Economy

Why Microfinance Needs to Return to Its Fundamental Goal

Originally a financial tool used for social good, microfinance is now increasingly used to generate money.

Microfinance is facing trouble because the purity of its mission has been diluted. Credit: Peter Haden/ Flickr (CC BY 2.0)

The Maharashtra government has announced that a four-member special investigation team (SIT) will probe allegations of misconduct against microfinance institutions (MFIs) in the state.

It has been alleged that several MFIs are charging women’s self-help groups (SHG) exorbitant rates and employing criminals for forcible recovery of dues. The government had pledged to form an SIT in the winter session of the state assembly in December. In its order dated April 12, the state home department said the Nagpur divisional commissioner will head the SIT, which will also comprise a member each from the state cooperation department, rural development department and the women’s economic development corporation.

The committee will probe the loans provided by the microfinance companies across the state with special focus on Nagpur and Amravati districts and submit a report to the government within 60 days. The SIT members will interview officers and employees of the institutions and also travel across the state.

“These companies are charging 14-30% interest on loans. It has been observed that these companies are threatening, putting pressure and abusing men and women to recover loans. Cases have been registered in Amravati and Nagpur districts,” the government order said.

Microfinance is facing trouble because the purity of its mission has been diluted. When it started, microfinance was a financial tool being used for social good. Now it has increasingly become a social tool used as a way to generate money, which is why it has lost a lot of its original sheen. This is one reason why microfinance often runs into heavy weather and hits periodic roadblocks and default crisis. A number of rigorous field studies have shown that even when lending programmes successfully reach borrowers, there is only a limited increase in entrepreneurial activity – and no measurable decrease in poverty rates.

Microfinanciers believe that direct evidence is not needed – that as long as microfinance institutions demonstrate high “repayment rates,” they can be assumed to be improving lives. The logic goes that if a person is able to repay their loan with interest, they must have used it productively. But this argument flies in the face of most studies. It is true that many studies have been conducted on the impact of microfinance, but not all of them are flawless. The few – and recent – stronger studies show mixed effects. The most encouraging effects are for programmes that don’t fit the traditional “lend to expand a business” story.

One concern is that as microfinance becomes more commercialised and increasingly concerned with large-scale impact, profits will take precedence over a social mission. Anything not strictly financial is cut in the name of “efficiency.” Profit-minded shareholders see training for entrepreneurs, financial literacy and counselling, skill training, or even the extra five minutes a caring loan officer might spend with a client as a cost rather than an investment.

Since most microfinance clients have little or no security or collateral to pledge, microfinance providers instead turn to what is called in microfinance parlance as “social collateral,” which is built through groups of borrowers who guarantee each other’s loans. The group concept has two variants – the international Grameen model and the indigenous Indian model.

These small-denomination loans are often used for a variety of purposes. It could be for small business or for coping with unpredictable incomes by making funds available to meet their basic needs and manage shocks, such as death or illness. Done right, these loans have shown promise in allowing some borrowers to build sustainable livelihoods.

“We must think beyond the standard microcredit model. Modern microfinance – savings and insurance, and more flexible credit products – often has generated larger impacts than simple credit,” says Dean Karlan, the well-known microfinance researcher and founder of Innovations for Poverty Action. “Financial services can make important differences in people’s lives, but we need more innovation and evidence to determine what is best to do, and meanwhile we should set our expectations appropriately.”

To ensure a smoother and dependable client base, microfinance has to rejig its agenda and properly realign its focus so that both social mission and business goals are properly balanced. Similarly, people should be made aware of modest gains that microfinance can deliver. The fairy tale narrative has done harm both to the industry and society and left the investors dismayed.

Poor people need, like everyone else, access to safe, sound, reliable and respectful systems in order to fulfil their financial needs. Microcredit still has a place in development economics. Paired with other development tools like cash transfers, microlending can offer a sustainable investment option for small entrepreneurs, leading to a renewal in its mission to fight poverty.

Critics say the industry has grown too fast, creating multiple loans to overextended borrowers. India isn’t the only country where micro customers have become overextended. Indebtedness has also been a problem in several other countries. A study on indebtedness in microfinance by the Institute for Financial Management and Research, a not for profit research organisation, has found that 23% of the MFI clients in its sample were over-indebted. The study also found that the drivers of over-indebtedness include low or unstable income, multiple borrowings, high loan sizes, poverty levels, use of loans and cross borrowings.

The industry has two credit bureaus now, Equifax Credit Information Services Pvt Ltd and CRIF High Mark Credit Information Services Pvt Ltd to check the creditworthiness of clients and arrest multiple lending. They check more than 100 million loan records.

But the credit bureaus have not been able to plug the malaise of multiple lending. Under the present RBI dispensation, individuals are entitled to loans from two MFIs. However, the borrowers use different identity documents for each MFI and are able to beat the system. The identity documents recognised by credit bureaus are voter ID, Aadhaar card and PAN card. Another serious deficiency is that these microfinance clients also avail individual loans as well as group loans from banks who report their credit data to CIBIL.

Thus MFIs are not in a position to get a correct assessment of entire loan obligations of an individual borrower. The assessment of indebtedness for a microfinance borrower is incomplete without the evaluation of borrower’s exposure to individual and SHG loans.

The growing use of mobile phones, digital services and mobile money accounts is beginning to fill that vacuum. Mobile operators are teaming up with banks, financial tech companies and data analytics specialists to use the data they have on customers to gauge their credit risk and offer microfinance products to some who would otherwise lack any proof of their capacity to repay a loan. Since they know how much consumers are spending on airtime and are able to infer other relevant information, such as whether a subscriber has a job, mobile operators can gauge how affluent an individual is and what size of loan they can afford.

If the customer is a regular user of a mobile money transfer service, the operator may also be able to assess how much disposable income they have. In fact, mobile operators’ data can be good enough to lower the lender’s risk significantly, enable interest rates to fall and make microfinance a more attractive proposition for small businesses and individuals alike.

Political leaders must realise that hope and rhetoric are great for burnishing one’s electoral credentials but not for figuring out what to do. They make good politics but bad economics and much less good sense. The poor are no longer quiescent; they can distinguish populism from genuine concern and demonstrate it through suffrage. Politicians may be right when they say that MFIs must practice microfinance responsibly. But they must also ensure that they are allowed to practice it sustainably.

Fixing one point on the economic continuum won’t make much difference unless all parts of the continuum improved at the same time. What the politicians need to do is focus on the crippling economy which can barely breathe in an environment of suffocation created by the severe currency crunch. What the rural population actually needs, and what can help MFIs, is more of economic oxygen.

Several MFIs endorse smart microfinance being espoused by the Smart Campaign but it is important that it is practiced on the ground. What is smart microfinance? Microfinance industry leaders from around the world came together in 2008 to launch a campaign to establish the Client Protection Principles. These principles are – appropriate product design and delivery, prevention of excessive indebtedness, transparency, responsible pricing, fair and respectful treatment of clients, the privacy of client data and mechanisms for complaint resolution.

To put the principles into action, the Smart Campaign was launched in October 2009. Today, it is a global effort with over 4,000 signatories, a wealth of tools and resources and an ambitious action agenda. One of the campaign’s fundamental mantras is: ‘Protecting clients is not only the right thing to do; it’s the smart thing to do.’

When these features are weak or missing, even well-intentioned lenders feel pushed into harsh practices. When word gets out that a lender is soft, mass default can quickly infect the whole portfolio.

The principles of smart microfinance are globally recognised as the basis of safe microfinance. They build strong, lasting relationships with clients, increase client retention and reduce financial risk. When they deliver transparent, respectful and prudent financial services, financial institutions ensure that their clients use financial services well and build a foundation for healthy operation for years to come.

Institutions need to be more diligent in their lending – but politicians also need to be wary. In taking aim at the occasional overstep, they may destroy microfinance itself. That would be a great disservice to the world’s poor. Let us get back to our fundamentals once again.

Moin Qazi is the author of Village Diary of a Heretic Banker. He has spent more than three decades in the development sector.