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Microfinance Questions: Part 1

May 29, 2011

A Look into the Indian Crisis

“A thinker sees his own actions as experiments and questions as attempts to find out something.  Success and failure are for him answers above all.”

It is a turbulent time in the microfinance sector and a lot of questions and criticisms have been raised.  Practices have been called into question, regulations have been passed and one of the pillars (if not the pillar) of microfinance as we know it has been toppled.  Are the accusations, rumors and finger pointing all deserved?  Will regulations being pushed through in India, and elsewhere, solve these issues or has the pendulum swung from prudent reform to stifling overreaction?

As the dust settles, and everyone tries to sort out the impact and implications of all this recent activity, we will likely find ourselves in a new era for microfinance and related development sectors (at least in India initially).  With genuine atrocities being attributed to lending practices in the India state of Andra Pradesh and the coerced departure of Muhammad Yunus from the Grameen Bank by the Bangladesh government, microfinance has been in the headlines quite a bit in recent months and, for the most part, not in a positive light.

A virtual tornado of press coverage exploded out of Andra Pradesh last fall when the story broke that indebted Indian farmers were committing suicide by the dozens due to high debt and the pressure they were under from the lenders to meet their repayment obligations.  While it now appears that much of the finger pointing and blame dumped on the microfinance industry was sensationalized or exaggerated, there is no doubt that several fundamental issues with MF practices in the state have been thrust into the spotlight as a result; including: an over-saturated market, creating cutthroat competition; a lack of oversight which allowed loan officers to harass borrowers with little or no consequences;  a looseness over the term “microfinance” in general and no regulatory structure to oversee the organizations operating under this umbrella term; the non-existence of a credit bureau, which contributed to a lack of communication between the different MFI’s and meant that lenders had no insight into a borrower’s current credit situation.  One effect from this last problem specifically, is that lenders began to take out additional loans from different MFI’s to make payments on their initial loans, which naturally led to an escalating spiral of increasing debt and repayment obligations.

Andra Pradesh boasted the highest concentration of MFI operators per capita in the world (still does, though it remains to be seen how many will survive the current sanctions) and the industry seemed to be in a state of nirvana.  Many of the larger MFI’s which began as non-profit organizations evolved into commercial institutions, some going public with IPO’s exceeding $1 billion US.  Capitalizing on the momentum, hype, and good publicity that microfinance had received over the preceding decades these large institutions, and hundreds of smaller ones, drove massively rapid expansion.  The sector grew from a portfolio of $252M in 2005 to over $2.5B in 2009 by some estimates, and this dizzying, seemingly ceilingless, rate of growth reminded a few observers of a similar scenario in the US housing economy and several sources foreseeing a bubble.  In the end, it was too much, too fast, and without a corresponding increase in infrastructure and oversight for the sector it was not sustainable.

That high level of concentration and rapid rate of growth resulted in ever escalating pressure on loan officers to increase their loan portfolio and carve out as much market share as they could grab.  Without an effective regulatory system in place, loans were increasingly disbursed with diminishing regard to the borrower’s ability to carry the debt, let alone if they were already carrying balances from competing lenders.  The result?  People took advantage of this “easy” credit and borrowed from multiple sources, lenders failed to properly evaluate potential borrowers and the stage was set for a self propagating system of increasing debt.  As the pressure on loan officers continued to grow they made increasingly riskier loans.  When borrowers were unable to make repayments loan officers escalated their recovery techniques.  As pressure was passed from the loan officer to the borrower some turned to other lenders to acquire the funds to repay the initial loan.  Obviously if borrowers are taking out supplemental loans to pay off existing loans they have lost the “road out of poverty” that microfinance is supposed to provide in theory.  This is not how the sector is supposed to work.

A simplistic way to think of this situation:

Competitive market + little regulation > pressure on loan officer > bad quality, high risk loans > inability to make repayments > increased pressure on borrowers > multiple loans > oversaturated market > overstressed, over served population > sector collapse/crisis.

There are certainly additional factors and influences at play on the ground that go beyond the scope of this post we will have to gloss over in the interest of brevity.  But many of the larger issues have been raised.  How do you implement an effective regulatory system that will be able to keep pace with the rapid growth rates being realized throughout India and other countries?  How will the heavy handed ordinance, suspending all MFI loan disbursement and collection activities, impact both the existing MFIs and the population they are serving?  In an effort to protect the poor from coercive practices has the government gone to far and deprived the silent majority of a much needed service?  Will India’s new direct cash transfer system have an impact on either poverty or the microfinance sector?

A lot remains to be seen in India and the world in general with regards to the direction of microfinance.  The illusion of the silver bullet is wearing off and increasingly studies and documentaries are calling into question the effectiveness of the sector in general.  Even in areas with better regulation, and without the extreme lengths reportedly resorted to by collection officers, doubts have been raised regarding the baseline principle that microlending can indeed help pull people out of poverty.  And, while most have little doubt that microfinance (practiced correctly) can be a hugely impactful tool in the fight against poverty, I for one sincerely hope that a deep look at the core principals and current best practices will lead to valuable changes moving forward.  The goal of course is to achieve positive reform and not to kill, or handicap, the industry.  Naturally, this is easier said than done.

Taking into consideration the changes coming and all of the questions swirling around microcredit I want to take a look at the microfinance product that I am working on in Mongolia and ask some hard questions regarding its effectiveness and whether or not it is truly reaching the vulnerable populations at the bottom of the ladder.  As this post has become over long as it is I will dive into this in a second post later this week.  In the interim I’d love to hear feedback, questions and thoughts on microfinance and where the industry is headed.

“Idealism is what precedes experience; cynicism is what follows”

For those interested in learning more about last year’s microfinance crisis in India here is an early case by case report on the suicides, reported cause, loan amounts, etc.

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