so when regulators ask them? Let us take the micro-finance crisis as an example again. There have been serious violations with regard to KYC and in many cases, the last mile end user clients are just not known. Imagine the consequences of this in line with the anti-money laundering regulations and global FSTF (Financial Services Task Force) recommendations. There have been many cases of lending to non-priority sector clients (including loans to founder directors) and there are no safeguards against these even as on date. Many a time, KYC forms include people who are no longer alive and I have personal documentary evidence of several such cases in AP and other states. Again, I am not sure that DFIs/banks have the capacity and ability to ensure compliance in REAL time and therefore, I would like to stress that arrangements like BCs should be upscaled, if and only if, banks demonstrate the willingness and capacity to have appropriate supervisory mechanisms in line with their regulatory responsibilities. We need institutions like SIDBI and commercial banks to be more accountable and transparent…with regard to the regulatory responsibilities they are discharging…after all, they mainly intermediate public deposits…

3.      Most importantly, how can the regulated financial service businesses assure themselves that their agents (=business correspondents), who are 3^rd parties, are not engaging in practices that could contribute to institutional and other failures including client level abuses? Again, as with the on-going micro-finance crisis, the banks and DFIs like SIDBI cannot do so with a good degree of confidence when the regulator/supervisor asks them. In fact, this turned out to be a killer assumption with regard to micro-finance – banks and DFIs assumed that MFI practices were good on the ground (let us give them the benefit of the doubt) and the regulator/supervisor also did do. The consequences are there for all of you to see and judge…a Macro mess (as Senior Colleague Al Fernandez would call it) with regard to micro-finance and financial inclusion on the ground. Anyone who states otherwise, is simply ignoring real ground level facts and perhaps trying to postpone the inevitable but impending collapse of the rural/alternative finance delivery system in India

Therefore, I would really hope that there is serious introspection into issues such as those given above before upscaling BC type arrangements, especially using Corporates. If the necessary safeguards can be built and implemented on the ground, then, there is perhaps a case for using BCs in India, although I still have very serious reservations with regard to using Corporates as BCs, as mentioned in my post of yesterday… http://microfinance-in-india.blogspot.com/2011/04/permitting-for-profit-companies.html

Last but not the least - when we deal with very vulnerable people, let us be extra careful and try to protect them from excesses and abusive practices that are so widely prevalent in micro-finance as well as the larger financial sector in India. The global financial crisis and the present Indian micro-finance crisis are still very fresh in memory and I am sure that all of you will agree that just as financial inclusion is a fundamental right and a noble cause, protecting clients is equally, if not more, important…

Jai Hind!

Have A Nice Day!

Permitting For Profit Companies (Corporates) As Business Correspondents: Lessons for The RBI and Other Stakeholders From The Indian Micro-Finance Crisis…

Ramesh S Arunachalam

Rural Finance Practitioner

The last few months have shown what HAVOC the inability to regulate and/or supervise can do in a field like micro-finance and/or financial inclusion

The proliferation of the decentralized MFI model using different kinds of agents[1] through informal outsourcing arrangements is perhaps responsible for much of the micro-finance mess in India currently. That said, therefore, the RBI must be very careful in pushing through initiatives {like using Corporates as Business Correspondents (BCs)} that it perhaps does not have the wherewithal to supervise and/or monitor[2], especially on the ground.  And for the record, DFIs and banks including SIDBI and others have miserably failed in their due diligence of NBFC MFIs and expecting them to do this with regard to the BC model (especially, after the recent and on-going Indian micro-finance crisis) is somewhat naïve.

The lessons from the present (field level) failure of micro-finance NBFC supervision in India continues to loom large and the RBI must really ponder on (if and) whether such new initiatives are indeed required and worth it for furthering financial inclusion. What I am arguing for here is an unbiased and objective evaluation of the pros and cons in “having Corporates as BCs”, especially in the light of the present micro-finance and financial inclusion field experiences. Everything seems okay on paper including PROs and CONs but when you visit the field and look at grass-roots realities, the problems and risks are totally different and I sincerely hope that the RBI does initiate such an exercise before facilitating large-scale implementation of these and other new initiatives for financial inclusion

While proponents of the model may claim many advantages with using Corporates as BCs, the risks are many and plenty too and I attempt to outline some of these here[3]:

First of all, there are huge conflicts of interest because a strong “Corporate BC - Bank Tie Up” could push unnecessary products onto the (vulnerable) people in garb of financial inclusion. Cross-selling of products is a huge aspect that cannot and should not be discounted and I can provide numerous examples from the India experience with regard to financial services

Second, Corporates tend to adopt models similar to the decentralized model that many NBFC MFIs are currently using and that is fraught with problems as has been pointed out with clear evidence in many of my previous posts – If anyone from RBI were to travel with me deep into Tamilnadu, AP, Karnataka, West Bengal and Orissa, I can VISIBLY show them what havoc “informal” outsourced micro-finance agents, solely focused on growth and profit, have (are) caused (causing) on the ground. I am not sure that there is a GOOD case for a Corporate BC category as that could result in formalizing these informal micro-finance agents – who are sure to picked up by the Corporates, who lack the last mile connectivity and familiarity with financial inclusion, in the event of them (corporates) being allowed to function as BCs. That could prove disastrous and I hope the RBI looks into this risk carefully

Third, with any initiative, we need to ask, what is the purpose and I am not sure that the outlook on BCs is all that clear. Financial inclusion is a must and a fundamental right but the methods used to achieve financial inclusion also need to be carefully considered as otherwise, the efforts may turn out to be counter productive. The crisis in AP and the unfolding problems in few other states are a great reminder of what can happen when the methods go wrong

Fourth, and here in lies the primary risk with Corporates – if to include some one, I provide them access to a loan but with the rider that they also buy my (group companies’) fertilizer or any other product, then, I am not sure that this is fair financial inclusion. This is one simple example and I can provide numerous examples from the financial inclusion space with regard to extremely literate (but vulnerable) people who have been forced to buy products that did not need in the first place. Many of them even considered approaching the Banking Ombudsman but did not do so because of the high perceived transactions cost in doing this. And if this is the case for literate and knowledgeable people, who are used to reading fine print, imagine what can happen to real vulnerable people at the grass-roots.

Fifth, the lessons from the personal loan saga of 2005/6/7 are still fresh in memory where many customers did not even receive their agreements and were not in the knowledge of the loan terms and conditions (usually in fine print and/or filled in subsequent to getting the signatures and sent much later to the customer etc). This happened primarily because (Corporate) agents of banks for personal loans were solely focused on fast and indiscriminate selling personal loans to people to make huge profits – today banks have almost withdrawn from the personal loan market due to the high levels of delinquency

I really hope that the RBI learns lessons from the on-going micro-finance crisis involving NBFCs, the past personal loan saga of 2005/6/7 involving (corporate) agents of banks and other such failures in the larger financial sector in India.

The case for financial inclusion is always a sound one but the risks in methods employed for financial inclusion must also be carefully weighed and addressed as otherwise, all our efforts could turn out counter productive…

Have a great day!

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[1] Please refer to posts in the following category: http://microfinance-in-india.blogspot.com/search/label/Micro-Finance%20Agents

[2] This is a genuine concern and the intention is not to offend any stakeholder including The Central Bank. I hope my views are taken in the right spirit! Thanks

[3] While the Bill and Melinda Gates Foundation paper cites some of the serious risks in Chapter 9, I am unable to understand the easy manner in which they explain away some of these very serious risks. I am also deeply concerned that the risks have been more mentioned, rather than dealt with in a comprehensive fashion.

Using Re-Engineered Value Chain Financing to Enhance Bargaining Power of Small/Marginal Agricultural Producers: A Present Day Imperative…

Ramesh S Arunachalam

Rural Finance Practitioner

1.               As noted in previous posts, the mere delivery of credit and more of this standard credit (for consumption and/or small production needs), as is currently practiced in micro-finance (or as part of the financial inclusion paradigm) is not very useful, always – as low income people in many contexts, like in India, and other such Countries (Uganda and Malawi in Africa) are engaged primarily in agriculture.

2.               The focus would need to be re-engineered towards ensuring delivery of quality credit that will reduce risk and vulnerability of low income clients engaged in agriculture and give them more choices - through alternative channels that afford lower costs, have greater trust and high levels of mutual acceptance.

3.               Quality credit would therefore necessitate a greater focus on post harvest and/or postproduction financing for agriculture and related sectors that provide (or can provide) significant livelihoods opportunities for low-income people.

4.               In other words, among other things, this would call for financing of agriculture produce marketing – a very critical aspect for small/marginal producers as it has the potential to enhance choices for them in terms of buyers etc. Of course, here, the existing relationships would need to be better understood if financial products are to be developed and delivered through appropriate channels[i].  

5.               Further, the re-engineering must be such that the delivery of financial services are used to strategically to drive higher rewards, better remuneration and greater power down the value chain as shown later in Figure 1– otherwise, it will be of limited use.

6.               And again, as said before, to achieve this, one needs to better understand existing relationships, particularly in post harvest and post production marketing situation in different agriculture value chains.

7.               An example of driving power down the value chain is the delivery of finance through a simple warehouse receipt mechanism as diagrammed in figure 2 below. While there have been attempts to do the same in India, large-scale frauds in small pilots have proved to be a deterrent. These should not however force us to abandon this excellent vulnerability reducing financial service that has worked rather well in other contexts:

“Experience from around the world illustrates that warehouse receipts can make a difference to producers. By storing their goods in a reliable warehouse until the price increases while using the goods as loan collateral, producers may access funds before they sell their goods. Warehouse receipts are often administered to producer groups, instead of individuals, which helps the flow of market information. Warehouse receipts also can create price transparency. This empowers producers to make informed sales decisions rather than waiting for “gate” buyers who often offer below-market prices. Producer organizations/Microfinance institutions (MFIs) also have a strong incentive to offer warehouse receipt financing. With this system, their risk is reduced because the system has a built-in use of collateral that can retain a high commercial value and be liquidated quickly.”[ii]

8.               Thus, there must be re-engineering to emphasize delivery of financial services that can enhance the competition among middlemen and other buyers, who buy products/produce/labour from small producers. This would translate to financing marketing of agricultural produce and labor of small scale producers[iii] and it can happen in a variety of ways (through various types of aggregators and channels). Some examples are given below:

a)     Enhancing Competition Among Buyers: Direct financing of middlemen and other intermediate buyers of produce/products[iv] so that small producers have greater choice of buyers and incentivising these middlemen to procure at better prices/rates;

b)     Risk and Vulnerability Reducing Mechanisms: Warehouse receipt and similar financing for other products whereby the small producer can store their produce/products, pledge the same, receive a loan and sell when the prices are higher. An example is leasing for urban vendors whereby they can store their produce on a daily basis at a cold storage facility and not sell their perishable item at a throw away price at the end of the day, just because they have no place to store it safely and being a perishable, it could get spoilt;

c)     Creation of Post Harvest Competitive Mechanisms: Financing of other post harvest mechanisms including special depots for auction so that small producers have choices – this has happened in small scale marine fisheries and SIFFS has successfully used auctions to help the fisher folk get better prices

d)     Other Strategies: Financing of small scale producers who use labor for their livelihood through an innovative mechanism like virtual livelihoods exchange, with appropriate aggregators etc

Thus, to summarise, we need a new APPROACH to financing agriculture value chains and one that is rooted strongly in the practical realities. With all due respect to all that has been achieved, let us face it that the livelihoods of those in agrarian/rural sectors in India especially are in great shambles, even 60 years after independence - the fundamental point being that to build livelihood security of small producers/farmers, there is an imperative need to reduce their vulnerability and risks while at the same time enhancing their bargaining and staying power. And well designed financial services can play an important part in that…

And as an experienced colleague remarked, ‘Irrespective of the sector, small producers are not getting rewards/returns commensurate with their effort put in, investment made, risk taken and value created mainly because their staying and bargaining power is low.  It is therefore very important to try and promote interventions that enhance the staying power of small producers - as then it will result in their having better bargaining capacity which, in turn, will mean that they can negotiate better with market elements and get a return or price, that is due to them’. This can surely be attempted by the financial services sector and should pay rich dividends to both the service providers and clients…

Have A Nice Day!

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[i] Of course, this would need to be validated specifically for a context, product and partner but these are general suggested arrangements.

[ii] Quoted with adaptation from UNTRS/FAO (2007), Arunachalam Ramesh S et al, “Enhancing Flow of Finance to Small Scale Marine Fisheries” and Bamako 2000: Innovations in Microfinance, Technical Note 5

[iii] Some of these would apply to fisheries as well, where post harvest financing would be very critical. Much of the same would be applicable for tangible goods and here again, the focus would be to create a good supply of post-production financing and creating competition among buyers of produce/products made by small scale producers. Likewise, in the case of labor, innovative financing mechanisms like a livelihood finance exchange using the web could be explored.

[iv] BASIX tried this in the initial years but again we need to study why it could not be scaled up and thereafter try and create an environment for the success of such mechanisms