There is undoubtedly a need to make microfinance institutions more transparent but capping lending rates will hurt numerous smaller MFIs operating in remote areas and thus may not help the poor.
CEO, Svasti Microfinance
Interest rate caps could force MFIs to avoid remote areas where the process of delivering loans and collecting repayments is people-intensive and quite expensive
According to reports, the finance ministry has suggested that public sector banks should ensure that microfinance institutions (MFIs) to whom they lend set a cap of 22 to 24 per cent on lending rates. Most MFIs in India charge customers 28 to 33 per cent (all-in costs including interest rate and processing fees).
We must understand why MFI interest rates are what they are. All lenders suffer three types of costs — cost of capital, loan loss provisions and transaction costs. Transaction costs for making many small loans are much higher than they are for making fewer larger loans. MFI clients live in remote areas. They do not have credit histories, collateral or financial documents to establish creditworthiness. The process of delivering loans and collecting repayments from them requires frequent physical interaction, is extremely people-intensive and quite expensive.
SKS Microfinance, India’s largest MFI, has reported total operating costs of around 12.66 per cent for fiscal 2009 in its IPO prospectus. Add to this the cost of funds for MFIs, which is around 11 to 12 per cent for the top MFIs and one to two per cent higher for smaller ones. Add further loan loss provision of two per cent, and you get 26 to 27 per cent as merely the break-even rate.
Remember that banks were charging all-in rates exceeding 45 to 55 per cent a couple of years back when they made small-ticket personal loans to lower middle-class customers. The only reason this business has halted today is the heavy losses and frauds. Even today, credit card and personal loan rates that banks charge are comparable to, if not higher than, MFI lending rates.
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A directive requiring MFIs to operate at a cap of 24 per cent will create panic among those institutions with systems, processes and infrastructure that, as currently designed, would make it difficult to immediately shift to dramatically lower rates. This is significant for the numerous start-up and smaller MFIs operating in remote or underserviced areas that lose money for many years before breaking even.
Capping interest rates for MFIs is advocated as a means of client protection, but it could have the opposite effect. Interest rate caps could force MFIs to avoid remote areas where it may be more expensive for them to operate. It could also make MFIs reluctant to reach out to the poorer segments of the population that require smaller loan sizes, which are more expensive for MFIs to administer. It may force excessive competition amongst MFIs servicing particular segments of the poor in particular regions that are relatively easy or less expensive to service, leading to multiple loans being made to these segments.
Also, most MFI loans are of one-year tenure with instalments collected weekly. A drop in interest rate from 28 per cent to 24 per cent on a one-year loan of Rs 10,000 translates into a total savings in the hands of the borrower of less than Rs 300 per year. This translates into reducing their weekly instalment by less than Rs 6 per week. In my experience of interacting with MFI borrowers, their top priority is to get bigger loan sizes and better service. MFI interest rates are far cheaper than the other available sources of credit for the poor, such as moneylenders. Availability of institutional finance is more important to the poor than a reduction in interest rates.
As MFIs establish their business model in each new market, compete for customers, capital, employees and banking relationships, economies of scale kick in and they adopt new technologies, they will innovate to reduce transaction costs and interest rates. Some leading MFIs have already announced a drop in rates and we will see more of this in the coming years.
As observed by the Raghuram Rajan Committee on financial sector reforms, liberalising interest rates would allow the formal sector to lend to the poor and keep them from the moneylender, though doing so would require the political will to accept the widespread evidence that low interest rate ceilings simply do not help the poor.
Instead, regulators must focus on improving MFIs’ lending practices, making them more transparent, ensuring clients understand the rates and terms of the loans and making sure MFIs take measures to reduce multiple lending to segments such as agricultural labourers for personal purposes. These are all important issues that deserve more attention and debate than MFI interest rates.
The views are personal
Principal Secretary, Andhra Pradesh government *
Microfinance institutions are achieving hyper profits at the cost of the rural poor, further impoverishing the already distressed rural sector
Microfinance lending is the story of how a system can move from “charity” to “robbery” led by avaricious elements raking in hyper-profits from the meagre surplus available with the rural poor. The atrocities being committed by microfinance institutions (MFIs) in the garb of lending to the poor and the resultant suicides in rural areas underline the urgent need to regulate this activity.
The irregularities committed by MFIs operating in Andhra Pradesh range from usurious interest rates, lack of transparency, cheating and using coercive mechanisms to recover loans, unveiling a new and a more cruel form of the moneylender system. Many of these MFIs have amassed huge profits and become commercialised at the cost of the rural poor, flourishing due to a lack of regulation.
Andhra Pradesh has, over the past decade, built the community-based self help group (SHG) movement. It has organised more than 10 million rural poor women into SHGs and federated them at the village, mandal and district levels. The government of Andhra Pradesh’s Society for Elimination of Rural Poverty (SERP) has achieved financial inclusion by linking these SHGs with the banks. Today, these SHGs have more than Rs 20,000 crore outstanding loans with the banks, bringing a radical decline in rural poverty.
It is this green pasture that MFIs have entered. MFI activities in Andhra Pradesh raise alarm bells for various reasons:
One, MFIs are poaching on the SHGs by showing them as joint liability groups (JLG) formed by them. SHG members are being induced to join JLGs by inducing the group leaders through promises of freebies. MFIs, therefore, are not helping spread financial inclusion, but are including themselves in existing set-up built over decades by SHGs.
Two, MFIs are resorting to multiple lending without conducting a due diligence exercise on the capacity to repay, purpose for the loan and its end use. As a result, prudential norms are being violated at will. This can destabilise the financial sector due to the possibility of large-scale defaults, thereby increasing non-performing assets, which can have a cascading effect on the balance sheet of the banks.
Three, in the case of non-payment or default, MFIs are using coercion and unethical means of recovery ranging from confiscating household articles, using goondas, forcing defaulters to take further loans for repayment and forcing poor women into prostitution, all resulting in considerable distress for the rural poor, driving some of them to commit suicide.
Four, there is no transparency on effective interest rates. Since the effective interest rates are concealed by weekly recoveries, the poor are unable to understand that the actual interest rates are over 30 per cent in most cases.
Finally, unlike SHGs, which are the community financial institutions, MFIs are achieving hyper profits at the cost of the rural poor, further impoverishing the already distressed rural sector.
So far, the Reserve Bank of India (RBI) has taken a stand-offish attitude to the problem, leaving a regulation vacuum. It needs to change its outlook given that the nature of these MFIs has changed over the past five years and they have become money-spinning businesses raking in hyper-profits.
Naturally, the Andhra Pradesh government cannot be a silent spectator to this “loot and scoot” system of MFI functioning. Since the RBI has stated that the state government is the best agency to regulate the activities of MFIs, we will certainly be looking at legislative measures to reign in their activities. We also feel that the draft Bill before Parliament to regulate the MFIs should be expedited. This will ensure that the unregistered MFIs’ activities can be curbed. We are in dialogue with the RBI to advise banks about the need to examine the activities of MFIs that register as non-banking financial institutions before lending to them. We strongly feel that the interest rate spread of MFIs may be limited to 8 per cent. They may also be mandated to disclose the “effective interest rates” to clients. The use of coercion and unethical practices in loan recovery should be strictly banned. Any distress deaths caused by MFI agents should be considered homicide and action should be taken under relevant section of Indian Penal Code.
*Rural Development Department