INSIGHT                                                         

The financial sector landscape continues to change in most developing countries in the Asian and Pacific Region with continuing liberalization, improvements in information technology, and increasing competition in the sector. The expansion of microfinance during the last decade has added a new dimension to these changes in many countries because it is gradually allowing access by the poor and low-income households to institutional financial services for the first time, and thus setting in motion a process toward ending their financial exclusion.

Microfinance in India

Microfinance in India started in the early 1980s with small efforts at forming informal self-help groups (SHG) to provide access to much-needed savings and credit services. From this small beginning, the microfinance sector has grown significantly in the past decades. National bodies like the Small Industries Development Bank of India (SIDBI) and the National Bank for Agriculture and Rural Development (NABARD) are devoting significant time and financial resources to microfinance.

The strength of the microfinance organizations (MFOs) in India is in the diversity of approaches and forms that have evolved over time. In addition to the home-grown models of SHGs and mutually aided cooperative societies (MACS), the country has learned from other microfinance experiments across the world, particularly those in Bangladesh, Indonesia, Thailand, and Bolivia, in terms of delivery of microfinancial services. Indian organizations could also learn from the transformation experiences of these microfinance initiatives.

            SHG as Borrowing Units

Self Help Groups (SHGs) form the basic constituent unit of the microfinance movement in India. An SHG is a group of a few individuals – usually poor and often women – who pool their savings into a fund from which they can borrow as and when necessary. Such a group is linked with a bank – a rural, co-operative or commercial bank– where they maintain a group account. Over time the bank begins to lend to the group as a unit, without collateral, relying on self-monitoring and peer pressure within the group for repayment of these loans.

             Banks as helping hand

With directed priority-sector lending an explicit feature of the formal banking sector,

India has built up a network of rural banks that is rare if not unparalleled in the world. The rural banking system, in its entirety, has an impressive coverage.

The reforms in the mid-90’s, following the recommendations of the Narsimham Committee Report, removed some of the constraints on the functioning of RRBs, easing their interest ceiling and allowing them to invest in the money market.

Since banks face substantial priority sector targets and microfinance is beginning to be recognized as a profitable opportunity, a variety of partnership models between banks and MFIs have been tested.

Figure 1 | Reorganization of the Banking Sector

Source: Harper (2002)

             NGOs as the middlemen

Self Help Groups are almost always formed with outside assistance. Developmental NGOs, often with considerable history of working in a particular area for projects like literacy, sanitation etc., take to organizing SHGs, bringing together people, explaining the concept to them, attending and helping coordinate a few of the initial group meetings, helping them maintain accounts and linking them with the banks.

With Swarnajayanti Gram Swarojgar Yojana (SGSY) launch in 1999 the SHG model received a further push from the government. Role of panchayat was examined in development of the integrated micro financing system.

Role of Commercial Banks

It has been shown quite conclusively that poor people need secure and accessible savings facilities as much as they need credit. Indian banks’ outreach to ‘micro-savers’  has been very impressive, even though it has not reached the poorest people; unlike the banks in Kenya and many other countries which demand high initial deposits and minimum balances, the Indian banks are far more lenient. However, the refusal of many branches even to open savings accounts for self help groups, and the continued success of local door-to-door savings collection businesses, where the saver pays for the service rather than receiving any interest, demonstrates that the banks do not completely satisfy the savings market. While the largest institutional investors in microfinance in India, NABARD and SIDBI, are government agencies focusing on SHG bank linkage programs, major private commercial banks like ICICI, HDFC and UTI to name a few have entered the sector with new models of investment and are expected to become key players on the supply side of the market.

Table 1 | Comparison of Interest Rates of Various Sources after adjusting for Transaction cost:

Source: Mahajan and Ramola

The transaction costs are similar to those for any other customer, the recovery rate is good or even excellent by Indian standards, they are willing and able to pay high rates of interest, and banks can satisfy their social mandate by doing business with them. India does not need new financial institutions, since it has an urban and rural branch network which is unrivalled for any country of a similar level of development. The SHG approach appears to be the right choice for Indian banks.

 Figure 2 | Distribution of SHGs among Different Bank Financial Models

Source: Kropp and Suran (2002)

Challenges and Issues

Regional Uneven Distribution

The first challenge is the skewed distribution of SHGs across States. About 60% of the total SHG credit linkages in the country are concentrated in the Southern States. However, in States which have a larger share of the poor, the coverage is comparatively low. The skewed distribution is attributed to

• The over zealous support extended by some the State Governments to the programme.
• Skewed distribution of NGOs and
• Local cultures & practices

Movement up the Value Chain

It is important to address the issue that after having formed SHGs and having linked them to banks, how can they be induced to graduate into matured levels of enterprise, how they be induced to factor in livelihood diversification, how can they increase their access to the supply chain, linkages to the capital market and to appropriate/ production and processing technologies.

Maintenance of SHG Service Quality

One of the important issues is to ensure the quality of SHGs in an environment of exponential growth. Due to the fast growth of the SHG Bank Linkage Program, the quality of SHGs has come under stress. This is reflected particularly in indicators such as the poor maintenance of books and accounts etc. The deterioration in the quality of SHGs is explained by a variety of factors including

• The intrusive involvement of government departments in promoting groups,
• Inadequate long-term incentives to NGOs for nurturing them on a sustainable basis and
• Diminishing skill sets on part of the SHG members in managing their groups.

Significant financial investment and technical support is required for meeting this challenge.

Role of State Governments

A derivative of the above is perhaps the need to extend the above debate to understanding and defining the role of the State Governments vis-à-vis the linkage programme. Let’s be clear: on the one hand, the programme would not have achieved its outreach and scale, but for the proactive involvement of the State Governments; on the other hand, many State Governments have been overzealous to achieve scale and access without a critical assessment of the manpower and skill sets available with them for forming, and nurturing groups and handholding and maintaining them over time.

 Emergence of Federations

The emergence of SHG Federations has thrown up another challenge. On the one hand, such federations represent the aggregation of collective bargaining power, economies of scale, and are a foray for addressing social & economic issues; on the other hand there is evidence to show that every additional tier, in addition to increasing costs, tends to weaken the primaries. There is a need to study the best practices in the area and evolve a policy by learning from them.

Figure: Microfinance Egg

            Policy Transformation

Focus on Customer: The customer is king, or in this case more commonly queen, and is always right. Banks should, however, try to overcome SHG members’ well-founded misconceptions by regarding SHG linkage as a product to be promoted rather than a scheme to be implemented. New savings and loan products are vigorously and effectively promoted with posters and in other ways.

Market oriented Service Development:  In particular it has been argued that RRBs as MFIs are essentially product- rather than customer-led in their approach to business. Their main focus is regarded as being on institutional rather than customer requirements. Crucially, therefore, it is evident that the behavior of management is integral to determining the success of organizations through their enactment of market-oriented information processing activities to develop and support market-led strategy. Equally, management behavior is integral to the creation of a market-oriented culture through influencing the prevailing values and beliefs of staff together with their shaping of the systems, structures and processes that impinge on the organization’s ability to deliver customer value in its market offers.

Figure 3 | Market Oriented Service Development Model

Source: International Journal of Marketing

Middle ground: A large part of the success of microfinance in Bangladesh and Indonesia has been to find a comfortable middle ground. Programs have taken important lessons from those who argue that if interest rates are raised to cost-covering levels, programs can ensure sustainability over time, thereby guaranteeing their ability to offer clients long-term continuous service. They have also been sympathetic to the concern that raising interest rates too high may undermine the social and economic impacts on clients and steer deserving customers away from microfinance. 

Microlenders have also worked hard to maintain quality standards, with the aim to charge a fair rate for a good product. By stressing convenience, reliability, continuity, and flexibility, programs have delivered products that are both much cheaper than those available from the informal sector and higher quality as well. 

Role of Middlemen: They should decide clearly whether they wish to evolve into micro-finance institutions themselves, by taking bulk funds and on-lending them, or whether they wish to focus on developing SHGs and then introducing them to banks. If they chose the latter course, they should attempt to share at least part of the cost of group development with the banks, so that the product can be self-sustaining rather than dependent on donor funding. 

Organizational Change: The regulatory environment for banks has been largely liberalized, but the internal management environment is often as tightly controlled. Organizational change is needed not only for micro-finance, but for the challenge of operating in the new and competitive market place, whether national or international. 

Banks should also attempt to develop less costly and more rapid ways of developing groups, as at least two Regional Rural Banks are already doing. They should recognize that it costs money to acquire new customers, even rather poor ones, and should be willing to pay this cost, whether by contracting the task out to NGOs or by undertaking it themselves.

Diversification of Product portfolio:  A critical but less-heralded breakthrough for Grameen was to create a loan product that allowed borrowers to repay in small, weekly installments. This suited poor households well, since they could repay out of the regular bits of income coming in daily or near-daily.

The main issue surrounding the effectiveness of RRBs is not the simple matter of providing low “price” loans, but developing financial products that are simultaneously desirable for their clients in addition to being commercially viable to themselves. Additional financial services like life insurance can be provided to the SHGs apart from loans and saving accounts services. 

Leasing is a dynamic type of business financing that is well suited to the microfinance industry. Many microfinance institutions (MFIs) are adding this new product to their financial services menu and using it to raise funds to finance capital equipment purchases. With leasing, an MFI can develop longer term financing mechanisms for its clients and increase their borrowing capacity. 

Training: Staff specialist training is essential to know the customer which is an SHG. The local language comfort has to be ensured so that a cooperative and nurturing environment is sustainable. Unfavorable management attitudes and behaviors are apparent in terms of their inadequacies to cope with complex situations and their pursuit of personal gain. This is often seen as a function of inexperience, limited capability, incomplete integration of functions, and power-related issues. Indeed, it has been suggested that the inadequacies of top management are a key obstacle to developing stronger market orientation, particularly in service industries. 

Development of Microbanks: An alternative MFI relying on the core principles of:

• Participation: Clients are selected by the microbank based on creditworthiness.
• Responsibilities/profit-sharing: The client is individually responsible for loan repayment, and is not involved in management, ownership or profit-sharing.
• Structure: Emphasis is given on a decentralized structure that gives decision flexibility and strong performance incentives to managers of the microbanks.

Role of RBI: Central banks have a potentially important role to play in the development of sustainable microfinance and the integration of microfinance into the broader financial sector. 

Central banks can contribute to the development of microfinance through careful and appropriately sequenced financial liberalization. This can increase the flexibility of banks and other financial institutions and enlarge the range of activities in which they engage, including microfinance. The scope for the establishment of small financial institutions is an important factor affecting the extent to which licensed financial institutions become involved in microfinance. 

Policy and Regulatory Measures: Sound macroeconomic policy and a non-restrictive regulatory environment are critical for growth of microfinance. The most effective way for governments to encourage commercial banks to become involved in microfinance is to ensure an appropriate regulatory and prudential framework. The elements of an optimal policy context are: 

• sound macroeconomic policies and basic infrastructure to ensure a growing economy
• minimal restrictions to profitable lending, particularly no interest rate caps
• enhanced ability to establish a small commercial bank which can focus on this sector
• Appropriate prudential regulations for this market including capital adequacy ratios, asset quality indicators and unsecured loan limits.

Having all these elements in place will not guarantee that commercial banks will start microfinance lending. However, there certainly would not be external constraints.

Role of state: Development of Microfinance Institutions (MFIs) through subsidization has already been established. Governments and donors have considerably increased their financial support for the promotion of MFIs so as to rapidly increase the number of clients. The state could play a role in the implementation of innovations such as microfinance services to agriculture or insurance services. A balance of power must be created between the state, the local authorities and the financial institutions through external control to avoid political intrusion while ensuring a dynamic adoption of innovation and sound financial practices. 

New Approaches: Newer approaches in India include the partial deregulating of interest rates, new institutional forms for cooperatives that put the emphasis back on inter-mediating the savings of their members, and a nationwide attempt, pioneered by nongovernmental organizations and now supported by the state, to create links between commercial banks, NGOs, and informal local groups. Securitization of MFI portfolios by commercial banks is underway. Micro loan securitization benefits MFIs in several ways: it decreases their cost of funds, provides a new source of off-balance sheet funding, and thus allows an MFI to expand lending operations. 

New sources of funding - At present the potential for new international sources of funding in India appears to be quite limited. The 40 percent priority lending target that exists for domestic Indian banks has given them a strong incentive to invest in the microfinance sector. This has led to some of the larger banks, such as ICICI, using MFI client portfolios to channel funds directly to borrowers. SKS, one of the largest MFIs in India, sees this model as potentially becoming the dominant means of providing lending to the poor.

Graph: Sources of MFI Funding

 Conclusion

A good microfinance program exhibits an attractive combination of the quality, depth, cost, breadth, length and variety of outreach. Progress in microfinance does allow improvements in one dimension of outreach without deterioration of another dimension. Indeed there are serious gaps between the current achievements and potential supply. Reducing the gap between current achievements and potential supply is the most immediate challenge for microfinance. Expanding the frontier requires more than greater technical efficiency; it requires innovation.