Microfinance 2.0

The last decade has seen a sensational rise and fall of microfinance in India.  After the crisis in Andhra Pradesh (AP) that claimed debt related suicides on account of exorbitant interest rates and high pressure collection tactics, the Reserve Bank of India (RBI) has finally put in place regulations based on the recommendations of the Malegam committee.   With massive defaults to contend with and the new regulation that places caps on the rates and spreads, the industry is struggling to find its feet again.  Many of the less efficient players are out of luck and out of business.  Others are tightening their belts and getting more efficient in their operations. But, is microfinance 2.0 just about process efficiency? Or can it be something greater?

Microentrepreneurs operate in a cash economy where nothing is registered and documented. There are no books to audit.  How then can you figure out if they are genuine and if they can be successful?  Traditional methods of risk assessment simply won’t work.  Rather, we need a different approach, one that builds profiles of success that are easily measurable and can be translated into effective risk assessment tools.

Where it began

Let’s start with the premise of microfinance and what it started out trying to solve over a decade ago.  Back in the ‘70s and ‘80s, microfinance- ‘small loans to the poor’ – was the domain of the banking sector.  First, the only reason they were lending was because it was the government mandate. The loans were so small that given the cost of servicing them, it was a losing proposition to begin with.  To make matters worse, banks ended up with massive defaults, sometimes even up to 40 per cent.   And when the borrower can provide no collateral and has no identification, how do you go after him?  He can simply disappear and even if you find him there’s no guarantee you’ll get anything back.

The microfinance industry in India began to take shape in the early ‘90s as banks pulled back from this customer segment, licking their wounds.  The problem ‘microfinanciers’ stepped in to solve was to find a way to make credit available to the poor on large scale in a viable way. This meant finding cheaper ways of delivering credit and mechanisms to ensure repayment.  On these counts the industry has had some fair success and some failure.  The group lending model where members guaranteed one another’s loans created peer pressure that ensured higher repayment rates than the banking sector ever achieved.   Also, the new ‘microfinance’ focused on women who turned out to be more reliable in the group dynamic.  Further, many microfinanciers dared to lend at rates almost three to four times what their banking predecessors had and found that there was easy uptake in the market. This meant much larger spreads than the banking industry had ever enjoyed. This made not only for viable lending, but for a highly profitable business model.  It was certainly not cheaper credit, but it worked.

Into a crisis

So, how did it go wrong? As investors and financiers flocked to the market to lay claim to their share of a high margin business, credit became an easy commodity.  In some markets, like in AP, where most of the large players began, loans were easy to come by and people began to borrow well beyond their means.  The peer pressure that worked so well when credit was scarce began to break down.  Borrowers could default on one loan and still access credit from another lender.  And the consequences to the defaulters?  Nagging loan officers standing at their doorstep hurling threats.  Pressure began to build in the system and the crisis began.

Moving ahead

But, what now? With the caps on interest rates and spreads, only those who can service loans viably at lower costs can survive. This will force greater operational efficiency in the model and borrowers will get credit at more reasonable rates. In the short term, credit supply to the poor will shrink which will reinforce the peer pressure.  And there will be more measured, responsible growth.  But, this isn’t just what all the fuss was about.  The fame of microfinance wasn’t simply that it could make profit by lending to the poor.  It was that this credit supply was touted as a path out of poverty.  The question is, was it? And if it wasn’t, can it be?

According to the Malegam committee report only about 20 per cent of the microfinance loans were used for income generating purpose, i.e. invested in a business. However, it is not known how many of those businesses did well and how many lost money.  In our own studies at Madura Microfinance Ltd., we have found that many of these businesses are not successful.  In this context much of the discussion around microfinance has been about how to help turn the poor into successful entrepreneurs through training and other means. However, while this is a necessary endeavour of the country, I would argue that it is not the job of microfinance.

A new model

So, what should microfinance 2.0 look like? The role of capital markets in general has never been to create entrepreneurs, but to find those who are, assess their potential for success and provide the capital to make it possible.  It is when the banking system has been most successful at this that it is most beneficial to an economy. I would argue therefore that microfinance 2.0 should be about this as well – to not just get efficient at providing credit to anyone that is poor but to transition to identifying and financing genuine microentrepreneurs with the highest chance of success or conversely, the lowest risk of failure.  This is no easy task however, but not impossible.  Microentrepreneurs operate in a cash economy where nothing is registered and documented. There are no books to audit.  How then can you figure out if they are genuine and if they can be successful?  Traditional methods of risk assessment simply won’t work.  Rather, we need a different approach, one that builds profiles of success that are easily measurable and can be translated into effective risk assessment tools.

With microentrepreneurs, particularly ones in rural ecosystems, there are three key aspects to risk: the first is ecosystem risk -what environment do they operate in? Do they have access to electricity, transportation and communication? These factors play enormously into the possibilities for entrepreneurial success. Imagine being in an isolated village where there is no way to transport your goods outside. Your market is then restricted to the limited population of your immediate surroundings. For the rural poor, this is far greater a risk factor than any other.  The second source of risk is business risk: what kind of business are they operating and how do ecosystem and individual risk parameters relate to their specific choice of business?  For example, business risk for perishable goods is more sensitive to transportation frequency.  The third source of risk is individual risk; not just parameters like literacy and education, but their profiles of social behaviour. Do they venture outside their village often? Have contacts in neighboring towns or villages? Have a cell phone that they use for business purpose? Read the newspaper? All of these factors determine how they will behave as entrepreneurs. The smaller their social and information networks, the fewer opportunities they encounter.  Building these tools requires some analytical rigour. However, this is the age of analytics and this is where I believe the sector needs to head.

The better we get at finding and funding the entrepreneurs with the greatest potential for success, the greater the return for every rupee – for the financiers, for the poor and for the country at large.

Dr. Tara Thiagarajan is the Chairperson and Managing Director of Madura Microfinance and a Director of Microcredit Foundation of India. She is primarily a scientist whose interests encompass understanding complex systems and using a science based approach to solve large scale human problems through scalable for-profit enterprise. She writes a blog called, The Physics of Poverty, link: physicsofpoverty.com., which looks into a science based approach to understanding poverty.

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