dhaka starting micro finance in india

8/8/2019 Dhaka Starting Micro Finance in India

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Dhaka Starting Microfinance in IndiaVijay Mahajan, Bharti Gupta Ramola and Mathew Titus, BASIX

The Demand for Microfinance Services

Credit: With a population of 1000 million, India has nearly 400 million people below orjust above an austerely defined poverty line. Thus, approximately 75 million householdsneed micro-finance. Of these, nearly 60 million households are in rural India and theremaining 15 million are urban slum dwellers. The current annual credit usage by thesehouseholds is estimated to be Rs 495,000 million or US$ 12 biilion!

Annual credit usage by 60 million rural poor households at an average of Rs 6000is Rs 360,000 million per annum - about two-thirds for consumption and one-thirdfor production needs (Based on a 1994 study carried out by the first two authorsfor the World Bank. The number has been rounded off and adjusted for 1998prices).

Annual credit usage by 15 million urban poor households at an average of Rs 9000is Rs 135,000 million per annum - about 55percent for consumption and 45

percent for production needs. (Based on a 1995 study carried out by the firstauthor for the SEWA Bank. The number has been rounded off and adjusted for1998 prices).

Savings and InsuranceApart from credit, there is an unfulfilled demand for savings and insurance services

For savings services, there are many service providers, but often unreliable. Asurvey of the urban informal sector by the third author reveals that 55 percent ofresidents suffer losses in both principal and interest from investments made inoperations that are best described as "fly-by-night". All this adds up to not onlymaking it time-consuming for mFIs to mobilise participation; but also and perhaps

more importantly for poor people to differentiate between an mFI and fly-by-nightoperators. For insurance, the only source is the nationalised insurance companies who do

have many schemes for the poor, but with limited access, except when tied togovernment schemes. Some microfinance institutions provide limited insuranceservices.

The Supply of Microfinance Services

All small savings are not microfinance, nor are all small loans. If we go by thatliberal definition, India is probably the world leader in microfinance. However, ifwe say microfinance is small savings, credit and insurance services, based oncertain design principles, then there is little microfinance provided by existingmainstream FIs (apex FIs, commercial banks, cooperatives, NBFCs) in India.

The total outreach of existing specialised microfinance service providers is quitelimited. There is no authoritative countrywide estimate of the microfinance fundsdisbursed or clients served. We have attempted a preliminary estimate inAppendix 1. Ideally such estimates should be made state-wise.

Informal alternatives for loans involve interest rates varying from 36 percent pa to120 percent pa. For savings, while there is no dearth of deposit takers, micro-savers suffer from "fly-by-night" risk.


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The Demand Supply Gap

Bridging the demand supply gap, even at high growth rates requires an environment thatattracts large numbers of microfinance providers. We recommend the adoption of a"three track approach", using mutually complementary strategies:

Incentivising existing mainstream FIs to enter microfinance seriously, byestablishing a supportive policy and regulatory environment.

Encouraging new microfinance institutions (mFIs) with a supportive policy andfinancial resources to enlarge and expand their services.

Building a strong demand system in the form of community-based developmentfinancial institutions (CDFIs), with the help of NGOs and others. Such a system isrequired to

convert latent demand into effective demand, wean away microfinance customers from moneylenders, remove the expectation of low interest rate and capital subsidies that have spoiled

borrowers over the years restore the repayment norm, and build local stake in grassroots financial structures

These CDFIs may be unregistered or registered. If registered, they may choose to besocieties, trusts, mutually aided cooperative societies (MACS) or even non-bankingfinance companies (NBFCs).

2. The Policy and the Organisational ContextIn this section, we begin by delineating the abiding challenge of microfinance how to

simultaneously achieve high access by the poor, while maintaining sustainability for anFI. We argue that the existing policy and regulatory framework militates againstsustainable provision of microfinance services, thus reducing access. Our argument isbased on an analysis of existing legislation, regulatory frameworks and the informalguidelines of major institutions. The second part of our argument outlines theorganisational constraints faced by both mainstream FIs and alternative mFIs. It isexamined from the point of view of blocks in growth in access and sustainability.

Twin Performance Measures: Access and Sustainability

High Sustainability

Sustainable financial services withlow access by the target clients Sustainable financial servicesreach the target clientsLowAccessHighly subsidised financial serviceswith low access by target clients Highly subsidised financialservices reach the target clients

HighAccess

Low Sustainability

3. Legal and Regulatory Framework


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There are many aspects of the existing legal and regulatory framework which discouragemainstream FIs from increasing outreach and achieving sustainability in microfinance.Further growth in microfinance can only be possible by redressing these limitations in thelegal and regulatory framework. Mainstream FIs find it difficult to significantly expand intomicrofinance for the following reasons:

Policy makers view of the market for microfinance services stems from over a 100years of attempts to get farmers out of the clutches of "usurious" moneylenders.Thus, it is accepted wisdom that farmers and poor people need low interest,subsidised credit. This shows up in policy: interest rates for loans below Rs 25,000and Rs 200,000 by commercial banks are still capped at 12 and 13.5 percentrespectively. Some attendant beliefs are that the poor cannot save, they areunwilling to repay loans, and administrative costs of serving them are high.

Consequently microfinance has historically been seen as a social obligation ratherthan a potential business opportunity. The leadership and managers ofmainstream FIs see the microfinance market as difficult to serve, risky and havinga low or negative net spread. Contributing to this position has been the fact thatsmall loans (IRDP, DIR, SC/ST) have been utilised historically as a tool fordisbursing political patronage, undermining the norm that loans must be repaid.This has made bankers cynical about lending to the poor.

There are specific problems with legislation: for example the NABARD Act does notallow it to refinance any private sector FI and do any direct financing (NABARDsdirect lending to micro-finance NGOs so far has been out of donor funds) NABARDalso refinances commercial banks/RRBs/cooperative banks who lend to mFIs.Similarly, the SIDBI Act restricts it from extending loans to the agricultural andallied sectors, whereas many of the members of self-help groups are engaged insuch activities.

The Regional Rural Banks Act does not permit any private shareholding in anyRRBs, and the Cooperatives Acts of all states do not permit district level coopbanks to be set up except by the state government. The result of these two lawstogether is that rural credit has been a monopoly of state owned institutions.

Some suggestions to improve the legal and regulatory framework

Deregulation of interest rates for all small loans and supporting the policy thatsmall loans can indeed be charged a higher rate.

Delinking poverty alleviation subsidised government programs from banks andmFIs.

Removing the governments monopoly on establishing formal institutions in therural sector. This includes privatising RRB and allowing independent Rural CoopBanks on the lines of independent Urban Coop Banks. The LAB policy should alsobe implemented.

Modification of the NABARD and SIDBI Acts to legitimately allow these apex bodiesto finance mFIs as part of their regular operations and not as "promotional"activity.

In the case of alternative mFIs there are problems not so much with the legal frameworkas with the fact that most mFIs have come up under inappropriate legal forms as non-profit societies/trusts. The issues are too numerous to be listed in the text and hence aredealt with in a tabular form in Appendix 2. We do urge the readers to look at thatappendix in some detail. However suggestions for reform are given below:


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Non-profit MFIs

The Ministry of Finance (Central Board of Direct Taxes) and RBI should seriously decide ifnon-profit mFIs can be allowed to engage in lending activity without threatening theirnon-profit status. If the decision is positive, then the following changes are needed:

Section 2(15) of the Income Tax Act should be amended to include "microfinance"as a charitable activity. For this microfinance may be defined tightly such as 80percent of the loan portfolio being in loans less than Rs 25,000.

A new section 10(23)(H) may be added to introduce a status for micro-financeinstitutions similar to infrastructure companies.

Section 11(5) of the Income Tax Act should be amended to allow non-profits toinvest in the equity capital of for-profit microfinance institutions, which they mayset up

Mutual Benefit MFIs

The Central Government should adopt a progressive cooperative act along thelines of the APMACS Act, 1995, to allow genuine member control and free coopsfrom government control and possibility of political interference. (This wasannounced by the Finance Minister in the budget speech).

NABARD should stop refinancing coops in those states where the government isnot amenable to enacting progressive legislation and where interest and principalwaivers are announced. (NABARD has done this in some cases, with positiveeffect.)

For-profit mFIs

The RBI Act, NBFC Rules, already recognise nine types of NBFCs, including leasingand hire purchase, and housing finance NBFCs. These regulations should be

amended to recognise a new form of NBFC specialising in microfinance. Thedefinition can be as given above at least 80 percent of the portfolio below Rs25,000.

Deposit taking should be allowed to NBFCs fulfilling certain prudentialrequirements, such as a minimum level of capital, sound management, etc. andnot linked to their being rated. Deposit insurance should be extended to NBFCsfulfilling these requirements

Section 36(1)(viii) of the Income Tax Act should be amended to includemicrofinance institutions as eligible under this provision, at present available onlyto housing finance companies which allows up to 40 percent tax rebate if theamount is set apart in a special reserve. This will also enable these mFIs, to acceptdeposits from non-profits.

The Local Area Bank policy announced in 1996 should be implemented forthwith toallow private small banks to come up in three contiguous districts.

The Regional Rural Banks Act should be amended to allow private ownership ofRRBs.

General


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A self Regulatory Organisation (SRO) of mFIs may be established to set standardsand enforce them. The proposed Association of microFinance Institutions of India(AMFII) is one such SRO.

4. The Problem of Financing mFIs

As the reader will notice, we are not even talking about the financing problems ofmainstream FIs. They are flush with funds and have access to enormous amounts of lowcost savings deposits. Indeed the poorer the region, the lower is its Credit-Deposit ratio most of eastern UP, Bihar, Orissa and the North-East have CD ratios of 20-30 percent.The rest of the deposits find their way into the financial sector.

Thus the only microfinance players who are facing a funds shortage are alternative mFIs,a vast majority of whom are NGOs. There are also NGO promoted SHG federations, (inAP) mutually aided coop societies, and a very small number of NBFCs. Existing practicesof bulk financing institutions such as the Rashtriya Mahila Kosh (RMK), NABARD andSIDBI, and even the FWWB have limited their funding only to NGOs. As a result, thelargest incentive to enter such services remains through the non-profit route.

NGOs invented micro-finance but NGOs are not the best type of agencies to carry outmicro-finance on a long-term sustainable basis. This is because the main funds of NGOsare grants, which are very limited. Moreover, if NGOs earn a substantial part of their totalincome from lending activity, they violate section 11(4) of the Income Tax Act and canlose their charitable status under section 12. This is because microfinance, even for thepoorest, is not a charitable activity under section 2(15) of the IT Act. Moreover, NGOs donot have the appropriate financial structure for carrying out micro-finance activities.Because NGOs are registered as societies or trusts, they do not have any equity capitaland can never be "capital adequate".

In the long run, the primary source of lending funds for mFIs has to be deposits.However, to reach that stage, an mFI has to become a going concern. Till that stage, themFI has to rely on borrowings. To be able to attract borrowings, the mFI has to haveequity capital. Thus, it is only possible to establish a financially sustainable mFI either asa cooperative or as a company. In most states, with the exception of Andhra Pradesh,Maharashtra and Gujarat, cooperatives

are politicised and state controlled, and thus not an appropriate form of incorporation foran mFI. That leaves an mFI with the choice to be incorporated as a company and thenbecome an NBFC or a Bank. The latter requires a licence and a minimum start up equityof Rs 100 crores, which is very difficult for an mFI to mobilise. The concept of Local AreaBanks (LABs), with a lower start up equity of Rs 5 crores, has not yet beenoperationalised by the RBI.

Thus, at the moment there are only two options either be a cooperative in AP/Maharashtra/Gujarat or be an NBFC. If an mFI opts to be an NBFC, because of thereasons stated above, it finds it very difficult to mobilise any borrowings from Indianfinancial institutions due to the negative image of NBFCs in general. Further, even depositmobilisation is not possible at least for the first three to four years, till a satisfactoryrating is obtained. That leaves the option of borrowing from foreign institutions, which isdifficult in the first place. Further, very few foreign institutions are willing to give rupeedenominated loans. Thus, mFIs taking foreign currency loans are subject to exchangerate risks, which they would not be able to handle.


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Suggestions to increase financial resources for mFIs

SIDBI, NABARD and the NHB should consider extending refinance facilities or linesof credit to mFIs, which are incorporated as NBFCs or MACS. The interest ratescan be nearly commercial from 13.5 to 15 percent.

SIDBI, NABARD, and NHB should also consider making an equity investment inmFIs so as to strengthen their capital structure as well as give greater supervision.

The RBI should treat bulk lending to mFIs by commercial banks, particularly newprivate banks who do not have a rural or urban low-income area branch network,as priority sector lending.

The RBI should allow banks to treat bulk loans to microfinance NBFCs as prioritysector loans.

The RBI should operationalise the Local Area Bank policy without any delay.SIDBI/ NABARD/ICICI/HDFC/ etc. may consider taking an equity position in someof the LABs.

In states where there is a possibility to set up mFIs under progressive cooperativelegislation, such as the AP Mutually Aided Cooperative Societies Act (MACS), 1995,SIDBI/NABARD/NHB may consider funding such MACS directly or through an apexstructure such as the proposed AP Mahila MACS.

Start up equity capital is difficult for most promoters of mFIs because most ofthem come from a developmental background. Yet, it is prudent to havereasonably high start up capital requirements to ensure that mFIs are establishedas serious institutions. Thus we suggest that the National Equity Fund (NEF) maybe used for supporting mFI entrepreneurs.

Many foreign donors have taken a policy decision to experiment with fundingmechanisms other than grants soft loans, commercial loans, guarantees andequity. One of the issues related to loans from foreign donors is that of exchangerate risk. Most mFIs can not bear or even get cover for long term exchange ratefluctuations. Thus, many donors are willing to give loans which are denominatedand repayable in Rupees. This should be encouraged by the Government of India.

If necessary, a new scheme possibly called "Rupee Repayable Foreign CurrencyBorrowings (RRFCB)" can be established and powers given to the RBI toadminister it.

Donors should develop alternative mechanisms to provide equity support.However, this often may lead to a situation where initially, the equity capital heldby foreign donors exceeds 51 percent of the total capital. This is not allowed underthe Foreign Investment Promotion Board norms for financial services, unless theinvestment exceeds $ 5 million. Most donors would not put in $ 5 million in asingle mFI. Thus this limit should be reduced to $ 1 million for mFIs.

The government should consider extending the "sweat equity" scheme (whereinthe promoters' contribution of effort and experience is counted in monetary terms)

to the microfinance sector. This is very apt since most mFI promoters have littlemoney of their own, though lot of developmental experience.

5. 5.Organisational ConstraintsCertain organisational attributes are necessary for microfinance institutions in becomingsustainable and increasing access. These are discussed below:

Organisation Leadership and Governance


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There is an absence of a supportive framework for encouraging entrepreneurs andentrepreneurial organisations to enter microfinance and contribute to increasingoutreach and sustainability of financial services. This largely stems from thebarriers to entry in rural financial services due to government monopolies. Further,the attitude of apex FIs and donors supporting mFIs is also based on a view thatmicrofinance should be done by non-profits, rather than by for-profits.

Non-profit mFI leaderships usually do not have any incentive to adopt bestpractices related to managing financial service organisations. Governance andaccountability are limited in case of non-profits. (This is not to deny that there aresome high performing non-profits in microfinance, but they are exceptional). Thecurrent lenders to non-profit mFIs are just beginning to acknowledge this.

In case of mutual benefit type mFIs, the assumption is that member control wouldensure good governance. Member control gets seriously limited as soon as the sizeand distance of an mFI grows beyond a few hundred members and a few villages.Differences in income, literacy and exposure levels can lead to the problem ofcontrol by a few in coops.

In the case of for-profit mFIs, of which there are very few so far, the issue ofinvestor benefit vs. user benefit remains. This can be resolved partly by makingdepositors and borrowers also shareholders.

Human Resource and Management Information and Control Systems

The lessons from some of the best mFIs around the world show that it is possibleto provide microfinance services to the poor at reasonable cost provided use ismade of certain methodologies group lending, peer guarantees, step-ladderlending, matching repayment terms with borrower cashflows, etc. Moreover, usemust be made of information technologies and performance linked incentives forstaff. However, all these ideas are unacceptable in the current regime ofmainstream FIs, which are largely government owned, with unionised employeesand officers, resistant to computers and performance incentives. Like mainstreamFIs, many non-profit and mutual benefit organisations are averse to idea of

incentives and performance linked payments. In mainstream FIs, though there is no shortage of qualified staff, they require

exposure to microfinance and a shift in attitude and behaviour towards thismarket. Many mFIs are already performing this role of exposure and training ofbankers. However, in mFIs themselves, there is a shortage of good quality staff atall levels, from village level barefoot accountants to back office systemsadministrators. The more senior level staff usually have better alternativeopportunities in the mainstream. Finally, in mutual benefit type of mFIs, staffproblems are acute, particularly when they grow beyond the level of one or twovillages.

Some Suggestions to Mitigate Organisational Constraints

Organisation Leadership and Governance

A major mentoring program should be started in microfinance. Donors/fundersshould demand this as the "dividend" for their investment. Pioneer mFIs should beasked to spawn new mFIs every few years along with experienced humanresources to lead them.

The government should offer a golden handshake to the staff of non-viable ruraland urban bank branches by allowing them to run the branches as independent


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mFIs, with lower costs and better spreads. The government equity can betransferred to the staff volunteering for this, over a period of time, through anemployee stock ownership plan.

Governance and accountability are limited in case of non-profits and need to beimproved. Their Boards must be made aware of their financial liabilities in case offailure. The lenders should be more stringent and insist on nominating a few

directors. Non-profit mFI leaders should be given proper incentives in the form of bonuses to

adopt best practices related to managing financial service organisations. In case of mutual benefit type mFIs, member control must be ensured by

institutional investors/lenders. Repeated election of the same office bearers shouldbe discouraged.

In the case of for-profit mFIs, institutional investors/lenders must insist on Boardpositions if they are taking a stake of more than 10 percent.

Human Resource and Management Information and Control Systems

Performance linked incentives for staff should be encouraged.

In mainstream FIs, exposure to microfinance and a shift in attitude and behaviourtowards this market, should be accelerated. Many mFIs are already performingthis role of exposure and training of bankers.

In mFIs themselves, the shortage of good quality staff at all levels needs to beovercome by converting the pioneer mFIs into training institutions.

Use of computers and telecom equipment must be encouraged by mFIs andinstitutional investors/lenders should conduct sample checks of operating data.

Customer satisfaction audits by independent agencies must be conducted fromtime to time.

Conclusion:To return to the title, the microfinance movement in India has got stuck in amire of legal, policy and organisational constraints and needs a "dhakka" to get along itsway. We have argued for adopting a three track strategy in this paper: re-orienting

exiting FIs in favour of microfinance, encouraging new specialised mFIs who see this astheir business, and establishing a network of community-based financial institutions(CDFIs). Eventually, it is this category of institutions which would ensure that both state-controlled and market-oriented mFIs work for the benefit of microfinance users.

Appendix 1: Apex and Wholesale Institutions Supporting Microfinance in India:

A Preliminary Estimate

InstitutionBackground Cumulative

Disbursement

(Rs million)Cumulative

Intermediaries

(Number) Access(Number)

National Bankfor Agricultureand RuralDevelopment(NABARD)

An apex refinanceinstitution set up in1982. Has promotedlinkage of self helpgroups with bankssince 1992. Data forSHG linkageprogramme only.

Mar 98: 214Mar 97: 118

Mar 98: 260Mar 97: 220

Mar 98:250,000(SHGs linked14,283)Mar 97:150,000(SHGs linked


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8,598)SmallIndustriesDevelopmentBank of India(SIDBI)

Set up in 1990. MicroCredit Scheme (asmall portfolio)started in March 1994.

May 98: 57(Sanctions Mar98: 166)

Mar 98: 116Mar 97: 79Mar 96: 47

Mar 98:89,000Mar 97:61,600Mar 96:20,900

HousingDevelopmentFinanceCorporation(HDFC)

Mainly involved inhousing finance-including to lowincome groupsthrough NGOs since1992. Started supportto Micro-financeinitiatives in 1997

Jun 98: 1020 sanctioned808 disbursed,all of it except 8,for low incomehousing

Jun 98: 75 Jun 98118,000

Rashtriya

Mahila Kosh(RMK)

Department of Women

and ChildDevelopment (Govt. ofIndia). Set up inMarch 1993 withcorpus of Rs 310million.

Apr 98: 353

(Outstanding inMar 98: 160)

April 98: 257 April 98:250,462

dhaka starting micro finance in india

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