Anand Sinha: Strengthening governance in Microfinance Institutions
(MFIs) - some random thoughts
Keynote address by Mr Anand Sinha, Deputy Governor of the Reserve Bank of India, at the
Federation of Indian Chambers of Commerce and Industry's (FICCI) workshop on
"Strengthening Microfinance Institutions (MFIs) - good governance and strategic people
practices", Mumbai, 23 April 2012.
* * *
Inputs provided by Ms Deepali Pant Joshi, Mr C D Srinivasan, Mr A K Misra, Ms Tuli Roy and Mr Jayakumar
Yarasi are gratefully acknowledged.
Thank you for inviting me to deliver the keynote address at this microfinance workshop.
Microfinance is currently at the centre of intense policy debate, especially, in the context of
governance and regulatory oversight related issues. The current workshop which focuses the
deliberations on governance issues in microfinance is, therefore, quite timely as well as
contextually relevant. I congratulate the organisers on their choice of subject for this
workshop and hope that the deliberations will help all of us in going forward.
Microfinance, involving extension of small loans and other financial services to low income
groups, is a very important economic conduit designed to facilitate financial inclusion and
assist the poor to work their way out of poverty. It has the potential to fill the critical gap left
by formal financial institutions in providing financial services to low income groups.
Mainstream institutions shied away from providing financial services to the poor considering
them unviable owing to high costs involved in reaching out to the unbanked/under banked
areas where there is not enough scale of operations due to low numbers and low value of
transactions. Other reasons cited for such exclusion are, perceived high risk and inability of
poor borrowers to provide physical collateral for raising loans.
Microfinance became a leading and effective strategy for poverty alleviation with the potential
for far-reaching impact in transforming the lives of poor people. It is argued that microfinance
can facilitate the achievement of the Millennium Development Goals (MDGs) as well as
national policies that target poverty reduction, empowerment of women, assisting vulnerable
groups, and improving standards of living. As pointed out by the former UN Secretary
General Kofi Annan during the launch of the International Year of Micro Credit (2005):
"sustainable access to microfinance helps alleviate poverty by generating
income, creating jobs, allowing children to go to school, enabling families to
obtain health care, and empowering people to make the choices that best serve
their needs".
Although microfinance cannot be seen as a panacea for poverty reduction, when properly
harnessed, it can make sustainable contributions through financial investment leading to the
empowerment of people, which in turn promotes confidence and self-esteem, particularly for
women. More importantly, the global experience with microfinance has shown that even poor
are creditworthy.
Studies have shown that microfinance plays three critical roles in development. Firstly, it
enables the very poor households to meet their most basic needs and protect/hedge against
risks. Secondly, concomitantly it is associated with improvements in households' economic
welfare. Thirdly, by supporting women's economic participation it helps to empower women
and promote gender equity.
I. Microfinance and India
Inclusive growth always received special emphasis in the Indian policy making. Government
of India and the Reserve Bank of India have taken several initiatives to expand access to
financial systems to the poor. Some of the salient measures are nationalisation of banks,
prescription of priority sector lending, differential interest rate schemes for the weaker
sections, development of credit institutions such as Regional Rural Banks, etc.
Despite the policy efforts, gap remains in the availability of financial services in rural areas.
The dependence of the rural poor on money lenders continues, especially for meeting
emergent requirements. Such dependence is more pronounced in the case of marginal
farmers, agricultural labourers, petty traders and rural artisans belonging to socially and
economically backward classes and tribes whose capacity to save is too small.
It is in this backdrop that microfinance emerged in India. The Self-Help Group (SHG)-Bank
Linkage Program (SBLP) which was launched in 1992 on a pilot basis soon grew
significantly. As per the latest estimates, SHGs enable 97 million poor households' access to
sustainable financial services from the banking system and have an outstanding institutional
credit exceeding Rs. 31,200 crore as at the end March 2011. SBLP is considered to be the
fastest growing microfinance initiative in the world. The other model of microfinance, i.e. MFI
model comprising of various entities, such as, non-banking financial companies (NBFCs),
non-governmental organisations (NGOs), trusts, cooperatives, etc. has also been growing
significantly in the recent years.
Microfinance- both SBLP and the MFI sector- has posted an impressive growth in the past
few years with the combined client outreach increasing from about 4.8 crore1 in 2006-07 to
8.6 crore in 2009-10. Loans outstanding to SHGs were Rs. 28,038 crore while loans
disbursed to MFIs by all agencies amounted to Rs. 13, 955 crore at the end March 2010.
II. Recent developments in microfinance sector
There has, however, been a sudden downturn in the prospects of the sector in the second
half of 2010-11 owing to reported excesses of some MFI institutions and the consequent
legislative response by a state government. On the back of these developments, the MFI
segment has taken a severe beating with rising delinquency ratios and downgrades by rating
agencies. Lenders have turned wary leading to drying up of funding channels seriously
impinging on the business. It is reported that disbursements by MFIs in Andhra Pradesh
plummeted significantly in the second half of 2010-11. The recovery rates that were 99 per
cent reportedly fell to a meagre 10 per cent, leading to huge NPAs which is causing
significant stress on the functioning of MFIs. While the loans given to MFIs during 2010-11
declined to Rs. 8448.96 crore from Rs. 10,728.50 crore in 2009-10, the amount of
outstanding loans reduced from Rs. 13,955. 75 crore in 2009-10 to Rs. 13,730.62 crore in
2010-11.
Many analysts attribute the current crisis to the irrational exuberance of some MFIs who
entered the segment with the sole emphasis on business growth and bottom lines. They
perhaps did not take due cognisance of the vulnerability of the borrowers and the potential
socio-political ramifications their aggressive approach could possibly lead to. The competition
among MFIs led to these institutions chasing the same set of borrowers, by free riding on
SHGs and loading them with loans that borrowers, possibly, could not afford. It is reported
that as at the end of March 2010, the number of loan accounts per poor household in Andhra
Pradesh was on an average more than 10. In their eagerness to grow business, the
institutions had given a go by to the conventional wisdom and good practices such as due
diligence in lending and ethical recovery practices. Over-indebtedness of the borrowers led
to difficulties in repayments and the forced recoveries by some MFIs led to public uproar and
the subsequent intervention by the state government.
The legislation enacted by the Andhra Pradesh Government has brought the customer
protection issues to the centre stage. The legislation stipulated mandatory registration of
MFIs, disclosure of effective interest rate to the borrowers, ceilings on the interest rates and
strict penalties for coercive recovery practices. One of the fall outs of these developments
has been the severe dent in the MFI business due to dwindling resources.
Reserve Bank constituted a Committee (Chairman: Shri Y H Malegam) to study issues and
concerns in the MFI sector. The Committee examined the issues and made
recommendations to address the present concerns. Some of the significant
recommendations are as under:
i. creation of a separate category of NBFCs operating in the microfinance sector to be
designated as NBFC-MFIs.
ii. imposition of a margin cap and interest rate cap on individual loans;
iii. requirement of transparency in interest charges;
iv. lending by not more than two MFIs to individual borrowers;
v. creation of one or more credit information bureaus;
vi. establishment of a proper system of grievance redressal procedure by MFIs;
vii. creation of one or more "social capital funds";
viii. continuation of categorisation of bank loans to MFIs, complying with the regulation
laid down for NBFC-MFIs, under the priority sector, etc.
The recommendations of the Committee have brought out clarity in regulation of MFIs and
led to the containment of the crisis without domino effect. Based on the recommendations of
the Malegam Committee, the Reserve Bank of India has issued detailed guidelines
permitting categorisation as priority sector advance, of bank credit to certain eligible MFIs.
Such eligibility is linked to core features of microfinance, such as, lending of small amounts
to borrowers belonging to low income groups, without collaterals, with flexible repayment
schedules and with particular emphasis on measures to curb over-indebtedness. Margin
caps and interest rate caps have also been stipulated to ensure protection of borrowers.
Subsequently, the Reserve Bank of India created a separate category of NBFCs dealing in
microfinance - NBFC-MFI and issued comprehensive guidelines covering, inter alia, fair
practices in lending such as transparency in interest rates, non-coercive methods of
recovery, measures to contain multiple lending and over-indebtedness.
Government of India has come out with The Microfinance Institutions (Development and
Regulation) Bill, 2011 which, among other things, envisages the Reserve Bank of India as
the sole regulator of microfinance sector covering all forms of MFIs in addition to
NBFC - MFIs which are presently being regulated by the Reserve Bank. The Bill has been
circulated among various stakeholders for their views.
III. Key lessons and the way forward
Having briefly covered the background to the current state of affairs let me now focus on
some of the specific issues that need to be examined to address the current impasse. While
a number of reasons have been attributed for the turmoil in the sector, such as, unjustified
high rates of interest, lack of transparency in interest rate and other charges, multiple lending
and over-borrowing, coercive methods of recovery, etc. I would consider the governance
deficit coupled with people risk, process risk and relationship risk as the more critical factors
that have precipitated the turmoil and need to be addressed. MFIs need to seriously examine
their governance systems and align their practices with the overall objective of microfinance
which is to facilitate financial inclusion and empower poor.
Governance in MFIs
Governance, as we all know, is essentially about doing business and maximizing
shareholders' wealth legally, ethically and on a sustainable basis. Being fair and to be seen
as being fair to all the stakeholders without discrimination or bias, is the test for good
governance. Governance system represents the value framework, the ethical framework, the
moral framework as also the legal framework under which business decisions are taken.
Governance would encompass self regulation both at the individual entity level and at
industry level through the SRO mechanism. These two would form the first line of defence
with the regulatory framework providing the backstop. In the absence of effective self
regulation, the regulatory framework becomes more prescriptive which raises costs to
regulators and supervisors in administering the regulatory framework and also increases
compliance costs to the regulated entities. This clearly is a suboptimal solution. The
considerable intellectual appeal of principles based regulation which had committed
proponents is a case in point. In the wake of the subprime crisis of 2008, it has yielded
considerable ground to the proponents of rules based regulation. Let me clarify that
principles based regulations and rules based regulations are not binary choices. What
distinguishes them is the less or more prescriptive regulations.
Governance is based on the basic tenets of transparency and accountability. Transparency
in decision-making provides comfort to all stake holders and accountability which follows
from transparency fixes responsibilities for actions taken or not taken. Together they
safeguard the interests of the stakeholders in the organisation.
There were serious deficiencies observed in the governance framework of some of the MFIs.
The corporate governance issues in the MFI sector were exacerbated by some of the
"for profit" MFIs, dominated and controlled by promoter shareholders which led to inadequate
internal checks and balances over executive decision making and conflict of interests at
various levels. Other undesirable practices such as connected lending, excessively generous
compensation practices for senior management, founders/ directors and failure of internal
controls leading to frauds precipitated the crisis. Some of the MFIs chased high growth
trajectory at the expense of corporate best practices. The listing and trading of the shares of
the "for profit" MFIs generated a set of incentives which attracted capital looking for high
returns whereas the capital suited for catering to the needs of the poor has to be patient
capital. This disconnect led to further worsening of the situation. What is more disturbing is
that there were enough warning signals of trouble in making over an extended period of time
but the MFIs, at least some of them, carried away by their immediate success, failed to pay
heed. These events have been narrated by Dr. Y V Reddy, former Governor, Reserve Bank
of India in an article titled "Microfinance Industry in India: Some thoughts" in Economic and
Political Weekly (EPW) (October 8, 2011). Relating the events in Andhra Pradesh, he has
stated that Government of Andhra Pradesh always had discomfort with the NBFC-MFIs and
every effort was made by the Reserve Bank of India to introduce a voluntary code of
conduct. Resolution in this regard was thought to have been achieved in 2007. In retrospect,
Dr. Reddy says that perhaps the trust that Reserve Bank placed in the commitment of MFIs
was misplaced and, given the track record, the Reserve Bank should have insisted on
enforceable regulation and not been content with an advisory role. Dr. Reddy's observations
lead to another very important tenet of corporate governance i.e. the need to pay attention to
the feedback loops, particularly the negative feedback loops and to take mid-course
corrective actions. Those who fail to do so, end up paying a heavy price.
Inclusive finance vs. regulations2
History is replete with examples that good intentions may not always lead to good outcomes.
Intentions need to be adequately backed by sound framework of governance and regulation.
This is demonstrated by the experience of sub-prime housing loans in US and microfinance
in India. When private sector emerged in microfinance, regulation responded positively by
providing a supportive enabling environment: (a) lending by banks to MFIs for on lending was
deemed priority sector; (b) banks were advised to lend to MFIs without a cap on interest
rates and (c) group guarantees were deemed as collateral for the purposes of asset
classification, prudential and provisioning norms. MFIs were expected to be carrying forward
the agenda of inclusion, and were fully aligned with the banking system. MFIs, however,
enamoured by the fast growth and expanding balance sheets, shifted goals, strategies and
practices. Dr. Reddy has observed in the same article that the assumption that the people
working in MFIs were committed to a value framework that aims at profit-making but not
profiteering or profit maximization, was not validated, going by the organisational structures
and incentive frameworks as well as the lifestyles of senior managers.
The MFI episode in India has, at least, two close parallels with the subprime crisis of 2008.
First, the origin of the subprime crisis was about extending loans well beyond the borrowers'
capacity to pay and second, compensation practices were a major contributing factor to the
crisis as these practices were designed to enhance risk taking and create value for share
holders but not to protect other stakeholders. Corrective actions are being taken in the
context of regulatory reforms for banks thorough, Basel III guidelines and for MFIs through
guidelines based on the Malegam Committee recommendations.
Learning from the crisis, we need to build a regulatory framework which ensures a balance
between flexibility to MFIs in their operations and regulations that ensure customer protection
and financial health of the MFIs. In the long run, MFIs also will be benefited by such
regulatory framework as it enables orderly growth and reduces uncertainty. The envisaged
regulatory framework must put in place restrictions and safeguards with regard to minimum
standards of governance, management and customer protection as well as the financial
health of MFIs. Naturally, robust regulations coupled with thorough risk based onsite and
offsite supervision are needed to foster entrepreneurship while encouraging inclusive and
sustainable economic growth, especially with reference to end users. This balance would be
provided by the regulatory framework derived from the Malegam Committee Report and the
SRO framework.
Balancing the dual objectives - social and financial
There is no denying the fact that self sufficiency and financial sustainability are the objectives
that MFI could pursue. However, in the race to earn profits, the social objective should not be
lost sight of. Mission drift, where the institution deviates from its original mission in pursuit of
a conflicting unannounced mission, is a major risk the MFIs face. The Boards of MFIs will
have to balance the objectives of various stakeholders, viz., the equity holders, the donors,
the borrowers and the overall society. Strong corporate governance could play a critical role
in balancing seemingly exclusive but potentially complimentary objectives from a long term
perspective.
The question of balance between profits and serving the financial services needs of the poor
is certainly an issue for MFIs. It is often asked that if the MFIs moderate their pace of growth
and shift their priorities more towards social objectives, would they be able to attract enough
investors to provide capital to enable the MFIs to take their activities designed to help the
poor forward. Similar questions have arisen in the context of substantially enhanced
regulatory framework for banks under Basel III, in particular the much higher capital and
liquidity requirements. There is an apprehension that with much larger capital and liquidity
requirements under Basel III to support similar level of activities, the Return on Equity (RoE)
would go down appreciably and consequently banks may not be able to attract investors to
provide capital. This line of thinking disregards the risk-return trade-off and the fact that
banks can raise their productivity and efficiency levels to protect their ROEs, at least partially.
It is hoped that when investors see a much more stable and safer banking system they would
be willing to supply capital at lower returns. Similarly, MFIs, which align their business
objectives with the requirements of the social segment they cater to, would be seen as stable
and less risky and would certainly prove attractive to the investors than the ones that provide
extraordinary but unstable returns. In this context, I would like to draw your attention to
Malegam Committee's recommendation of "creation of one or more domestic social capital
funds".
Customer protection and responsible finance
Responsible finance is the most important lesson from the current episode. Given the
vulnerability of their customers, MFIs need to be more mindful of their needs and capabilities.
Chasing customers and sometimes, as it is alleged, poaching them from other segments of
microfinance and loading with more debt would lead to issues such as wrong selection of
borrowers, over-indebtedness and eventually to delinquencies.
MFIs, therefore, need to revisit their business model and ensure more responsible financing.
This would require them to adopt approaches to select their borrowers with diligence, ensure
that their lending is not leading to over-indebtedness and be more human and ethical in their
recovery methods.
Building enabling organisational climate
There is a strong need to build good practices within the institutions and encourage
organisational culture which values customer protection and well being. The frontline staff
need to be educated about the organisational values and social mission so as not to get
swayed by the short term performance targets. Further, the organisational culture should
nurture values like honesty, respect, transparency etc.
Self regulation
Events in the last few years have indicated that the "for profit" model of microfinance, where
there is a heightened emphasis on rapid scale and high profitability, has not been very
successful in meeting their social objectives nor has such a model been sustainable. While
regulatory responses are being put in place to address the current impasse, a degree of
self-regulation is a must in building robust and efficient microfinance institutions going
forward. Self regulation would require putting in place a code of conduct that would allow for
a reputation-building mechanism and adherence to best governance practices.
Transparency
With the customer base being largely from the low-income group whose financial knowledge
and sophistication cannot be taken for granted, it is incumbent upon the MFIs to be
transparent about the interest charged and the total cost to be borne by the customers. It
was reported that some MFIs not only charged excessive interest, but had also loaded many
other components to the overall cost. MFIs need to remind themselves, that while dealing
with vulnerable sections of the society, the argument of "caveat emptor" does not always
hold good.
Credit information
Absence of comprehensive credit information has been a handicap in the development of the
sector. The multiplicity of financing institutions acting independently increases the level of
information asymmetry among them, which may lead to delays in sanction, double financing,
etc. The building up, and sharing, of credit information will help in enhancing synergies
among the various institutions and also ensure avoidance of multiple financing and
consequent over-indebtedness. In this context, let me add that as per Credit Information
Companies (Regulation) Act, 2005, NBFCs, as credit institutions, are required to be
members of at least one Credit Information Company (CIC) (currently there are four CICs).
What is important is that credit data regarding all the borrowers should be furnished to the
concerned CIC accurately and timely and full use should be made of the database of CICs
while extending credit, to guard against adverse selection and over indebtedness.
Diversification
It was observed that MFIs found a few geographies more profitable than others and against
conventional wisdom which advocates diversification, ran in droves to the same geographies
with southern region showing significant concentration of SHGs and MFIs. Excessive
proliferation of entities in a few regions, led to immense, and, sometimes, unhealthy
competition leading to perverse practices. It is now comforting to see that, learning from the
recent episode, the MFIs are reorganising themselves and are spreading into, hitherto,
untapped regions. Diversification helps not only MFIs in withstanding any region specific
shocks but also help customers at large, by spreading the microfinance across the country.
Improvising the business model - reducing costs
Microfinance is a labour intensive sector involving significant delivery costs. While the entities
could build these costs into their services and charge the customer, which many in fact did,
the more efficient way of protecting or increasing one's margins is reducing the operational
costs by enhancing efficiency and leveraging technology. MFIs should not pass on their
operational inefficiencies to clients in the form of prices that are far higher than they need to
be. Considering the profile of the borrowers who are poor, to whom even a small increase in
rates could make a lot of difference, MFIs should strive to build more cost effective and
efficient delivery models to serve their clientele better.
Credit rating of MFIs
The rating of MFIs assumes critical importance as MFIs are sourcing financing from banks
and other institutions. There are several MFIs in the country and their rating helps the
lenders to choose the right one. Further, such positive discrimination helps the better
managed MFIs in reducing their borrowing costs and also acts as a dis-incentivising factor
for not so well managed ones.
Moving beyond finance
The poorest sections of the poor require considerable handholding in terms of input supply,
training, technical support, market linkages, etc. The formation and nurturing of such groups
require not only providing of financial services but also institutional development services, all
of which would require a greater role for the MFIs. In order to achieve its full potential in
empowering the poor, microfinance should become an integral part of the financial sector
and MFIs need to play a larger developmental role.
IV. Summing up
At a time when financial inclusion is at the center stage of the regulatory landscape, the last
mile connectivity provided by the MFIs has to be leveraged upon, to include the hitherto
financially excluded. Although the MFIs are facing tough times, there is a fair degree of
opportunity to build long-term sustainable business around microfinance. Balancing the
interests of the vulnerable borrowers as also the microfinance institutions; effective
regulations, well calibrated transition time and some breathing space to the institutions could
help the microfinance sector to turn around, expand and help achieve inclusive growth.
The recent episodes in the MFI sector have raised certain serious concerns on the
governance issues. MFIs should identify their unique role in the financial system and should
put in place robust governance standards to balance the dual objectives of social utility and
financial sustainability.
I am sanguine that the Workshop would deliberate extensively on the issues. I wish the
workshop all success.
References
Bank for International Settlements (2012), Financial sector regulation for growth, equity and
stability, BIS Papers No. 62
Hulme, D and Mosley, P (1996), Finance Against Poverty, volumes 1 and 2, London:
Routledge
Joshi, Deepali Pant, Microfinance for Macro change, Gyan Books 2011
Key Principles for Microfinance (2004) - CGAP - Consultative Group to Assist the Poor
Littlefield, E., Hashemi, S. & Morduch, J. (2003). Is Microfinance an Effective Strategy to
Reach the Millennium Development Goals? Focus Note no. 24. Washington:
CGAP - Consultative Group to Assist the Poor.
Moses, J S; Rajesh, Raj; Prasad, Gopal; Kumar, Neeraj and Kumar, Navin, (2012)
Microfinance in India- Progress and Problems National Bank for Agriculture and Rural
Development (NABRD), Status of Microfinance in India 2010-11
Reddy, Dr. Y V: Microfinance Industry in India: Some thoughts, Economic and Political
Weekly (2011) XLVI NO. 41
Simanowitz, A and Brody, A (2004), Realising the potential of microfinance, id21 insights,
December, Issue -51
Srinivasan, Microfinance India: State of the Sector Report 2011
United Nations, Building Inclusive Financial Sectors to Achieve the Millennium Development
Goals (International Year of Microcredit, United Nations, 2005)