Follow Us:

Eye on microfinance~I

Microfinance was once applauded as the world’s most powerful tool for eliminating poverty. The initial microfinance boom brought many benefits. But it is now widely reported that the effects of microfinance loans on poverty, health and other social outcomes have been ‘small and inconsistent’.

Moin Qazi | New Delhi |

The beleaguered microfinance sector in India now seems to be on the active radar of regulators and there is hope that his flailing sector will get sturdier wings. The Reserve Bank of India (RBI) has released a consultative document on uniform regulation for companies engaged in microfinance business.

The document aims at harmonising the regulatory frameworks for various regulated lenders in the microfinance space.

The key proposals include a common definition of microfinance loans for all regulated entities, capping the outflow on account of repayment of loan obligations of a household to a percentage of the household income, a Board-approved policy for household income assessment and no pre-payment penalty or requirement of collateral along with greater flexibility of repayment frequency for all microfinance loans.

The proposals also include alignment of pricing guidelines for NBFC-MFIs with guidelines for NBFCs, introduction of a standard simplified fact sheet on pricing of microfinance loans for better transparency, and display of minimum and maximum and average interest rates charged on microfinance loans on the websites of regulated entities,

Microfinance programmes are small-scale special purpose vehicles for poor and underprivileged persons who normally fail to meet the eligibility norms of formal financial systems. These were supposed to provide the poor with the capital they need to start small businesses. They are more popularly called microcredit programmes.

Many of the self-employed entrepreneurs are women, who make a living with tailoring, weaving, snack vending, noodle-making and setting up their own sewing workshop or vegetable stall. Informal credit could not provide adequate working capital for these small businesses, and the lack of financing often prevented them from growing and becoming sustainable. Low-wage workers primarily take out micro-loans to pay off other unpaid debt, meet vital needs such as food, medicine or school costs or fund their children’s weddings. It is less common to use loans for business and agricultural purposes.

The cost to borrowers will inevitably reflect the risk of lending because many borrowers don’t have credit histories; thus, risk is assumed to be relatively high and is priced accordingly. Giving poor people small loans without collateral, albeit at higher interest rates than on conventional loans, was meant to spur entrepreneurship and allow people to bootstrap their way out of poverty. Most borrowers are women with no steady work. They buy consumer goods on hire purchase, and take loans for coming-of-age ceremonies or to cover family illnesses. Some borrow to send their husbands or sons abroad for work. If the job fails to work out, the man returns and the woman is saddled with debt.

The apparent winning card for MFIs, however, was their use of social collateral as opposed to the physical kind; women rarely had land or other assets to put up. They offer better terms than informal lenders. It has been found that with appropriate, accessible, and fairly priced financial services, people can build their savings, cover the costs of unexpected emergencies, and invest in their families’ health, housing, and education.

Microfinance was once applauded as the world’s most powerful tool for eliminating poverty. The initial microfinance boom brought many benefits. An obvious one was a decline in the use of loan sharks. The interest rates charged by formal lenders are lower though some microcredit outfits are purely commercial operations. Up until the late 2000s, microfinance was hailed as a financial magic bullet by many. It hasn’t quite turned out that way. That is the theory, but evidence is rare and mixed. Microfinance is not a magic bullet but it does provide a tangible and calculable boost to poor communities in their efforts to escape the cycle of poverty. It is now widely reported that the effects of microfinance loans on poverty, health and other social outcomes have been “small and inconsistent”.

There are doubts on whether microfinance truly helps the poor or drives them further into poverty with aggressive client recruiting and high-interest lending. Experts are questioning the myth that the poor can easily take a ladder out of poverty with some credit; or that microcredit can be financially self-sustaining. The reality is far more complex.

Microfinance is now on a slippery slope, moving from good to bad. It is facing trouble because the purity of its mission has been diluted. When it started, microfinance was a financial tool being used for social good. Now it has increasingly become a social tool used as a way to generate money, which is why it has lost a lot of its original sheen. This is one reason why microfinance often runs into heavy weather and hits periodic roadblocks and default crises.

There is huge difference between the rhetoric of ending poverty and the actual services offered in villages and slums. Where interest caps have been introduced, micro-loan providers required up-front fees from customers structured as percentages of the loans, ensuring that effective interest rates remained higher than the cap. An absence of credit bureaus allowed borrowers to seek funds from several platforms at the same time, creating a “borrow from Peter to pay Paul” scenario. There are now adequate organised Credit Reference Bureaus but they have also has been faulted for occasion in a country like India where there are multiple ways available to ingenious operators for manipulating records. Low-income households, in particular the rural poor, are exposed to unsteady flows of money. The reasons are many, including seasonal unemployment related to the agricultural labour cycle, sickness or death in the family, or weather shocks, among many others. Given the variability and vulnerability of their income, they value formal microfinance because it is more reliable, even if it is often less flexible than other tools to manage their cash flow. Banks offer cheaper credit but are mired in thickets of red tape.

Microcredit is primarily targeted at women, meaning that the worries of daily income for household needs and debt repayment fall overwhelmingly on female shoulders. When liability levels become unsustainable, many are forced to seek out debt bondage ~ labour as a means of paying off microfinance loans ~ in hazardous occupations. The fact is that microloans do help some people ~ but they also carry severe risks. Those who are financially illiterate or unfortunate are at considerable risk of sinking into a spiral of debt when this kind of lending goes wrong. Complementary elements like microinsurance and remittances both protect vulnerable families from health shocks and enable bread-winners to send cash quickly wherever it’s needed.

Microcredit, the flagship product of microfinance companies sector has shifted from a not-for-profit approach to a neoliberal model dominated by commercial banks. While previously loans were tightly regulated in terms of amounts, interest rates and collateral, and often underwritten by states when necessary, now lending has expanded to allow more unstable borrowers to take part without state protection or relief in times of crisis.

Microcredit has been a victim of three forces: overhyped rhetoric, imprudent lending, and the profit-focused nature of capitalism. Thus, microcredit requires a delicate and ongoing balancing act between undesirable extremes. It’s no wonder then that accusations fly when balance is lost. MFIs have placed their clients in debt peonage by bombarding them with loans.

Microfinance champions argue their effectiveness by sharing moving stories of microentrepreneurs. However, it is generally unclear (a) how these stories were selected; (b) how representative they are of the results as a whole, and (c) the extent to which creative framing and emphasis might play a role in emphasizing the positive aspects of the story while glossing over the negative.

The evidence of impact should normally be systematically collected (with as little opportunity for editorial slant as possible) and representative of overall results (which generally means collecting information on a large number of people rather than on a few). A single study ~ no matter how persuasive and rigorous ~ is not necessarily evidence that microfinance can create similar effects in the future. Many MFIs work on many different types of projects, in many different areas. It is important to consider whether any encouraging results might be (a) a simple fluke or (b) applicable only to the most successful programmes, not to MFI activities as a whole.

Microfinance needs a relook and must undergo soul searching. It is very important to think outside of the borrowing box, as microfinance will have to move beyond its traditional roots. Recent evidence suggests that relatively simple tweaks to microcredit products ~ including flexible repayment periods, grace periods, individual-liability contracts and the use of technology – may change their impact on both clients and institutions. Microfinance businesses should be consistent in applying best practices in evaluating repayment capacity, offering transparent terms and conditions and using credit bureau information to avoid overstretching clients with debts.

To enable the poor to work their way out of poverty, they need to be enabled to move up the steps of the financial ladder through graduated credit. Loans should be made available in staggered doses, with every new tranche disbursed on the basis of the satisfactory repayment behaviour of the clients. This will also ensure that vulnerable groups do not get into a debt trap and make credit dispensation more efficient and qualitative.

The writer is the author of Village Diary of a Heretic Banker. He can be reached at [email protected]

(To Be Concluded)