Road ahead in lending to poor

By Roopen Roy Nov 23 2010

Tags: Op-ed

Adam Smith in his book An Inquiry into the Nature and Causes of the Wealth of Nations provided us insights on how colonial trade was splendidly profitable. “The colonies will be obliged both to buy very dear and to sell very cheap.” The "buy cheap and sell dear" concept actually works very well in any business. Let us take micro-finance institutions (MFIs). They borrow money from banks at 10-13 per cent and lend them at 24-40 per cent. The spreads are huge. The cost of disbursement and collection of tiny loans is albeit high. But scale, efficient pro cesses and technology can drive these costs down leaving a very tidy profit.

Private equity funds figured this out long ago and invested in MFIs. One of the MFIs that listed recently was oversubscribed by almost 14 times. It delivered unprecedented wealth to early birds. There is nothing illegal about the MFI business model. It charges legal rates of interest. It provides financial access to the poor. It even displaces the hated village loan shark. So what is troubling? Is it not a little bizarre that a rich investor in the US is becoming richer by advancing loans to the poorest women in India while borrowing funds from goverment-owned Indian ba nks? What is more worrisome is the risk it has created to the tax-payer and our banking system.

Let us examine the different micro-finance business models. Let us start with the Grameen Bank. First of all it is a bank. It takes deposits from poor people, predominantly women and lends to the poor. All shareholders are the very same poor borrowers. Therefore, it is like a closed user group. The maximum rate of interest for loans in Grameen is 20 per cent, education loans are at 5 per cent and loans to the poorest segment are often interest free. Whatever shareholder value Grameen creates goes to the shareholders –not to any wealthy private investor. Grameen does not borrow money from government-ow ned banks and the society outside the closed group is not exposed to the risks of Gr ameen. The second model is that of the village loan shark. It is capital based.

The money-lender lends his own money. He cannot access commercial bank funds at “priority sector lending” rates. So, if there is a natural calamity or a bad crop he may suffer losses. But rarely does he go bust because he has covered his risks by charging usurious rates of interest of 60-100 per cent. However, he creates no exposure to banks or to tax-payers.

The MFIs are not organised as banks. Most of them are non-banking financial companies. While their narrow capital base comes from the founders and private investors, they access huge amount of loans from banks, most of them government-owned. Many banks fail to meet their targets for priority-sector lending. To meet their “quotas”, they lend to MFIs, which are in the business of giving tiny loans to poor borrowers. Indirect financing to agriculture and small industries through such intermediaries is classified as priority sector lending. Lending to the “priority sector” is at least 2-4 percentage points cheaper.

It may seem like a “win-win” situation. Commercial banks meet their “priority lending” quota and the MFIs access loans at concessional rates. All is well until trouble begins to brew in the MFI sector when the banks wake up with cold shivers in their spines. The banking sector has a large exposure to the MFIs which are facing liquidity crisis. The exposure of banks to MFIs is thought to be in excess of Rs 25,000 crore.

Vijay Mahajan, president of the Microfinance Institutions Network, which represents 44 of India’s leading micro-finance lenders, has recently stated that commercial bank loans to the sector were drying up and borrowers were refusing to pay. “We are facing collapse,” Mahajan told the media, adding, “Unless something changes on the ground, the industry as we know, it is basically gone.”

The current model of MFIs of borrowing cheap from government-owned banks and lending dear to poor customers and creating exceptional shareholder value for private investors is fundamentally flawed.

CK Prahalad’s concept of fortune at the bottom of the pyramid is often cited to justify making money from the poor. In the last edition that he released a year before he died, Prahalad refuted that interpretation himself, “Simply sta­ted the pyramid must become a diamond. A diamond assumes that the bulk of the population is middle class”. To achieve this, the Grameen Bank model of social business is a sharp instrument in changing the sh ape of the pyramid.

The current mainstream thinking in India is to regulate the MFIs sensibly and expand the reach of commercial banks to the rural areas through ba­nking correspondents. Wh ile executing more of the mainstream strategies faster, it could be worthwhile to issue retail, rural banking licenses to MFIs and others and allow them to charge interests higher than commercial loans. After all, today’s MFIs are providing retail lending services to people at the bottom of the pyramid. That way they will be able to garner savings from the poor like Grameen Bank and reduce their cost of borrowings further.

They will be prevented fr om contaminating our banking system with their risks. And they will be regulated by the Reserve Bank of India. There should be no one complaining about more competition in this under-served customer segment.