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This Term Paper / Assignment / Project has been submitted by

Mr. AASHISH DAHARIYA ID No: 211127

On ECONOMICS- II During the Winter Semester 2013
Topic- The Role of Microfinance in India for Empowerment of Poor People.
Footnoting is done by NUJS Law review citation style.

INTRODUCTION
Microfinance is a general term to describe financial services or credit to low-income individuals or to those who do not have access to typical banking services.1 Microfinance is also the idea that low-income individuals are capable of lifting themselves out of poverty if given access to financial services. 2 Microfinance is defined as any activity that includes the provision of financial services such as credit, savings, and insurance to low income individuals which fall just above the nationally defined poverty line, and poor individuals which fall below that poverty line, with the goal of creating social value.3 In India, microfinance mainly follows two delivery approaches – (a) groups are formed by Non-Government Organizations (NGOs)/Government agencies and linked to commercial banks (SHG Bank Linkage Programme – SBLP)4 (b) groups are formed by NGOs/Non-Banking Financial Companies (NBFCs) who perform the role of a financial intermediary and lend to the groups after sourcing loans from financial institutions (Microfinance Institution (MFI) Bank Linkage Model).5 While the former has grown under state patronage, the latter has been nurtured by privately held developmental groups. In this project the researcher will first address the question whether the supplier which provide credit have failed or not to provide credit to the rural India? After that the researched will focus on the methods which can be used to improve the supply of credit system? Furthermore the researcher will focus on the economic model on which the microfinance sector works? Then the researcher will discuss about why microfinance bill, 2012 is needed and what are the problems with the bill?
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Ravinder Kumar, Managing and Inproving the Microfinance Facility for India’s Rural Poor People, November, 2011, available at http://zenithresearch.org.in/images/stories/pdf/2011/Nov/18_vol-1_issue7%20_%20%20%20RAVINDER%20KUMAR%20Improving%20The%20Microfinance%20Facility%20for%20Ind (last visited on March 11, 2013). 2 Id. 3 Id. 4 Debdatta Pal, Revisiting the Micromanagement of Microfinance: Case of India, October, 2012, available at http://www.vikalpa.com/pdf/articles/2012/Pages-from-Vikalpa374-63-68.pdf (last visited on March 11, 2013). 5 Id.

FAILURE OF CREDIT SUPPLIERS TO PROVIDE CREDIT IN RURAL AREAS
Currently, a total population of 1.1 billion is being served by 50,000 commercial banks, 12,000 co-operative bank offices, 15,000 regional rural banks and 100,000 primary agriculture societies.6 This density of financial services, however, belies the availability of financial services to low-income households, which make up a significant chunk of the Indian population.7 Before exploring why financial services have failed to reach this segment of the population, it is necessary to first define their target.

Target of Microfinance- the population of India can be divided into four different groups according to each group‘s income level of household. The top level are the rich who each more than $20000 annually which constitute only 0.4% of the total population.8 Then there are the middle class people who earns in between $4000 to $20000 annually which comprise of 5.9% of the total pollution.9 Then there are the Aspirers which are 22% of the total population and earn in between $1800 to $4000 annually.10 Lastly are the primary targets of the microfinance sector, the deprived class which make up to 72% of the total population. Their income level is less than $1800 annually. 11 They are the low income persons who are self employed that do not have access to formal financial institutions like banks. In the rural areas of India, they are usually the small scale farmers and household based entrepreneurs who engage themselves in generating small income by activities like food processing and petty trade.12 In urban areas, micro finance activities are more diverse and include shopkeepers, service providers, artisans, street vendors, etc.13 Micro finance clients are usually poor with relatively no source of income and non poor who have an unstable source of income and hence vulnerable. India has the largest population of

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Lok Capital, Microfinance Industry in India, March, 2010, available at http://www.microfinancegateway.org/gm/document-1.9.43423/05.pdf (last visited on March 11, 2013). 7 Id. 8 Id. 9 Id. 10 Id. 11 Id. 12 Ashish Chopra, Analysis of Microfinance Industry in India, March, 2011, available at http://dupedia.co/forms&projects/Microfinance%20Industry%20in%20India.pdf (last visited on March 11, 2013). 13 Id.

poor in the world which goes up to 800 million who live on the brink of subsistence. 14 The bottom 5% of India‘s poor, considered ―ultra poor‖, face even deeper levels of chronic hunger, persistent poor health and illiteracy.15 The reasons behind the formal financial sector‘s failure to reach such a large segment of the Indian population are manifold and operate in a self-reinforcing manner.16 The main problem which restricts the banks to provide credits to poor people is that it has to pay extremely high variable and fixed cost for this small transaction.17 As well as a very high ratio of poor people live in rural areas which are inaccessible. For this population, the cost of visiting a traditional bank branch is prohibitive due to the loss of wages that would be incurred in the time required. Concurrently, if seen from a bank‘s perspective, it is financially impractical to operate a bank‘s branch in these remote rural areas as the cost is high and the volume of return is low. 18 Moreover, these poor people are not into the products which are offered by the banks to the rest of the population as they have different immediate needs, lower financial capacities and variable income streams.19 Furthermore these poor people do not have assets to offer as collaterals for the credits provided by the banks as the rest of population have. Additionally, these poor people are usually illiterate and hence lack financial knowledge which makes it nearly impossible to consider the existing financial services offered which provide no ancillary support to mitigate these challenges.20 As the poor people cannot access the formal financial sector i.e. banks, hence they rely on the traditional money lenders to get the credit and fulfil their financial needs. The credit is available with these money lenders but it comes with a huge rate of interest ranging from 60%-100% on annual yields; hence forces the poor people into classic debt trap which entrench their poverty.21 Credit from moneylenders has not traditionally acted as a tool for business expansion or enhancement of quality of life, but rather as a lifeline for immediate consumption or healthcare needs.
14 15

Id. Id. 16 LOK CAPITAL, supra note 6. 17 Id. 18 Id. 19 Id. 20 Id. 21 Id.

METHODS TO IMPROVE ACCESSIBLE CREDIT IN RURAL INDIA
Traditionally money lenders were the primary source of credit available in the rural areas of India. They were either rich farmers or landlords or a community with money lending as traditional occupational hazard. After intervention by the government, RRBs and NABARD were established to refinance all rural credit and developmental funds.22 Various types of creditor exist today in rural areas even after invention by the government and the establishment of financial institutions. Though banks, cooperative societies and government institutions are the primary source of credit in rural, private moneylenders continue to be important among credit providers in rural areas.23 Forming and nurturing small, homogeneous and participatory self-help groups (SHGs) of the poor has today emerged as a potent tool for human development. This process helps the poor, especially the women from the poor households, to collectively identify and analyses the problems they face in the perspective of their social and economic environment.24 It helps them to pool their meagre resources, human and financial, and priorities their use for solving their own problems.25 The emphasis on regular thrift collection and its use to solve immediate problems of consumption and production not only helps to meet their most urgent needs, but also trains them to handle larger financial resources more skilfully, prudently and with a more lasting impact. 26 Proper regulations should be promoted in the microfinance sector which protects the interest of the stakeholders and promote growth of this sector. After the Andhra Pradesh crisis field visits can be adopted as a means to keep an eye or check on the ground level staff and the recovery method that they adopt and corrective actions can be taken if there is need of it.27 MFIs should be encouraged to open new branches in the rural areas were microfinance penetration is low by providing financial assistance. This will reduce the initial cost of providing credit as well as increase the reach of microfinance in remote areas and will keep a check on multiple lending. 28 MFIs should also provide many range of product as the banks provide like savings, credit,
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Vishal Vivek Jacob, Microfinance- Current Status and Growing Concerns in India, October 1, 2011, available at http://www.iitk.ac.in/ime/MBA_IITK/avantgarde/?p=475 (last visited on March 11, 2013). 23 Id. 24 KUMAR, supra note 1. 25 Id. 26 Id. 27 JACOB, supra note 22. 28 Id.

financial advice, remittance and also no financial services like support and training.29 As MFIs act as a substitute to the banks in the areas where there is no access to banks, providing these range of products will also facilitate the poor people to gain all the services which the rest of the population enjoys. As there is no fixed rate of interest charged by MFIs different MFIs charges different rate of interest, even few MFI charges additionally and provides interest free deposit (a part of the loan amount is kept as deposit on which no interest is paid). 30 All of this make the pricing of credit very confusing for the borrower and hence incompetent in terms of bargaining power.31 So a common way of charging interest rates should be followed by the industry, so that the borrower can get a chance to compare products of different MFIs before buying the product. This will also make the market competitive and hence small firms will not be dominated by the big firms, therefore the market will not be in hands of few firms. MFIs should improve their technologies and should use new application to reduce their operating costs, so that they can provide credit at even a lower rate of interest as they provide now.32 The reach and growth of MFIs are restricted due to inadequate funds, to overcome this problem other sources of loan funding be found.33

MICROFINANCE SECTOR’S ECONOMIC MODEL OF ITS OPERATION
It has been noticed that the traditional financial services sector has failed in its effort to provide adequate credit to the low income group. The microfinance business model has been designed to address this critical issue.34 The model followed by most of the MFI‘s is the JLG (Joint Liability Group) model; this model envisages five to ten women acting as co guarantors for the rest of the group.35 This strategy is handy as it encourages the inclusion of fiscally responsible co members. The other critical area which makes this model an attractive proposition relates to the stipulation that future loans would be issued only on the basis of prior repayment record of the group. 36 This in turn encourages timely repayment of loans.

29 30

Id. Id. 31 Id. 32 Id. 33 Id. 34 LOK CAPITAL, supra note 6. 35 M S Sriram, Microfinance: A Fairy Tale Turns into a Nightmare, October 23, 2010, available at http://www.mssriram.in/sites/mssriram.in/files/epw-fairytalenightmare_0.pdf (last visited on March 11, 2013). 36 LOK CAPITAL, supra note 6.

The size of micro loans varies from an initial size of 100$ to 150$ while subsequent loans could range from 300$ to 500$ with the rate of interest generally in the range of 25% to 35%. 37 The schedule for repayment could be on a weekly or monthly basis while the term for the loan generally ranges from a period of 6 months to 2 years.38 Traditional finance institutions‘ loan rates are lesser compared to the rates charged by microfinance institutions due to a variety of factors. One of the main reasons behind the charging of a higher rate of interest is the administrative costs associated with the servicing of smaller amount loans compared to the costs incurred for the servicing of larger loans.39 In addition, a unique factor of MFI‘s is the doorstep services that are offered to the customers. The costs incurred with regard to this factor are high especially in the context of rural areas where the density of population tends to be low. Due to the factors enumerated above, MFI‘s generally have high operating ratios in the range of 6% to 15% which again is contingent upon the size of operations and the efficiency levels of the MFI in question.40 This model enables MFI‘s to achieve a ROA of about 3% to 5% while simultaneously boasting of ROE in the range of 20% to 30%.41 These high ROA and ROE numbers are dependent on factors like low cost financing from commercial banks along with the ability to maintain high portfolio growth and quality. 42 It has been generally observed that the portfolio quality for a typical MFI is superior to that of a commercial bank with the rate for Non Performing Assets of an MFI ranging from 0.2% to 3% in comparison to rates of 3% to 10% for a commercial bank.43 The discipline inherent in the JLG model combined with the mutual support informally embedded in such groups with relation to the loans of the members contributes to the high quality and performance of the MFI portfolio.The maturity of the business model subscribed to

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Id. Tara S Nair, Microfinance: Lessons from a Crisis, February 5, 2011, available http://www.epw.in/commentary/microfinance-lessonscrisis.html?ip_login_no_cache=cbed2465bc2ef38cca62150d8f980fb7 (last visited on March 11, 2013). 39 Id. 40 LOK CAPITAL, supra note 6. 41 Id. 42 Id. 43 Id.

at

by the MFI‘s can be seen from the rates for ROA ranging from 3% to 5%. This high rate of ROA can be achieved with the refining of the business models followed by the MFI‘s.44 An MFI provides various kinds of products to its customers. These range from providing loans for a start up to providing sums required as working capital. 45 Agricultural loans are also provided by MFI‘s to deal with problems relating to crops and livestock. 46 Credit for the purposes of general consumption is also advanced by MFI‘s these days. The move of MFI‘s to provide educational loans and loans for house improvement could herald progressive changes in society while giving the microfinance movement a boost.47

THE NEED FOR MICROFINANCE INSTITUTION BILL, 2012
This can be explained by the example of Andhra Pradesh crisis. A spectacular expansion of microfinance sector occurred from 1990s to 2000s in the state of Andhra Pradesh and it became the sole centre of microfinance in India, and was known as ―Mecca of Microfinance‘. 48 Alongside with it, self- help group (hereinafter SHG) which is a state sponsored programme that join or link the SHG to formal banking sector and MFI expanded at a very swift speed over 2000s.49 But this high rate of growth came to a halt in October, 2010 when this period of boom turned into a period of bust. It was huge news in the media as approx 54 microfinance clients have committed suicide under the pressure of crippling debt burdens and coercive methods of the microfinance sector for repayment of debt. These suicides were contrasted to the considerable fortunes made by the executives of microfinance corporations.
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The Andhra Pradesh

government passed an ordinance- The Andhra Pradesh Microfinance Institutions (Regulation of Money Lending) Act, 2010 in response to clamp down the MFIs due to these cases of suicides.51 The aim of this act was to tighten down MFIs ability to borrow further funds from the banks as well as it restricts the MFIs to collect back the existing debts from its clients. Hence, this resulted in a crisis as MFIs were unable to function properly which led to many companies facing
44 45

Id. JACOB, supra note 22. 46 Id. 47 Id. 48 Marcus Taylor, The Microfinance Crisis in Andhra Pradesh, India: A Window on Rural Distress, 2012, available at http://www.foodfirst.org/en/microfinance+india (last visited on March 11, 2013). 49 Id. 50 Id. 51 Id.

insolvency.52 This ultimately resulted in breakdown of the market for micro-financing in Andhra Pradesh and hence, let to market failure. In order to avoid such crisis in the future the researcher would give an argument for explaining why the regulation by the government is necessary or compulsory to correct market failure. This is backed by twin arguments embedded in the ‗public interest‘ theory. First, externalities and monopolies often lead to market failure.53 Second, government action is capable of correcting the market.54 So, the ownership of the market given to the government can be extreme measure to ensure that the market is stable and is not under the monopoly of a strong and big firm; hence employment of a independent body which regulates the market is essential. The critiques, mainly from the Chicago school, states that if the competition in the market fails to correct market failure even then the government need not to interfere.55 They argue that the firms of the market will create an independent body which will make a fair code of conduct which is accepted to be followed by the industry. 56 Here, the industry self-regulates its activities as well as firms. Furthermore on the one hand, the industry maintains relationship with the government and on the other; it has the power to take actions against any individual firm which broke the code of conduct and hence endangered the entire industry‘s prospect. 57 This leads to four broad strategies– market discipline, self-regulation through industry bodies, government regulation, and state ownership.58 The move is a trade-off between two social costs— ‗disorder‘ where MFIs overcharge and abuse & ‗dictatorship‘ where government could impose external cost on private agents.59 Rather benefiting from this competition among the multiple firms the poor microfinance clients will borrow multiple dents from multiple firms. This will result in accumulation of many debts which outside the repaying capacity of these microfinance clients. Where competition fails, industry is expected to form associations which would take proactive steps to reinstitute consumer confidence through fostering transparency, ensuring consumer protection, and
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Id. PAL, supra note 4. 54 Id. 55 Id. 56 Id. 57 Id. 58 Id. 59 Id.

penalizing the erring player.60 Malegam Committee‘s (2011) recommendation for interest rate capping may be an attempt to make the price closely indicative of the relative scarcity of loan which otherwise seemed to be overpriced in certain markets and this has been incorporated in Micro financing bill, 2012.61

PROBLEMS WITH MICROFINANCE INSTITUTION BILL, 2012
Section 2 (i) of the bill recognizes five types of organizations providing micro finance services as MFIs, namely: a) society registered under the societies act; b) a trust; c) a non-banking financial company; d) any other corporate body; e) any other entity defined by the Reserve Bank of India.62 Thus by this definition the bill actually limits its coverage and scope; hence excludes livelihood based cooperatives, banking institutions and money landing activities covered by other central and state laws.63 The bill basically deals with the corporate sector of microfinance i.e. MFIs and it is quiet vague on the ways to deal with SHGs which is developed because of long term client‘s saving activities.64 Should a federation, then, be considered a potential MFI or a client institution that receives loans from MFIs? The bill is not clear on this point.65 A further question needs to be asked on clubbing of societies with corporate bodies, even as there is a welcome recognition to regulate the NGOs, societies and all other entities in the sector. 66 Is the government simply legitimizing the operations of all corporate entities by clubbing them with other so-called non-profit agencies or do the two needs to be treated differently?67 If a distinction is made between the two, then perhaps the inclusion of federations will become easier to tackle. Furthermore section 1568 states that if any organization is to be registered as a MFI, its net owned fund should not less than Rs 500000/-. This limit should be

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Id. Id. 62 Archana Prashad, Women and Microfinance Institution Bill, 2012: Some Issues of Concern, July 2, 2012, available at http://peoplesdemocracy.in/beta/content/women-and-micro-finance-institutions-bill-2012 (last visited on March 11, 2013). 63 Id. 64 Id. 65 Id. 66 Id. 67 Id. 68 The Micro Finance Institutions (Development and Regulation) Bill, 2012.

removed as the MFIs will only be induced to register multiple companies and societies in order to evade such registration.69

The proposed bill certainly have problems but the biggest one of them is that there is no provision which put a curb or limit on the interest rate which a MFI can charge; hence the MFI are charging interest rates from 24 to 36 percent, even more in some cases.70 According to this bill the RBI has the power to determine the ―aggregate percentage rate (i.e., rate of interest, and all other costs incurred) and the limits to ‗margin‘ (profits) being harnessed by MFIs. 71 But the women whose empowerment is the main focus of microfinance in India have been demanding credits at cheap and affordable rate of interest have no assurance in the bill. The main aim of microfinance is to provide credit to the deprived and financially excluded section of the society who have no access to banks, the government has to ensure that MFIs do not charge higher rate of interest than what a public sector bank charges while providing credit to women or SHGs which usually vary from 4 to 12 percentage depending on the subsidy provided by the government.72 In terms of the institutional structures and rules, the bill provides the RBI unrestricted and enormous powers to regulate the operations in the sector and make rules accordingly.73 Also this bill gives the power to the RBI to delegate powers to other body for making decision like NABARD. Furthermore, it seeks to provide for district, state and national level Micro Finance Councils which are merely advisory in character and with the main aim to promote micro finance activities.74 In the bill there is limited representation in general for women, apart from that there is no provision for representation of organizations like SHGs of joint liability group (hereinafter JLG), or even for women‘s organizations in these councils.75 The unfair means of practice currently performed by the MFI which led to Andhra Pradesh crisis has no mention in the bill. The issues related to the coercion practices for repayment of debt are

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PRASAD, supra note 62. Id. 71 Id. 72 Id. 73 Id. 74 Id. 75 Id.

left on the discretion of the RBI and any grievance redressal mechanisms being notified by it.76 In this form, the bill does not address the specific concerns of the families where women borrowers are facing harassment and in some cases even committing suicides to escape from the exploitation of MFIs.

CONCLUSION
The main focus of providing microfinance was for the empowerment of rural people especially women. But during the growth of microfinance sector its focus shifted from social welfare to profit maximization which ultimately led to the Andhra Pradesh crisis. After this crisis the state government made laws will resulted in insolvency of many MFI and market failure of this sector and hence poor people were once again unable to get small loans. Hence the government drafted the Microfinance Bill, 2012 with an aim that this bill will correct the market failure and once again poor people have access to micro credit which will result in their empowerment. Furthermore the bill is analyzed by the researcher. Thus in the preliminary analysis of the microfinance bill, it shows that the bill does address the needs of women borrowers whose empowerment are the main focus in India of the micro finance sector. Rather it is one more step in the direction of legitimizing the activities of corporate MFIs and integrating small borrowers with the market. 77 Therefore women‘s organizations need to analyze it carefully and build a sustained campaign that will put pressure on the government to redraft this Bill in order to address their specific concerns.

76 77

Id. Id.