Thursday, September 23, 2010

MICROFINANCE- The New new thing.

(This article appears in Moneylife Magazine)


Microfinance is the new buzzword. In the name of ‘financial inclusion’ no one has bothered to either regulate them or decipher them. The first IPO was a roaring success with all making money. Hopefully all the forthcoming IPO’s from this sector will also help all stakeholders to make money.
Microfinance is not an easily scalable business. Being small is a virtue in this industry. This is because the lending has to deal with groups of borrowers whose characteristics change from region to region. In its simplest form, it involves lending small amounts (usually around ten thousand rupees) to each borrower in a group of four to five people, and make each one of them responsible collectively and individually. ThLis works fine when the needs are small and genuine. Moral suasion helps. The typical lending is for ten to eleven months, with weekly repayments. All is in cash. Some lenders have used this model to push compulsory insurance products at the borrowers and reap the benefits of the high commission that the insurance company pays. The lending rates typically vary from thirty to fifty percent per annum and the insurance commission is the icing on the cake.
In the early days, most microfinance companies started off with a lot of social fervour and with grants from multilateral agencies that support the cause of upliftment of the poor. Most companies started off as ‘not for profit’ companies. Gradually, the realisation that a listing is good, made these companies buy shell companies that had NBFC licenses and then merge the business in to them. In the process, the founders and the staff rewarded themselves with more than market salaries and huge stock options (mostly with zero outlay). The founding NGO’s took their money and so will the private equity investors who grabbed this opportunity.
I would urge those who are interested in this subject, to go through the papers written by Prof M S Sriram of IIM Ahmedabad, who holds a key position in the area of Microfinance. He has documented some very interesting case studies about the beginnings of the microfinance companies, which gives us a good insight in to a few of the promoters and professionals of the high profile industry. I found the paper titled “A Paper on Commercialisation of Microfinance in India” particularly fascinating. This paper documents how the professionals who started off with a ‘not for profit’ motive ultimately get back to making money, forgetting the start up vision.
I do not see this business as a scalable model. It is tough to scale up a business when it involves dealing with people (remember, the borrowers are of the highest risk category, with no wherewithal and unable to get credit from the banking system) across different regions, religions, castes and communities.
It is unlikely that microfinance companies will help to significantly replace the traditional moneylender. Maybe they would bring down the interest rates a wee bit, but not substantially. Given the ticket size and the collection costs, I do not see any lending below, say, thirty percent per annum being economically viable. Yes, if they sacrifice on employee costs, they can, but then why would anyone do this?
The other big factor is the ease with which the companies raise money. Having a large amount of lendable resources is the biggest threat. I think geographical scaling is not possible. The next risk they will take is of increasing the ticket size. I hear of the limit being raised from ten to twenty-five thousand. This is extremely high risk. Already, if you go through the offer document of the recently listed SKS Micro, the fact that frauds do happen is indicated. When ticket sizes are small, the number of frauds will be lower. Since it is an element of the business model to hire people at different locations, without much training or financial scrutiny, employee frauds are bound to keep going up. Credit standards also would get diluted (if not already happening).
The other big issue is one of regulatory imposts. Today, the microfinance companies operate in a vacuum, with total freedom. They do not have to disclose the rates of lending etc to the borrower. Once they start doing all this, there is bound to be social and moral pressure to lower the rate. For some time they will pretend to do so, by creating some fancy structures and selling other products like insurance etc to protect yields. However, I do not see this as a sustainable thing. Also, as the problems of collections start mounting, employee turnover is bound to increase exponentially. The capital market welcome to SKS micro will push up employee costs as each one who wants to hit the capital market will try and poach anyone with prior experience.
In the eighties, we used to have a lot of NBFC’s that went in to consumer finance. Today they are shuttered down and dead. Will microfinance companies give them company in the graveyard?

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