An Architectural Plan for a Microfinance Institutional Network
This paper proposes an architectural design for a microfinance service delivery network. It emphasises that savings followed by credit, insurance and money transfer, in descending order of priority, are the most important financial services needed by the poor. Microfinance may be classified as primary and secondary. Whereas the primary microfinance service includes savings, credit, insurance and money transfer, the secondary service includes enterprise credit, pension, equity transaction, leasing, etc. The paper then argues that competition with compassion and right to earn profit under the lens of a rational regulatory and supervisory framework and government’s active participation in capital formation, both human and physical, are the major forces necessary to fuel the healthy, sustainable and useful growth of microfinance institutions. The paper finally proposes a layout of the MF network, defining the roles of different entities, viz, government, central bank, microfinance authority, banking partner, rating agency, deposit insurance agency, promoter, capital provider, human capital building institution and, finally, MF clients.
R DASGUPTA
M
Whereas the first aspect is an operational barrier in terms of high transaction cost and high risk, the second aspect creates attitudinal barriers: generally, a middle or upper middle class person would prefer to do business with the better off rather than the poor.
Against this background the paper discusses the (i) attitudinal axioms, (ii) MF needs, (iii) MF reform requirement, and (iv) an architectural plan for the healthy growth of MF services. These have been discussed in Sections I, II, III and IV, respectively.
I Attitudinal Axioms
The following four axioms along with the empirical justification may be put forward to understand the barriers and find ways to overcome the same. Axiom 1: Mainstream financial institutions are not genuinely interested in MF services because of (i) higher transaction cost,
more than 40 per cent of microcredit in rural areas is serviced by informal institutions [RBI 2000]. (iii) During the immediate post-reform period, the share of priority sector lending came down to 33 per cent in 1999-2000 vis-à-vis the mandatory level of 40 per cent and agricultural lending to 11 per cent vis-à-vis the mandatory level of 18 per cent. Axiom 2: The central monetary authority is more comfortable by aligning itself to the wavelength of government. Justification 2: (i) In the immediate post-reform period, rural and microcredit were kept on the backstage when the government too shied away from rural and social sector investment. (ii) The priority sector instead of being debated was redefined, modified and expanded so that all the banks surpassed the limit of 40 per cent. The redefinition was biased against microcredit [Dasgupta 2001]; the proof of which is that a very few banks fulfilled the obligation of 10 per cent of weaker section credit in the postmodification period. (iii) The central bank occasionally shares its concern about the higher rate of interest, which is a part of the political speeches of government too, without making way for a conducive market environment, which can effectively reduce the interest rate. (iv) Without showing enthusiasm to bring new microfinance institutions (MFIs) under its regulation and supervision fold, the central bank disallows them from providing deposit services to the poor, which is the most important financial service. Axiom 3: The government makes pro-poor policies with more of political concern and less of economic and welfare concerns. It is attracted more towards “Haves” rather than the “Have-nots”. Justification 3: (i) The government instead of improving rural and agricultural infrastructure and formulating market-friendly agricultural policy, adopts a lazy route to instruct banks to increase the flow of agricultural credit, not necessarily to marginal and small farmers. (ii) The government, fully knowing
Economic and Political Weekly March 18, 2006 the inefficacy of government-sponsored credit schemes and perils and leakage of the subsidies, continues with the scheme in some form or the other to avoid the wrath of pseudo supporters of poor.
(iii) On the one hand, the government “forces” the banks to lower the rate of interest to the agricultural sector; on the other hand it restricts both intra and inter-country trade. Both together help only the local, urban vocal consumers, not the poor farmers.
(iv) Government’s “loan-waiving” policies do not help the borrowers in the long run. They become “blacklisted” in the banks. Also, the banks lose strategic interest in that sector. (v) The government does not provide any incentive for MF services, which may enthuse the banks to evaluate the commercial viability of such services. Axiom 4: Whenever the deterioration level reaches a nadir, society awakens, a leadership emerges, experiments are conducted and pressure is put on the “rulers” to change the working of the system. Justification 4: (i) The self employed women’s association (SEWA) formed a union in 1972 to fight for their rights and to combat the oppressive terms of the informal credit sector and started SEWA Bank in 1974, owned by small women [NABARD 1995]. (ii) The Mysore Resettlement and Development Agency (MYRADA), initially set up for the resettlement of Tibetan refugees in Mysore, felt the need for an alternative credit system for the poor and experimented with a credit management group (CMG) which is the forerunner of self-help group (SHG) [NABARD 1995]. (iii) During the same period that Mohammed Yunus established the Grameen group model which attracted world attention, a few Indian NGOs responded to the model and started providing financial services to the poor. (iv) Some of the MF leaders besides providing services, started lobbying with the monetary authorities. Consequently, NABARD launched a pilot project to experiment with 500 SHGs in 1991-92; the Reserve Bank of India (RBI) constituted a working group to study the experiment in 1994 and finally came up with a circular in 1996 to allow and encourage banks to carry out business with “informal” SHGs which indeed was a landmark policy in the area of financial management.
In this kind of axiomatic environment, very few MFIs continue to exist to fulfil the demand unless a strong civil society exists to influence government policies. Although commercial banks were nationalised and a large number of rural branches were opened, only around 5 per cent of small and marginal farmers have access to commercial banks and less than 10 per cent of net bank credit goes to weaker section people [Dasgupta 2005]. This is despite the fact that 40 per cent of rural credit which is mostly microcredit is met by the informal financial system [RBI 2000]. Regional rural banks (RRBs) were especially created to cater to the need of the poorer people. But not much attention was paid to professionalism and sustainability. As a result, in 1992, after 15 years of existence only 23 RRBs out of 196 RRBs were in profit. Efforts were made to strengthen them. Subsequently, 160 were in profit in 2004; 90 are, however, still having an accumulated loss. But the strengthening process has completely changed the characteristics of the RRBs. The credit deposit (CD) ratio of RRBs is around only 40 per cent. More than a quarter have a CD ratio of less than 25 per cent [Dasgupta and Rao 2003]. They have ceased to be credit, let alone microcredit, institutions. So far as the cooperatives, again created for poor, are concerned they have been hijacked by the less poor, the landowners and allied political interests [Harper 1998]. India is one of the countries having a problem with credit cooperatives [Yaron 1992].
All these only highlight the scarcity of MFIs in India. The situation has arisen, perhaps because, these institutions are statesponsored commercial institutions mixing business and welfare traits in a single product, not market-driven business institutions. The above-mentioned axioms have led to policies and strategies not based on economic principles of competition, market price, appropriate performance appraisal policy, long-term innovative investment and enhancing credit productivity through credit plus efforts, but on charitable or vote bank considerations like subsidies, lower rates of interest, waiving of loans, meeting targets, government-sponsored schemes and, most unfortunately, politisation of credit. No effort has been made to either ignite private formal interest or encourage the informal system to reach the masses at competitive prices.
There is, however, a marginal change in the thought process due to axiom 5. Experiments are being conducted; a few new policies are being announced. Private initiatives have resulted in a large number of MFIs, some of which in fact transact loan business of few hundred crores of rupees with poor people. However, this is not enough. A paradigm shift is required from “financial sector reform” to “microfinance sector reform” for a much more widening and deepening effect across the country.
II MF Needs
It is important to understand the MF needs and the nature of MF services required before discussing the reform process and designing the architecture for MFIs. As mentioned earlier MF implies providing financial services in a small quantity to poor people. However, informal surveys indicate the following needs of poor in descending order of priority: (i) savings,
(ii) credit, (iii) insurance, and (iv) money transfer. Besides the above, pension, equity transaction, leasing and any other financial services too in small quantities may be added to the menu list of MF.
Again, informal discussions list the following reasons for savings in the descending order: (i) safe custody for future consumption during the lean period, (ii) old age (pension substitute), (iii) exigency (insurance), (iv) purpose based, viz, marriage, education, pilgrimage, etc, (v) asset creation, etc. What it underlines is the major emphasis on the “security” character of savings, rather than the “growth” character which has much less significance.
So far as credit requirements are concerned, the needs in descending order are (i) life cycle, (ii) emergency, (iii) primary economic opportunity, i e, operation and expansion of existing business, and (iv) secondary economic opportunity needs, i e, investment and asset creation in a new venture. The last is in fact not a general internally driven need of the poor, but a need envisaged by civil society. Whereas the first three may be termed as a microcredit need, the last one may be categorised as microenterprise credit need within a broad classification of microfinance.
Within insurance services, (i) savings and deposit, (ii) health and accident, (iii) production failure, (iv) market failure, (v) life, and (vi) asset protection are the different needs in a descending order of priority.
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Whereas microsavings, microcredit, microinsurance and money transfer may be categorised as primary microfinance services; microenterprise credit, pension, equity transaction, microleasing, etc, can be categorised as secondary services. The need for primary services arises out of internal demand, whereas the need for secondary financial services generally arises out of external societal perception and demand and requires non-financial assistance like (i) capacity building and (ii) forward and backward linkage in a large amount. Whereas the primary financial services basically improve the financial inclusion and alleviate poverty by reduction of personal cost, the secondary services attempt to attack poverty through the growth process. Both are important. However, unless the poor graduate in the inclusion process, they may not succeed in the growth process.
III MF Sector Reform
The main objective of the reform has to ensure growth of sustainable MFIs to increase the access of the poorer people to competitive financial service for (i) availment of the service, as discussed above and (ii) use of the financial resource for increasing income for both personal gains and sustaining economic growth.
To fulfil the above objective, two sets of factors: (i) the demand and (ii) supply sides need to be addressed. Demand side factors include the ability to (i) avail the service, (ii) respect the service, and (iii) utilise the resource efficiently. On the other hand, supply side factors include (i) capital, (ii) regulation, (iii) supervision,
(iv) delivery models, (v) sustainability, (vi) adjustment to ability level of the demand side and then improving the ability level.
For this, an environment of competition, compassion, cooperation, commercial and curiosity needs to be created so that the MFIs respect regulation, reporting, rigour, rating and result. The policy-makers have to create the above environment for the healthy growth of MFIs with above features. Otherwise “bad money will drive away the good money”.
Competition is the keyword in any market economy, which gives the consumer the best product at the least cost. The same is true for the supply of financial services. However, there will be competition for commercial, i e, profitable not any lossmaking, proposal; secondly competition entails easy entry. Competition therefore has to be engineered by reducing the barrier, allowing earning adequate profit through a transparent process for generating curiosity among others to enter into the business to create further competition to reduce prices and provide an efficient service. A compassionate approach is required to nurture this process. The poor may not be readymade customers; they need to be strengthened with compassion to enable them to avail the service efficiently. At the same time, cooperation is required from the MF clients so that they understand the business requirements of the service providers and abide by the rules. They need to be truly empowered through a capacity building process so that neither they do any wrong, nor they let others do any wrong. Competition, if unregulated, may lead to the monopoly defeating the market philosophy. Too much of aggressive competition resulting in faulty decisions, however, may cause a breakdown of the system. Regulation and supervision therefore are extremely necessary. Whereas regulation makes rules and norms, supervision ensures compliance.
Regulation and supervision imply that the MFIs are rigorous in their accounting process; transparent in reporting necessary information to the microfinance authority (MFA) and public at large; strive for mandated results efficiently for which they have established themselves; and get themselves rated regularly through a transparent process to make use of the available resources for the deployment towards the poor.
For mainstream financial institutions the MF business may be cost intensive because of a high establishment cost, which increases both transaction and risk cost. Low cost MFIs alone with a rich information of the local environment, low transaction cost and presumably low establishment cost and high attitudinal inclination can provide competitive financial services. Unfortunately, these local players are expected to lack (a) capital and also (b) local deposit resources in the beginning. The vision of the MFI therefore is expected to create (a) a deposit resource from these poor MF clients and (b) a capital base by expanding business with the poor for slowly and gradually graduating to mainstream financial institutions.
As both deposit opportunity and credit absorption capacity are very small in the beginning, the capital requirement for any financial institution (FI), especially an MFI, need not be mandated as an absolute amount, but it has to be in relation to the level of business or level of asset (loan) created, i e, a capital adequacy ratio to adequately cover the risk of depositors.
In the operation of FIs, capital is supposed to have two significant aspects: (i) size and (ii) protection of depositor’s interests. Size determines the level of business and size is expected to influence efficiency. However, so far as the size effect is concerned, there is no conclusive proof as yet whether size is correlated with profitability [Rammohan 2005; Bagchi and Banerjee 2005]. In the case of mainstream FIs, rather it is argued that it prevents competition. The second aspect is indeed important. However, capital size alone cannot take care of depositors. The financial business depends upon trust, which is generated out of the good health of the institution. Otherwise, no FI in case of a collapse can take care of depositors with its all-inclusive capital.
There are, therefore, quite a few preventives like the capital adequacy ratio, asset classification, income recognition, provisioning, exposure limits, investment fluctuation reserve, etc, which are more important. Besides, there is the provision of deposit insurance. Although good health in terms of “high net worth”, which is the outcome of high profit and low nonperforming assets, is important for all the FIs, it has to be extraordinarily good for MFIs to protect depositors’ interest, as a large number of depositors have a deposit level much more than Rs 1 lakh, which is insured. The gap needs to be protected through the net worth, which is indeed a combination of capital size and good health. But as argued earlier, in case of a collapse, even net worth may not be able to protect the entire deposit amount, which can be protected only through trust and good health.
In the case of MFIs, the role of capital in terms of protection of interest is still less as there will be hardly any deposit account with Rs 1 lakh or more, which cannot be completely insured. It, however, can be argued that in case of a zero-capital MFI, the insurer may not have the confidence in the MFI for insuring the deposit. Minimum capital is therefore necessary. A minimum amount of start-up capital, however, is again necessary for carrying out the operation till the revenue takes care of expenditure.
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The above discussions underscore the importance of logistics in terms of (i) capital, (ii) health, and (iii) faith for success of microfinance activity.
Capital
Logic demands that capital criteria should not be used as a tool for barrier to entry; capital is expected to define the size of business, promising an adequate return. As the size of business of MFIs is supposed to be small at least in the beginning because of (i) a lower propensity to save, (ii) low income level, (iii) low credit absorption capacity of the prospective clients, and also the
(iv) low professional skill of the MFI, the capital requirement to start the MF business may be small. Statutory requirement too therefore needs to be small.
Assuming (i) credit level of Rs 5 lakh in the initial years with repayment cycle of not more than two years, (ii) about Rs 3 lakh of annual expenditure, and (iii) five years to attain sustainability, about Rs 25 lakh of capital may cater to the credit need of about 1,000 poor people of five villages. By this time, the MFIs are expected to gain experience, confidence and more importantly, build up larger resources through surpluses and deposits for expanding the activity to a large number of villages at least the entire block.
Whereas a majority of the MFIs may be having a business of few lakhs of rupees, a very few as mentioned earlier may have business of a few hundred crores. Both cannot be evaluated at par. The MFIs therefore may be broadly classified into three categories: (i) small local level, MFIs (SLMFI) operating in a few villages within a district with loan outstanding of up to Rs50 lakh,
(ii) medium size wide level MFIs (MWMFIs) operating in a few districts within a state with business level less than Rs 5 crore, and (iii) big size vast level MFIs (BVMFIs) operating in neighbouring states with a business level of more than Rs 5 crore. Capital requirement for these three types of MFIs may be fixed at the level of Rs 25 lakh, Rs 50 lakh and Rs 2 crore respectlvely.
Health
Health is a function of good nutrition and a good metabolic process, both under the watchful eye of a doctor. Nutrition is derived from the income process, which depends upon business size, cost and price. MFIs must be allowed to cover the entire cost. Rate of interest charged by MFIs and mainstream FIs are not comparable. Whereas the rate of interest in case of the latter is the cost of funds alone for the borrowers, in case of the former it includes transaction and opportunity costs too, since MFIs provide doorstep service while mainstream FIs provide the service at branch. The price must be controlled by the “market” rather than the “command” mechanism. What is, therefore, important is to maintain the competitive environment. This is the fundamental reform requirement.
The second aspect of health is a good metabolic process or internal functioning of the MFI. The first job in this direction is to develop (i) an efficient information system, (ii) expertise to diagnose the information, (iii) ability to suggest good medicine, and (iv) authority to carry out a surgical process to tackle a cancer which cannot be cured by medicine.
What is thus required are: (i) a very efficient reporting system,
(ii) an effective regulator, (iii) a trained supervisor, and (iv) a rigorous rating mechanism. For efficient and fast processing of information, technological infrastructure is again a necessary condition.
Faith
Lastly, faith in the system is important for (i) MFI depositors who consider the system as custodian of their savings, (ii) MFI borrowers who can have access to this institution for genuine credit need, (iii) the MFI promoter who can run it as profitable venture, and (iv) the provider of capital either as equity or debt who can expect competitive return on their capital.
For the first category of agents, deposit insurance is the first condition. For the credit seekers, credit plus items in case of micro enterprise credit are more important. For third and fourth categories the right to earn competitive profit is essential.
The fundamental reform process therefore warrants an environment which encourages entry of a large number of MFIs, allows competition, formulates right rules and ensures compliance so that the MFIs have a healthy growth which command, not demand trust.
IV MFI Architecture
The first issue is whether another set of MF legislation and regulatory framework is required or not, when already a large number of institutions are providing the required service under a different regulatory system. The answer is very much yes, as all financial service providers must come under one roof because all such institutions are somehow interlinked and a failure of one may have a cascading effect on the other. One small ignition may cause a big fire. Secondly, the existing framework is not very conducive for a healthy growth of MFIs: (1) societies, trusts and section 25 companies are inappropriate for the for-profit business which is extremely important for sustainability of MFIs, and attraction of capital from market, and cannot accept deposits which is the most important MF service; (2) non-banking finance companies (NBFCs) require a capital of Rs 2 crore to start a business, which is high for local level MFIs; deposit mobilisation is not easy as lending with poor is considered risky, and it makes difficult for MFIs to get investment grade which is necessary for deposit collection; (3) nidhi companies under section 620 of the companies act can lend against collateral only, which violates the definition of microcredit, i e, collateral free (tangible) credit;
(4) state-controlled cooperative banks have a poor public image, and now extremely difficult to get licence from RBI; (5) virtually unregulated mutually aided cooperative societies (MACS) may indulge in risk taking behaviour resulting in collapse, and do not attract tax exemption [Sa-Dhan 2006]. Registering as a local area bank (LAB), which requires a higher capital amount of Rs 5 crore is another option. It is, however, very difficult to get a licence from RBI.
Some of the rules with regard to capital requirement or deposit mobilisation may be relaxed. But the advantage may be taken away for non-poor clients. It is therefore important to have a new legislation with poor clients in the centre: satisfying their needs and creating architecture to suit their convenience.
With the above aspects in mind, a design has been proposed in the accompanying chart giving the required architecture for MFIs, which incorporates financial service demands and reform elements.
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Central bank Regulation (Delegation of power) Supervision monitoring S and M data bankMF authority S and M Output information (Setting up recommendation) (Information)MFIs (Feedback) Financial Services Credit Plus Activities (FSCPA) Banking partner Promoter Capital provider promoter individuals donor MFI (Developing human capital) Rating agency (Output information) Deposit insurance agency Clients (Obligation) (Creation)(FSCPA) (Decision)(Input information) Chart: Architecture of MFI Operation
Government
Legislation incentive policy
Apex level training and
human capital
Capacity-building,
research institutions governance, business
project analytical studies
(Developing human capital)
The six crucial entities in the design are (i) central bank, the ultimate authority on regulation, supervision and monitoring of any financial institution, (ii) a MF authority (MFA) to take up the job of regulation, supervision and monitoring of MFIs on behalf of the central bank, providing the summary information and crucial signals to the central bank, making accessory services like rating, deposit/credit insurance available through existing or newly set-up institutions, (iii) the central government, making necessary legislation for creation of MF architecture, financial policies for the healthy growth of MFI like tax incentives, access to financial resource for providing service to the poor, reforming labour laws for the benefit of both MFIs and their staff, and creation of human capital for the development of MFIs,
(iv) supporting institutions like rating agencies, deposit insurance agencies, training institutions, etc, (v) banking partners providing banking facilities to the poor client directly or indirectly through the MFIs, and finally (vi) MFIs, the service providers.
MFI may be promoted by a single or group of individuals or any institution including mainstream FI with own and/or marketcapital after obtaining an appropriate licence from the MFA for providing services to the poor and low-income people. Since a MFI is basically meant for the poor, at least in the entry level, it may be useful to design a unique identification number for all Indian citizens. The national database may store this identification along with other information like religion, caste, income, literacy, landholding, profession, etc, for different administrative and analytical purposes. The database may be modified every 10 years during the census.
The MFIs will choose a scheduled commercial bank as a banking partner for banking transaction on behalf of its clients. The main job will be to deposit savings and transfer money. The proposed MFIs will spell out its business plan, jurisdiction, growth plan and expertise in the application form for the grant of licence. The MFA while granting licence on the basis of the above will determine the capital structure over a period of time. The MFIs will not have any access to any government financial resource as financial capital for direct financial operations.
Initially, the MFIs will not use the deposit of the clients for lending operations. The amount will be with the banking partner. Lending will be done from its capital and reserve. The deposit base can be used for lending operations only after the deposit insurance agency agrees to bring the MFI into its fold after getting a nod from the rating agency. Rating agencies will provide the fee-based services to the MFIs. The MFA will prescribe a ceiling on the use of deposit for lending purposes which will be determined by the cash reserve ratio and the rating score of an individual MFI. While the MFA will deal with the individual MFI, the overall formula will be endorsed by the central bank, the ultimate monetary authority.
The MFA will design the supervision and monitoring model. It may be in the line of recommendation of the 1999 task force of NABARD. As both the number of institutions (MFIs) and number of clients are going to be very large, the technological infrastructure is an extremely important item in the development of the MFI network. There has to be a minimum amount of availability of technological infrastructure with the MFIs for creating a proper database and providing information to the MFA. The MFIs will provide all the necessary financial services to the poor on their own and also in collaboration with banking partners and other FIs. They will also tie up with other institutions for providing necessary credit plus services to clients by charging a competitive fee.
The government will not have any direct relationship with any MFI and its clients. The main job of the government will be to create a competitive environment for the birth of a large number of healthy MFIs without interfering in their implementation and administrative process.
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In this regard, the first task of the government is to bring a legislation for MFIs underlining (i) the definition of microfinance in both qualitative and quantitative terms, (ii) a new registration act indicating capital requirement, regulatory and supervision authority, (iii) character of the MFI in terms of nature of operation to be carried out directly or indirectly, clientele group, area of operation, sources of fund, use of surplus, income tax rules, governance, etc.
The second and a very important task of the government is to take an active part in the development of human capital for MFIs. The government has already proved its credibility in this regard by successfully establishing Indian Institutes of Management, Indian Institutes of Technology (IIT), universities and other educational institutions, which are the pillars of success of the Indian industrial and financial sectors. Similarly, institutions need to be established by the government for development of the microfinance sector. At present, some of the MFIs complain that they are creating human capital, only to be plundered by the neighbours. This discourages MFIs to engage in activity which ultimately results in loss for MF clients, i e, the poor. The government as it has done in the past for the benefit of the “haves” must actively take part in the process of human capital formation, which is going to influence the life of the poor. The poor themselves require both educational and vocational inputs, which too must be met by the government. All this may be through building new institutions, strengthening existing institutions and modifying the existing curriculum in the educational network.
Besides creating human capital, the government needs to be a party to the process of all other necessary physical capital formation. In any case the government must not engage itself in providing the financial service in any form, and all the costs incurred at present must be diverted to human capital formation or incentivising the environment.
Postscript
As the time passes, new demands may be generated; cracks may be found in the existing design; and another architectural plan may be required. There is always scope for new institutions. Development is all about creation and destruction of institutions as per the demand of time.
m Email: nibmweb@nibmindia.org
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