Is the micro-finance like Indias sub-prime?

Introduction Ever since Dr Y V Reddy, the former Reserve Bank of India governor - credited with saving the nations financial system from the 2008 meltdown said in an interview that microfinance is like the sub-prime for India, a debate has erupted in the academic and media circles as to the validity of his statement. Ultimately, its something like sub prime lending, Dr Reddy told Economic Times in an interview. The same incentives are operating here... it was securitization and derivatives that operated in the US. Here it is the priority sector lending by banks. In this context it is apt to examine the veracity of his statement by examining the various aspects of this once highly popular concept that made Dr Mohammed Yunus, a global figure and a Nobel laureate for his renowned concept of Bangladesh Grameen Bank. So, what is Subprime lending? Basically, subprime lending refers to loans extended to people with poor repaying ability that ultimately led to defaults. , the similarities do not end there: Indian micro-finance and The US Sub-Prime have a lot more in common including opaque practices, high salaries and commissions inducing unethical business, leverage and several other issues. In his paper, Mr Ajay Tankha notes that, there are, however, other serious concerns related to the quality of MFI lending to the poor. These include: Microfinance interventions are essentially supply-led, offer limited products and do not take cognizance even of existing knowledge about client needs. The graduated increase in loan size for repeat clients is the growth strategy for most MFIs. Clients tend to access larger loans without a prudent consideration of their repayment capacity. MFIs overlap some in geographical areas resulting in multiple loans and high-clientlevel risks Some MFIs by chasing rapid growth - the "too big too soon" phenomenon - may be overstretched affecting the quality of financial services provided by them Leverage of external and commercial funds could contribute to compromises in the original wider social objectives of the NGO-MFIs The blame for this unfortunate situation falls most squarely on the microfinance institutions, or M.F.I.s, that failed to restrain aggressive growth even as the market became increasingly saturated. Microfinance leaders in India are now working intensively to put measures in place that would hold back multiple lending. Investors must also swallow a big spoonful of blame. Because they paid dearly for shares in the M.F.I.s, they need fast growth to make their investments pay off. Regulators share some responsibility, however. The public-sector policy environment has treated microfinance institutions as orphan children of the financial sector rather than helping them to build solid foundations. Therefore, while experts are slowly but surely getting to identify conditions that could result in micro-finance as being heralded as Indias sub-prime, it is about time that we explore this question Is micro-finance Indias sub-prime? in a detailed and objective

manner. We attempt to do this in a series of successive posts where we raise the questions such as (but not limited to) the following and examine whether indeed micro-finance could be called as Indias sub-prime: Are clients having multiple loans and do they appear to be (over) indebted? Are they in a position to repay loans from their known (legitimate) sources of income/cash? Have institutions (for whatever be the reason) provided successive loans (one after one another), despite knowing that the concerned clients cannot repay existing (multiple) loans from the known (legitimate) sources of income/cash? Have clients used one loan to repay another a loan? Is periodic refinancing is required to provide sufficient liquidity to enable the client to service another/existing loans? Has an additional loan been provided mid way through an on-going loan and especially, on easier terms? Have there been a series of delinquent payments and one equalising payment (often from another loan) and has this pattern been repeated? Have coercive repayment practices been used to ensure better repayment? Has there been a lack of transparency with the product terms and the like, especially, in terms of the effective interest rates as well as other issues? Has growth of institutions been unusually large and has it been supply led? What are the motivations for the concerned institutions (MFIs) to grow this rapidly? To show better operating results? Have greater returns? Pay higher salaries and commissions to staff/management? Get better valuations? Tap capital markets at a premium etc? And most importantly, has there been policy as well as regulatory/supervisory failure, in one sense or another? And I leave you with these questions so that you can ponder on whether (or not) microfinance could be called as Indias sub-primeand make no mistake, if it turns out to be Indias sub-prime, then, a lot of stakeholders including regulators, will have to (satisfactorily) explain to the Indian public on why this happenedand of course, regulation would no longer be able to use a hands-off approach to micro-financewhich has indeed been treated as an orphaned child (in a regulatory sense) for several (long) years now The Rs 25,000-crore microfinance industry is facing tumultuous times ever since the biggest, SKS Microfinance , created a controversy two months ago by sacking chief executive Suresh Gurumani.

There was a confluence of woes for the sector when the Andhra Pradesh government came up with legislation curbing their operations. Banks pulled back on lending as some of the institutions were behaving more like moneylenders and in some cases drove borrowers to suicide.

Indian banks such as SBI , ICICI Bank and Axis Bank are estimated to have lent Rs 16,000 crore to micro lenders. ICICIs lending is at Rs 2,000 crore, SBIs at more than Rs 1,000 crore and Sidbis at Rs 4,000 crore, according to data from rating company Care.

The financial magnitude may not be the same with the Indian microfinance industry being tiny compared with the subprime lending crisis that led to more than a trillion dollars of losses and sank many venerable institutions.

But there are similarities such as opaque practices, high salaries and commissions inducing unethical business, and leverage.

The current practices may create systemic problems too, unlike moneylenders who operate with their own money. If it is profit and if there is lending, aggressively, then its just moneylending, said Mr Reddy, who was criticised before the credit crisis for his conservative approach to policymaking. Also, if you look at it, the resource is leveraged, its not just moneylending business. The moneylender normally lends out his own money, whereas here the MFI is actually borrowing money from depositors and lending the money. So essentially, he is a moneylender, but a leveraged moneylender.

Many admit to the fact that the industry has gone astray with the lure of superlative returns as private equity investors such as Sequoia Capital smelt an opportunity. But that did not mean that its role in financial inclusion could be discarded.

Yes, I agree with Mr Reddy when he says a lot of perverse incentives got aligned, said Vijay Mahajan, chairman of BASIX, a micro lender, and head of Microfinance Institutions Network. Here perverse incentives got aligned like in the US and in two years the sector went from helping the poor to preying on the poor. These institutions are no more the not-for-profit ones as envisioned by Nobel Laureate Mohammed Yunus, so regulations are essential, says Reddy. Bangladesh-born Yunus had seen micro lending as a vehicle to lift people out of poverty rather than enhance returns of

wealthy

investors

in

private

equity

funds.

The idea that MFIs should be treated like banks but given soft regulations is dangerous, said Mr Reddy. We had a somewhat similar experience with urban co-operative banks. Total microfinance loans in India today are about $6.5 billion. If banks lend 80 percent of that, their exposure would be $5.2 billion. Thats only 0.7 percent of banks $707 billion total outstanding loans today. The biggest losers from this entire debacle, however, will be the borrowers. The debtors are primarily women living at or below the poverty line, who will be forced to close their promising entrepreneurial ventures if excessive losses result in the demise of MFIs. Worse still, these women will again be at the mercy of village moneylenders that charge exorbitant rates of interest and would be their only source of credit. So who is to blame? The Economist ran an article last week arguing that it was unfair to accuse MFIs when 82 percent of households in Andhra Pradesh had borrowed money from an informal source while only 11 percent had an MFI loan. These figures do not absolve MFIs of their moral responsibility to prevent excessive borrowing (average household debt in Andhra Pradesh is eight times the national average) by borrowers who then need to turn to the village moneylender to repay the original MFI loan. The irrational exuberance of borrowers and irresponsible lending on the part of mortgage originators that resulted in the U.S. subprime housing crisis should cue governmental and regulatory agencies in India and the United States to design an MFI business model that helps, not harms, the 400 million and 40 million people living in poverty in each country, respectively. The first decision will be to determine if it is feasible for MFIs to have the dual mandate of providing credit to the poor and maximizing shareholder profits. The tremendous growth of microfinance in India encouraged firms to go public to raise capital for additional lending. Several experts, including Nobel Peace Prize laureate Mohammad Yunus, thought this move was a mistake in what they consider a purely social sector. On the other hand, MFIs in the United States have found it difficult to stay in the black. For example, Accion, the largest microlender in the United States, is still reliant on donations after 20 years of operation. Thus, MFIs will need to strike the delicate balance between

running their organizations with the best practices of private enterprises while simultaneously meeting their social goals. The more immediate need, however, is for the initiation of better financial literacy programs and training in business skills for borrowers. Federal Reserve Chairman Ben Bernanke best explained this in a speech on the U.S. microfinance industry: [MFIs] must take a holistic approach, offering interconnected services that complement lending activities and are targeted at entrepreneurs at each stage of business development. By instituting a wise and prudent regulatory structure which balances MFI profits and borrower protections, India and the United States can continue to extend credit to the poor while maintaining financial soundness. Is microfinance the new subprime? We've been hearing that portentous analogy for years, and now that the Indian state of Andhra Pradesh is riveting the world with stories of loanshark-style microfinanciers driving borrowers to suicide, the claim has taken on fresh currency. Considering the industry's growing commercialization, it is an obvious comparison to draw. But the most obvious metaphors are not always the most appropriate ones, and sloppy metaphors can easily drive bad policy.

For sure, there are some real similarities between microfinance in India today and the pre-crisis subprime mortgage market in the U.S, and we can learn from them. As microfinance institutions have quickly grown, profit-seeking money has flooded into the sector. Loans to poor households have kept pace, with the number of borrowers surging from 8 million to more than 20 million over the past three years. With this growth, some borrowers have gotten in over their heads. Press accounts offer sensational stories of borrowers pressured to take out one loan to pay off another falling even deeper into the chasm of debt. While it is difficult to discern reality in Andhra Pradesh, given the tangle of political and business interests at play, we can't dismiss the fact that people in India, just like people in the U.S., want to be better off. When resources are available, they will take advantage and some will go too far, whether driven by pushy salesmen or their own desires. This is inherent in finance, which is why any system, not just one that is rapidly commercializing, needs safeguards, like ways to monitor over-indebtedness.

This can be difficult to see when it comes to microfinance, because, much as with the subprime market in the U.S., there is an ideological underpinning that makes us want to believe nothing too bad can happen. In the U.S., owning a house is considered a fundamental part of the American Dream. Similarly, microfinance promises to change lives, to help people lift themselves out of poverty. Microfinance brings empowerment and dignity, we tell ourselves. And who could be against dignity? The U.S. certainly could have used some pushback on its ideology and perhaps the same can be said of microfinance today. But while it may be useful to draw some comparisons to the U.S. subprime debacle, India's experience is drastically different in significant ways.

To start, we should recognize that Andhra Pradesh is in a much less precarious position than the U.S. was a few years ago, when an entire nation was caught up in the delusion that house prices would never stop their steep ascent. Most of the complaints about the microfinance sector in India come back to unscrupulous practices like loan officers talking borrowers into taking on too much debt and collection agents being coercive. These are serious allegations and the government of Andhra Pradesh has smartly moved to ban strong-arming, increase disclosure about loan costs, and control the number of loans one person can receive. But the core of the problem is at least not a profound misunderstanding and misuse of most families' largest asset.

Another important contrast follows from the fact that the U.S. subprime mortgage industry was built on a fundamentally different equation and a fundamentally different pathology. At the heart of the subprime crisis was risk-based pricing. Thanks to credit scores, lenders had elaborate knowledge about any given individual's likely ability to repay a loan; the game was not to just lend to those who could repay, but to price loans sufficiently high to cover the costs of those who were expected to default. The premise of microfinance is at the other end of the spectrum: lenders intend to recapture every dollar they loan out and take great pride in the high percentage of loans repaid. It is easy to compare a high interest rate on a subprime mortgage to a high interest rate on

a microfinance loan, but these two rates come from very different philosophies about how to make money from extending credit. In the case of microfinance, if anything, the problem rests with an overly obsessive pursuit of perfect loan repayments. The relatively high prices for microfinance loans (beginning at about 25% on an annualized basis) largely reflect the high costs of small-scale transactions in a labor-intensive business. Microfinance interest rates in India are already falling in the wake of this month's crisis; slashing them further through stringent usury laws will undermine an industry which holds the promise to do substantial good. In that light, last week's microfinance law capping interest rates at 24% per year in Andhra Pradesh strikes a laudable balance between the interests of populist politicians versus lenders trying to keep businesses afloat. The most important distinction between microfinance and subprime mortgage lending is that most microfinance institutions got their start through an impulse to create opportunities for unbanked and excluded citizens. Embedded in the institutions' DNA is a desire to do right by the world, not just make money off of it. Commercialization may be changing the industry sometimes too fast and creating conflicting interests but there are still plenty of good people involved who are open to having thoughtful conversations. Many argue that microfinance in India is now "too big to fail." Perhaps, but the industry is not too far removed from the lives of poor Indians to care deeply about the direction things head from here. At 4 billion USD, the amount of money at stake in Indias microcredit industry seems insignificant if compared to that of the US sub-prime mortage crisis . Yet India is not only a fast- growing economy but also home to a huge number of poor, who have become dependent on microcredits for their livelihood. This is the main reason why the microcredit industrys recent crisis there has dealt a severe blow to Indias hopes of letting the market forces solve the poverty problem. The microcredit industry worldwide was kick-started by Dr Muhammad Yunus. By making loans worth a few hundred dollars mostly to women living in poor rural communities in Bangladesh, his Grameen Bank contributed heavily to alleviating

endemic poverty in the country by stimulating the development of small-scale cottage industries. Founded in 1983, the poors bank has 2,564 branches today, a staff of 19,800 and 8.29 million customers, of which 97 percent are women living in villages across Bangladesh. The banks success in financially assisting the poor and promoting self-employment was rewarded with a Nobel Peace Prize and it influenced policymakers at a time when belief in the power of the market forces to bring about economic development and prosperity, even to the poorest of nations, was at its peak. Hoping to assist its own poor, India established a microcredit industry as well, albeit radically different from the experiment in Bangladesh. Initially, the lenders of microfinance for the poor were NGOs. For the past 10 years, unfortunately, for-profit foundations, venture capitalists and even the World Bank became major players in Indias fast-growing microcredit industry. One such company, SKS, that sports George Soros and one of the founders of Sun Microsystems as stakeholders, has doubled in size every year for the past few years. In August 2010, the companys initial public offering has raised 350 million USD. Its brand of inclusive growth, however, has hurt many an Indian borrower, especially in Andhra Pradesh, which is today at the epicentre of Indias microcredit crisis. According to Vijay Mahajan of Basix Microfinance, SKS as well as many other microfinance lenders are guilty of growing too fast, lending too aggressively to customers who lacked - as in the US - the ability to repay their loans, and of concentrating their activity in the same geographical area. By charging interest rates ranging between 15 and 35 percent, these companies now stand accused by Indian local politicians like Reddy Subrahmanyam of making hyper-profits off the back of the poor. In October, together with some colleagues from Andhra Pradesh, Mr Subrahmanyam has pushed through legislation aimed at regulating lending and collection of microcredits. The same month, 2 billion USD outstanding went unpaid, in order to force microcredit companies to offer better and cheaper loans to Indias poor. In Dr Yunus view, microcredits should not have been used as a profit-making vehicle in the first place - one of the reasons why so many of Indias poor find it hard, if not impossible, to repay outstanding loans.

In Andhra Pradesh where the current crisis has erupted, there are some 975.362 self-help groups (SHG) with 11 million members, acting as collective borrowers from banks or microcredit companies. Fifty percent of the states poor have taken out multiple loans, whilst 80 percent of them do not work in agriculture, trying to make a living as smallscale distributors of vegetables and dairy products instead, or as rural tailors or carpenters and the like. Whilst Indias banks require loan applicants to wait for three, sometimes five months, the microcredit companies approve a loan in only three days, without means testing any of them. Repayments are required weekly, interest rates are high and collection agents have already pushed 54 roughed-up customers to commit suicide. The mistaken belief that market forces can be counted on for everything, including the eradication of poverty, is the ultimate cause of the present-day Indian microcredit debacle. Dr Yunus had established his bank in a largely Islamic country, where assisting the poor is one of the four pillars of Islamic faith and, at the same time, money-lending for profit is expressly forbidden. Outside Bangladesh, however, the microcredit industry cannot truly contribute to alleviating the plight of the poor. As Indias case proves, reliance on the forces of the market might even aggravate matters. Another lesson from the current crisis that cannot be ignored is that in eliminating poverty there is no substitute for resolute government action and for redistribution of wealth policies. In other words, the state-centered Beijing consensus and development model does a much better job of fighting poverty than the Washington consensus, focused on deregulation, the market and political democracy. Anti-poverty policies were successful to date only in countries like China, Brazil ,Venezuela, Bolivia or Ecuador, where the state is actively managing and financing projects to that effect. The sooner Indian politicians realise this, the better for Indias poor. Sub prime lending is the curse responsible for crippling the U.S. financial system. The massive extension of credit to people who lacked extensive credit histories and documented earnings seems, in hindsight, the mother of the dreaded phase of global financial meltdown or the recession that crippled global economy affecting all segments of global populace.

Lending tiny sums to the needy in shape of micro lending has built a track record of effective poverty relief. Micro credit pioneer Muhammad Yunus, who founded Bangladesh's Grameen Bank in 1983, won the 2006 Nobel Prize. And microfinance, which now touches the lives of more than 100 million people, is one of the few bright spots in the troubled financial sector. These sub prime loans provide working capital to budding entrepreneurs, usually women--small amounts of cash to buy a sewing machine or livestock. Frequently, credit is extended to groups; peer pressure turns out to be a powerful motivating factor. But figuring out the borrowing capacity of people who may not keep records is a labor-intensive proposition. "Globally, microfinance is showing characteristics of the Western financial markets before the collapse," says Sanjay Sinha, managing director at Micro-Credit Ratings in Gurgaon. "In the U.S., homeowners were given loans at 120 percent of the value of their properties. In rural India, people are being lent to at 150 percent of the value of their enterprises." Microfinance firms make loans in poor areas largely shut off from traditional banking services. The past two years have been marked by surging defaults in some countries. Microfinance markets in Nicaragua, Morocco, and Pakistan have seen default levels climb to more than 10 percent, the threshold that marks a "serious repayment crisis," according to a February report from policy and research firm Consultative Group to Assist the Poor. India, where more than 600 million people live on less than $1.50 a day, is the world's largest microfinance market. Most microfinance loans in India range from 5,000 to 20,000 rupees ($108 to $431), with interest rates ranging from 18 percent to 33 percent. Although Indian microfinance firms have reported bad-loan ratios of about 2.5 percent on average, levels may be higher because some lenders roll over loans to struggling borrowers to avoid defaults, says Micro-Credit's Sinha. Microfinance lending in India may surge by about 40 percent annually over the next few years, says Sinha. SKS, betting the potential for growth will attract investors, is seeking regulatory approval for an initial public offering. Basix Group, which focuses on poor households in rural areas and provides loans averaging about 3,000 rupees, may sell shares in an IPO next year, says Chairman Vijay Mahajan. Others are likely to follow. Until now, microfinance companies have relied on loans and grants from banks, insurers, and foundations for funding, he says. Micro-Credit's Sinha worries that growth in the microfinance market is masking an erosion of lending standards that may spark rising defaults. India doesn't have a

nationwide system for tracking borrowers' credit histories, making it hard for lenders to check whether clients have multiple loans. "There is significant investor interest in microfinance companies' public issues, but it's being driven by irrational exuberance," says Sinha. Rural lending can be particularly tricky. "If there's a bad monsoon and the farmers lose their crops, our money can go along with it that year," says Amit Kalokhe, a loan officer at Mumbai-based Hindusthan Microfinance. The firm tries to reduce risk by lending to groups of people rather than to individuals, founder Anil Jadhav says. "That way if one person defaults, others can pay the amount," he says. The 10,000-rupee advance to towel maker Rathore in Mumbai was part of a loan to a group of women, according to the company. The Chairman of the Prime Minister's Economic Advisory Council, Dr C. Rangarajan, said on Wednesday that the business model of the country's microfinance institutions (MFI) is predominantly faulty and they need to revisit it. MFIs must ensure that credit is given to poor people at an affordable cost to support their income earning activities, Dr Rangarajan said at a Skoch microfinance conference. He said MFIs must extend credit only after taking into account every borrower's repayment ability. Meanwhile, the Chief Economic Adviser to the Finance Ministry, Dr Kaushik Basu, said at the same event that the MFIs should not be regulated too heavily as that would affect their very existence. Referring to the high cost of MFI credit, Dr Rangarajan said, It is basic business strategy to ensure that the rate at which any institution lends must be such as to enable the borrower to repay the principal amount. If it is not possible then it is a self-defeating exercise. Therefore MFIs must introspect and decide on the level of margin they want to keep given their cost of borrowing from banks and ensure that greater effectiveness is involved in the process of lending, he said. Dr Rangarajan also pointed out that MFIs have resorted to multiple lending predominantly for consumption purposes of the borrower. This is self-defeating and inconsistent with the repayment capacity of the borrowers. The provision of credit for consumption purposes has to be a small part of the total MFI credit, he said. The idea of asking MFIs and banks to go to rural areas is to ensure that the income earning capacity of the borrowers and their repayment abilities are increased, he said.

The crisis that has rocked Andhra Pradeshs micro credit industry is like this- the AP state government passed an ordinance placing a moratorium on all new microfinance loan originations and collections of existing loans. The move was purportedly prompted by a desire to protect women borrowers after a spate of suicides, but there is also a view that the ordinance has been motivated in large part by the governments desire to promote its own Self-Help Group (SHG) schemes that are in direct competition with the microfinance sector. a comparison between the sub prime housing bubble in the United States and the current spate of defaults in Andhra Pradesh is particularly useful while thinking about the unsustainable growth of the micro-lending sector in Andhra. As Roodman points out, Vikram Akulas SKS Microfinance has grown from 11,000 borrowers in 2003 to 5.8 million borrowers currently; yes, thats an over 52,000% growth in ten years. While the other for-profit MFIs are not quite as large, they have also experienced significant growth. In thinking about the sustainability of the for-profit micro-lending model, the questions often asked revolve around issues like mission drift, profiting off the poor, etc. The rejoinder from people like Akula has thus far been to point to steadily decreasing interest rates (even as return on equity increases), while also contending that the problem with abusive loan-collection agents is restricted only to a few rogue agents. However, all of this obscures a far more fundamental question: has the growth in credit outstripped sustainable demand? The Andhra Pradesh debacle drives home a key point. To evaluate microfinance, you cannot just look at randomized trials in isolated locations, important as those are. You must also come to grips with the dynamics of the industry. Imagine if rigorous studies of sub prime mortgages in the U.S. in 200304 had concluded that they were working greatborrowing households earned more, spent more, etc. That would not have been the whole story. At least among debt-related suicides, the typical pattern was that the loan troubles would build up over years, as the people borrowed from whomever they could. Then, typically, some traumatic event would trigger the suicidea public shaming by a creditor, a beating, a threat of rape. Thus when people end their lives they may owe only a small share of their debts to MFIs. Yet I can imagine that MFIs, because they insist on on-time repayment, are more apt than (subsidy-softened?) self-help groups to trigger such events. According to the Government of Andhra Pradesh, more than Rs 25,000 crore has been lent to over 80 lakh poor families. On an average each family owes Rs 30,000. Most MFIs charge 27 per cent interest on loans. Some MFIs seem to use strong-arm tactics in loan recovery, with a few reported suicides. The Andhra

Pradesh Government reacted with an ordinance to regulate MFIs. Most likely, the MFIs might be forced to write off a big chunk. SKS MICRO FINANCE-THE PHENOMENAL GROWTH STORY PARAMETRE 2006 2007 2008 BRANCHES 80 275 771 DISTRICTS 19 102 235 STAFF 574 2389 6425 MEMBERS-IN 2 6 18.7 LAKHS LOANS-IN 152 445 1679 CRORES OF RUPEES 2009 1354 336 12814 39.5 4399

First, MFIs were in a hurry to grow fast. SKS Microfinance, a listed company, has grown 90 per cent annually for the last four years (see Table above) from just two lakh members to 40 lakh members in less than three years. The loan disbursements have gone up from just Rs 150 crore to over Rs 4,400 crore in three years. Growth prompted investment grades from rating agencies. Whenever loans are disbursed in haste, one can anticipate problems later. Second, the concept of self help group (SHG) was not followed. The concept involves forming groups of 15-20 women, who meet regularly, understand each other's problems and bond for a while. They are expected to save a small amount, keep the money in bank and earn interest. A member could borrow when she falls ill and can't go for work. She would return the money with 18-24 per cent interest to the group. The recovery is almost certain, due to peer pressure and bonding with the group. Such group formation and bonding takes a minimum of six to nine months. The MFI did not have so much time and wanted to grow rapidly in tune with their private equity investors. They went in for the Joint Liability Group (JLG) method. Their agents would persuade five women to form a group and each guaranteed the others' loans. Most members of JLG could not develop the special bonding they would have in SHG. Third, the MFI apparently charged lower interests of 12-18 per cent in JLG, compared with that of 18-24 per cent charged by SHGs primarily run by the PSU banks. MFI interest rates were non-transparent and effective rates often were over 27 per cent, considering loan processing fees, penalties and hidden charges. THE SUBPRIME BUBBLE How did the borrowers repay? Many adopted what is now known as ever greening' tactics. They would borrow on Mondays from one MFI and repay to the other MFI on Wednesdays. Since all of them were growing with plenty of funds from the private sector banks, the party went on. Of late the PSU banks too joined the party. For instance a major PSU bank that had Rs 1,000 crore exposures to SHG based loans lent another Rs 60 crore to MFIs.

Should we credit the Government of Andhra Pradesh for bursting the MFI bubble? Has the lending reached many sub prime borrowers? Prima-facie the evidence seems in favour of the government. Each poor family seems to have borrowed over Rs 30,000 per year. While every MFI claims that it has lent just Rs 10,000 per family, multiple lending suggests a higher figure. Most MFIs claim they have lent for income-generating activities. In reality, most lending has been for consumption purposes buying a TV, repairing a house, paying for school-college fees or for serious illness of a family member. Thus, indiscriminate lending and irresponsible borrowing was encouraged, leading to the sub prime bubble. THE WAY OUT First, the sector has to be regulated by the state governments. They can, however, go overboard and stifle the sector. Politicians would be too happy to ask people not to repay their loans to banks. The Andhra ordinance expects MFIs to obtain approval to make tiny loans, which is impractical. Hence, regulation has to be tempered by a sensible institution like RBI. Second, the regulation should encourage bonding their members, with savings, self-help, education, and not just credit. Money has to be lent only when the economic viability of projects is well established. The capacity of a village or a cluster to support income-generating activities has to be worked out to cap MFI lending geographically. Third, the MFIs who give credit to crores of women groups don't employ women to the same extent. Most show just 3-4 per cent women employees. This percentage must go up drastically. A holistic scheme to help the poor has to include health insurance, self-help, education, employment and finally credit. Many MFIs overturned this philosophy by concentrating just on credit. Putting MFIs back on track DISENCHANTMENT WITH THE MFIS TODAY on grounds like usurious interest rates and the adulation that prevailed earlier are both impassioned responses to proximate aspects of the sector. The deeper institutional logic behind their emergence, the initial widely-accepted success and the current disillusionment must inform the proposed regulation-centred reform to make it meaningful. Oriented towards the formal, banks could not satisfactorily address the information asymmetries in the informal sector arising from factors like the absence of creditworthiness documentation, the high cost of evaluating dispersed clients and an office-centric orientation. Combined with limited collateral possibilities, this led to high bank NPAs in their policy-mandated informal sector loaning. The MFIs arose to fill this institutional gap. Like the moneylender, communitylevel presence reduced information asymmetries. Semi-formal organisations with manageable scale and geographic spread provided significant efficiencies. Group loans linked loan access to the conduct of other group members and created social collateral through peer pressure against misuse and default. Community outreach behind group formation ensured informed members incentivised to influence inclusion of sound fellow members. Handholding for

effective loan use mitigated key risks. The MFIs naturally attracted personnel committed to community work in a social development mode. Donors helped absorb the significant costs of community outreach. With MFIs expanding in scale and new entrants displaying diverse motivations, the model is beginning to splutter. Entry of for-profits shifted attention from community-level preparatory work to quick results at scale through centralised management. Aggressive shareholder-focused strategies are a natural corollary to entry of listed companies. Multi-crore packages are a far cry from the zeal that drove the sector, giving management obvious incentives to target short-term success while leaving the increasingly-visible downside for others. So, as the MFI sector begins to resemble its banking cousin, it faces similar problems in serving the poor. To be fair, significant preparatory expenses and limited low-cost funds availability to the expanding sector contributed to high lending rates and increasing reliance on corporate against social development frameworks. However, as recent interest lowering responses of some MFIs reveals, there exists a significant margin that a competitive or better-regulated environment can address. Resolving these issues is critical, given the irreplaceable role of MFIs in serving the poor. The imperative is heightened by the limited success of the Swarnjayanti Gram Swarozgar Yojana (SGSY) scheme, which suffers from many weaknesses of the earlier Integrated Rural Development Programme (IRDP) on account of incentive issues inherent to public provision. Conceiving the reform will not be a trivial exercise. Given the increasing scale, formality and varied motivations across the sector, natural self-regulation from a deeper commitment is no longer possible. Success factors in earlier years were delicate aspects that came together spontaneously in a small sector. They cannot be decreed. However, while the clock cannot be turned back, similar outcomes can be substantially induced through a formal, but light-handed, policy and regulatory framework offering appropriate incentives and opportunities. This could potentially nudge the varied players on the scene today to mimic the earlier success. Developing such a framework would be the major challenge before the Malegam Committee. Key issues like access to low-cost funds would need to be addressed. Permitting deposits is a serious option. Regulatory approvals for this, subject to compliance with prudential norms, could be granted and scaled up on attaining milestones reflecting progressive achievement by MFIs in sustainably nurturing borrower groups and deposit management. Deposit insurance could be built into the arrangement. Credit being only one of the many inputs to poverty alleviation, services like risk mitigation through insurance of borrower ventures, while safeguarding against moral hazards, could be allowed to MFIs in a similar accountable manner. The framework could also incentivise adoption of traditional MFI handholding practices.

Partnerships between banks and local MFIs could be greatly stepped up to form the core of a transformed industry structure. Incorporating MFI delivery, this approach could potentially overcome shortcomings of the government-run SGSY scheme and be a market maker providing a disciplining template for the sector. On achieving scale, it could enable fulfillment of key regulatory objectives through market forces. MFI selection and scaling up of the partnerships could be based on fulfillment of outcomes-linked milestones to minimize vested interests in MFI selection. Independence and credibility of the regulator, as also effective monitoring and evaluation, or M&E, would be key components of the arrangement. Third-party mechanisms and outsourcing could enable skeletal structures and prevent creation of huge regulatory empires. The dispersed nature of the sector would favour a multi-tiered and decentralized regulatory structure. The higher and intermediate (possibly national and state) tiers could look predominantly at aspects like policy frameworks, standards setting and M&E, with lower (perhaps district) tiers focusing on implementation issues. The structure of an institution like Nabard for which such a role has been suggested is conducive to such regulatory responsibility being built in. Inter-se roles of the national and state governments in this entire process would need to be clearly worked out. A framework on these lines incorporating appropriate norms and compliance milestones to guide regulatory decisions could shape the MFI sector substantially incentivised to replicate old world MFI success. Politically-oriented steps like encouraging non-repayment will irretrievably vitiate the largely healthy credit culture MFIs have established against all odds. Initiatives involving ad-hoc regulatory statutes that outlaw the symptom rather than cure the disease will be equally self-defeating. Imprudent actions will accentuate the crisis, which the informal economy can ill-afford. The subtext of the question is the implication that, like those sub-prime mortgage loans in the U.S. that turned out to be a catastrophic house of cards, some approaches to microfinance are starting to also look like another way for financial whizzes to make money off poor people. As microfinance institutions have quickly grown, profit-seeking money has flooded into the sector. Loans to poor households have kept pace, with the number of borrowers surging from 8 million to more than 20 million over the past three years. Kiviat and Morduch, while writing about the explosion of microfinance in India, go on to compare and analyze the backlash against profit-seeking microfinance institutions in India and those mortgage lending practices in the U.S. that many

say helped cause the global economic meltdown. It is the profit-seeking money thats behind much of the growth and which is causing all the fuss in microfinance. The big problem for microfinance today, many experts say, is that as a field it lacks a standard measure of its social impact. They can measure the dollars going in, going out, the interest rates charge, the return on investment and all the financial stuff. But are they helping the poor get out of poverty? Indian micro-finance and The US Sub-Prime have a lot more in common including opaque practices, high salaries and commissions inducing unethical business, leverage and several other issues Here perverse incentives got aligned like in the US and in two years the sector went from helping the poor to preying on the poor the similarities do not end there. The sub-prime lending abuses that fueled the U.S. housing bubble demonstrate the dangers of financial services to the poor done wrongly. The sub-prime industrys core failures in consumer protection (i) tempting low-knowledge customers into over-indebtedness, (ii) ignoring capacity to repay in making loan approval decisions, (iii) failing to clearly disclose and explain loan terms are the fruits of intense competition and ineffectual regulation. The blame for this unfortunate situation falls most squarely on the microfinance institutions, or M.F.I.s, that failed to restrain aggressive growth even as the market became increasingly saturated. But while it may be useful to draw some comparisons to the U.S. sub prime debacle, India's experience is drastically different in significant ways. It is easy to compare a high interest rate on a sub prime mortgage to a high interest rate on a microfinance loan, but these two rates come from very different philosophies about how to make money from extending credit. In the case of microfinance, if anything, the problem rests with an overly obsessive pursuit of perfect loan repayments. The relatively high prices for microfinance loans (beginning at about 25% on an annualized basis) largely reflect the high costs of small-scale transactions in a labor-intensive business. In the centuries old mortgage market, there were tiers of borrowers creditworthiness, and sub-prime was really sub-prime, comprising of people not likely to be able to repay the loans. The micro finance asset class itself is quite new - it caters to a set of people who have not been able to access formal credit earlier. Importantly, unlike the mortgage market, the exclusion in this market was not due to lack of clients' creditworthiness, but due to the inability of financial institutions to find a mechanism to assess their creditworthiness. Group lending turned out to be the innovation that helped bridge this gap. This mechanism can also help in minimising predatory lending, because of multiple people being involved. In the US mortgage market, the growth in credit to the sub-prime borrowers was primarily driven by government's mandate to provide the loans

and willingness to buy and hold the risk explicitly or implicitly, as well as the rapid inflow of easy liquidity from abroad. It was not due to the financial markets' newfound optimism about the sub-prime borrowers' creditworthiness. So, ceteris paribus, as long as the basic process is strong, the growth in micro finance sector should not hurt. Micro finance is being pushed because of ideology rather than fundamental business logic: The only government-provided incentive that commercial micro finance enjoys in India is by being one of many asset classes classified under priority sectors, with no special incentive for MF as such. So, this is not exactly directed lending in the way US sub-prime mortgage loans were, which may have led to lax underwriting. REFERENCES 1. http://economictimes.indiatimes.com/news/economy/indicators/Microfinan ce-in-India-is-like-subprime-lending-Y-V-Reddy/articleshow/6972903.cms 2. VIVEK KULKARNI-Microfinance, India's sub-prime crisis-Business Line15-1-2011 3. ANUP WADHAWAN - Putting MFIs back on track The Economic Times15-1-2011