Dhaka Starting Microfinance in India

Vijay Mahajan, Bharti Gupta Ramola and Mathew Titus, BASIX

The Demand for Microfinance Services

Credit: With a population of 1000 million, India has nearly 400 million people below or
just above an austerely defined poverty line. Thus, approximately 75 million households
need micro-finance. Of these, nearly 60 million households are in rural India and the
remaining 15 million are urban slum dwellers. The current annual credit usage by these
households is estimated to be Rs 495,000 million or US$ 12 biilion!

• Annual credit usage by 60 million rural poor households at an average of Rs 6000

is Rs 360,000 million per annum - about two-thirds for consumption and one-third
for production needs (Based on a 1994 study carried out by the first two authors
for the World Bank. The number has been rounded off and adjusted for 1998
prices).
• Annual credit usage by 15 million urban poor households at an average of Rs 9000
is Rs 135,000 million per annum - about 55percent for consumption and 45
percent for production needs. (Based on a 1995 study carried out by the first
author for the SEWA Bank. The number has been rounded off and adjusted for
1998 prices).

Savings and Insurance

Apart from credit, there is an unfulfilled demand for savings and insurance services

• For savings services, there are many service providers, but often unreliable. A
survey of the urban informal sector by the third author reveals that 55 percent of
residents suffer losses in both principal and interest from investments made in
operations that are best described as "fly-by-night". All this adds up to not only
making it time-consuming for mFIs to mobilise participation; but also and perhaps
more importantly for poor people to differentiate between an mFI and fly-by-night
operators.
• For insurance, the only source is the nationalised insurance companies who do
have many schemes for the poor, but with limited access, except when tied to
government schemes. Some microfinance institutions provide limited insurance
services.

The Supply of Microfinance Services

• All small savings are not microfinance, nor are all small loans. If we go by that
liberal definition, India is probably the world leader in microfinance. However, if
we say microfinance is small savings, credit and insurance services, based on
certain design principles, then there is little microfinance provided by existing
mainstream FIs (apex FIs, commercial banks, cooperatives, NBFCs) in India.
• The total outreach of existing specialised microfinance service providers is quite
limited. There is no authoritative countrywide estimate of the microfinance funds
disbursed or clients served. We have attempted a preliminary estimate in
Appendix 1. Ideally such estimates should be made state-wise.
• Informal alternatives for loans involve interest rates varying from 36 percent pa to
120 percent pa. For savings, while there is no dearth of deposit takers, micro-
savers suffer from "fly-by-night" risk.
 The Demand Supply Gap

Bridging the demand supply gap, even at high growth rates requires an environment that
attracts large numbers of microfinance providers. We recommend the adoption of a
"three track approach", using mutually complementary strategies:

• Incentivising existing mainstream FIs to enter microfinance seriously, by

establishing a supportive policy and regulatory environment.

• Encouraging new microfinance institutions (mFIs) with a supportive policy and

financial resources to enlarge and expand their services.

• Building a strong demand system in the form of community-based development

financial institutions (CDFIs), with the help of NGOs and others. Such a system is
required to

• convert latent demand into effective demand,

• wean away microfinance customers from moneylenders,
• remove the expectation of low interest rate and capital subsidies that have spoiled
borrowers over the years
• restore the repayment norm, and
• build local stake in grassroots financial structures

These CDFIs may be unregistered or registered. If registered, they may choose to be

societies, trusts, mutually aided cooperative societies (MACS) or even non-banking
finance companies (NBFCs).

2. The Policy and the Organisational Context

In this section, we begin by delineating the abiding challenge of microfinance – how to

simultaneously achieve high access by the poor, while maintaining sustainability for an
FI. We argue that the existing policy and regulatory framework militates against
sustainable provision of microfinance services, thus reducing access. Our argument is
based on an analysis of existing legislation, regulatory frameworks and the informal
guidelines of major institutions. The second part of our argument outlines the
organisational constraints faced by both mainstream FIs and alternative mFIs. It is
examined from the point of view of blocks in growth in access and sustainability.

Twin Performance Measures: Access and Sustainability

High Sustainability

Low Sustainable financial services with Sustainable financial services High

Access low access by the target clients reach the target clients Access
Highly subsidised financial services Highly subsidised financial
with low access by target clients services reach the target clients

Low Sustainability

3. Legal and Regulatory Framework

There are many aspects of the existing legal and regulatory framework which discourage
mainstream FIs from increasing outreach and achieving sustainability in microfinance.
Further growth in microfinance can only be possible by redressing these limitations in the
legal and regulatory framework. Mainstream FIs find it difficult to significantly expand into
microfinance for the following reasons:

• Policy makers’ view of the market for microfinance services stems from over a 100
years of attempts to get farmers out of the clutches of "usurious" moneylenders.
Thus, it is accepted wisdom that farmers and poor people need low interest,
subsidised credit. This shows up in policy: interest rates for loans below Rs 25,000
and Rs 200,000 by commercial banks are still capped at 12 and 13.5 percent
respectively. Some attendant beliefs are that the poor cannot save, they are
unwilling to repay loans, and administrative costs of serving them are high.
• Consequently microfinance has historically been seen as a social obligation rather
than a potential business opportunity. The leadership and managers of
mainstream FIs see the microfinance market as difficult to serve, risky and having
a low or negative net spread. Contributing to this position has been the fact that
small loans (IRDP, DIR, SC/ST) have been utilised historically as a tool for
disbursing political patronage, undermining the norm that loans must be repaid.
This has made bankers cynical about lending to the poor.
• There are specific problems with legislation: for example the NABARD Act does not
allow it to refinance any private sector FI and do any direct financing (NABARD’s
direct lending to micro-finance NGOs so far has been out of donor funds) NABARD
also refinances commercial banks/RRBs/cooperative banks who lend to mFIs.
Similarly, the SIDBI Act restricts it from extending loans to the agricultural and
allied sectors, whereas many of the members of self-help groups are engaged in
such activities.
• The Regional Rural Banks Act does not permit any private shareholding in any
RRBs, and the Cooperatives Acts of all states do not permit district level coop
banks to be set up except by the state government. The result of these two laws
together is that rural credit has been a monopoly of state owned institutions.

Some suggestions to improve the legal and regulatory framework

• Deregulation of interest rates for all small loans and supporting the policy that
small loans can indeed be charged a higher rate.
• Delinking poverty alleviation subsidised government programs from banks and
mFIs.
• Removing the government’s monopoly on establishing formal institutions in the
rural sector. This includes privatising RRB and allowing independent Rural Coop
Banks on the lines of independent Urban Coop Banks. The LAB policy should also
be implemented.
• Modification of the NABARD and SIDBI Acts to legitimately allow these apex bodies
to finance mFIs as part of their regular operations and not as "promotional"
activity.

In the case of alternative mFIs there are problems not so much with the legal framework
as with the fact that most mFIs have come up under inappropriate legal forms – as non-
profit societies/trusts. The issues are too numerous to be listed in the text and hence are
dealt with in a tabular form in Appendix 2. We do urge the readers to look at that
appendix in some detail. However suggestions for reform are given below:
Non-profit MFIs

The Ministry of Finance (Central Board of Direct Taxes) and RBI should seriously decide if
non-profit mFIs can be allowed to engage in lending activity without threatening their
non-profit status. If the decision is positive, then the following changes are needed:

• Section 2(15) of the Income Tax Act should be amended to include "microfinance"
as a charitable activity. For this microfinance may be defined tightly – such as 80
percent of the loan portfolio being in loans less than Rs 25,000.
• A new section 10(23)(H) may be added to introduce a status for micro-finance
institutions similar to infrastructure companies.
• Section 11(5) of the Income Tax Act should be amended to allow non-profits to
invest in the equity capital of for-profit microfinance institutions, which they may
set up

Mutual Benefit MFIs

• The Central Government should adopt a progressive cooperative act along the
lines of the APMACS Act, 1995, to allow genuine member control and free coops
from government control and possibility of political interference. (This was
announced by the Finance Minister in the budget speech).
• NABARD should stop refinancing coops in those states where the government is
not amenable to enacting progressive legislation and where interest and principal
waivers are announced. (NABARD has done this in some cases, with positive
effect.)

For-profit mFIs

• The RBI Act, NBFC Rules, already recognise nine types of NBFCs, including leasing
and hire purchase, and housing finance NBFCs. These regulations should be
amended to recognise a new form of NBFC – specialising in microfinance. The
definition can be as given above – at least 80 percent of the portfolio below Rs
25,000.

• Deposit taking should be allowed to NBFCs fulfilling certain prudential

requirements, such as a minimum level of capital, sound management, etc. and
not linked to their being rated. Deposit insurance should be extended to NBFCs
fulfilling these requirements

• Section 36(1)(viii) of the Income Tax Act should be amended to include

microfinance institutions as eligible under this provision, at present available only
to housing finance companies which allows up to 40 percent tax rebate if the
amount is set apart in a special reserve. This will also enable these mFIs, to accept
deposits from non-profits.

• The Local Area Bank policy announced in 1996 should be implemented forthwith to
allow private small banks to come up in three contiguous districts.
• The Regional Rural Banks Act should be amended to allow private ownership of
RRBs.

General
 • A self Regulatory Organisation (SRO) of mFIs may be established to set standards
and enforce them. The proposed Association of microFinance Institutions of India
(AMFII) is one such SRO.

4. The Problem of Financing mFIs

As the reader will notice, we are not even talking about the financing problems of
mainstream FIs. They are flush with funds and have access to enormous amounts of low
cost savings deposits. Indeed the poorer the region, the lower is its Credit-Deposit ratio –
most of eastern UP, Bihar, Orissa and the North-East have CD ratios of 20-30 percent.
The rest of the deposits find their way into the financial sector.

Thus the only microfinance players who are facing a funds shortage are alternative mFIs,
a vast majority of whom are NGOs. There are also NGO promoted SHG federations, (in
AP) mutually aided coop societies, and a very small number of NBFCs. Existing practices
of bulk financing institutions such as the Rashtriya Mahila Kosh (RMK), NABARD and
SIDBI, and even the FWWB have limited their funding only to NGOs. As a result, the
largest incentive to enter such services remains through the non-profit route.

NGOs invented micro-finance but NGOs are not the best type of agencies to carry out
micro-finance on a long-term sustainable basis. This is because the main funds of NGOs
are grants, which are very limited. Moreover, if NGOs earn a substantial part of their total
income from lending activity, they violate section 11(4) of the Income Tax Act and can
lose their charitable status under section 12. This is because microfinance, even for the
poorest, is not a charitable activity under section 2(15) of the IT Act. Moreover, NGOs do
not have the appropriate financial structure for carrying out micro-finance activities.
Because NGOs are registered as societies or trusts, they do not have any equity capital
and can never be "capital adequate".

In the long run, the primary source of lending funds for mFIs has to be deposits.
However, to reach that stage, an mFI has to become a going concern. Till that stage, the
mFI has to rely on borrowings. To be able to attract borrowings, the mFI has to have
equity capital. Thus, it is only possible to establish a financially sustainable mFI either as
a cooperative or as a company. In most states, with the exception of Andhra Pradesh,
Maharashtra and Gujarat, cooperatives

are politicised and state controlled, and thus not an appropriate form of incorporation for
an mFI. That leaves an mFI with the choice to be incorporated as a company and then
become an NBFC or a Bank. The latter requires a licence and a minimum start up equity
of Rs 100 crores, which is very difficult for an mFI to mobilise. The concept of Local Area
Banks (LABs), with a lower start up equity of Rs 5 crores, has not yet been
operationalised by the RBI.

Thus, at the moment there are only two options – either be a cooperative in AP/
Maharashtra/Gujarat or be an NBFC. If an mFI opts to be an NBFC, because of the
reasons stated above, it finds it very difficult to mobilise any borrowings from Indian
financial institutions due to the negative image of NBFCs in general. Further, even deposit
mobilisation is not possible at least for the first three to four years, till a satisfactory
rating is obtained. That leaves the option of borrowing from foreign institutions, which is
difficult in the first place. Further, very few foreign institutions are willing to give rupee
denominated loans. Thus, mFIs taking foreign currency loans are subject to exchange
rate risks, which they would not be able to handle.
Suggestions to increase financial resources for mFIs

• SIDBI, NABARD and the NHB should consider extending refinance facilities or lines
of credit to mFIs, which are incorporated as NBFCs or MACS. The interest rates
can be nearly commercial – from 13.5 to 15 percent.
• SIDBI, NABARD, and NHB should also consider making an equity investment in
mFIs so as to strengthen their capital structure as well as give greater supervision.
• The RBI should treat bulk lending to mFIs by commercial banks, particularly new
private banks who do not have a rural or urban low-income area branch network,
as priority sector lending.
• The RBI should allow banks to treat bulk loans to microfinance NBFCs as priority
sector loans.
• The RBI should operationalise the Local Area Bank policy without any delay.
SIDBI/ NABARD/ICICI/HDFC/ etc. may consider taking an equity position in some
of the LABs.
• In states where there is a possibility to set up mFIs under progressive cooperative
legislation, such as the AP Mutually Aided Cooperative Societies Act (MACS), 1995,
SIDBI/NABARD/NHB may consider funding such MACS directly or through an apex
structure such as the proposed AP Mahila MACS.
• Start up equity capital is difficult for most promoters of mFIs because most of
them come from a developmental background. Yet, it is prudent to have
reasonably high start up capital requirements to ensure that mFIs are established
as serious institutions. Thus we suggest that the National Equity Fund (NEF) may
be used for supporting mFI entrepreneurs.

• Many foreign donors have taken a policy decision to experiment with funding
mechanisms other than grants – soft loans, commercial loans, guarantees and
equity. One of the issues related to loans from foreign donors is that of exchange
rate risk. Most mFIs can not bear or even get cover for long term exchange rate
fluctuations. Thus, many donors are willing to give loans which are denominated
and repayable in Rupees. This should be encouraged by the Government of India.
If necessary, a new scheme possibly called "Rupee Repayable Foreign Currency
Borrowings (RRFCB)" can be established and powers given to the RBI to
administer it.

• Donors should develop alternative mechanisms to provide equity support.

However, this often may lead to a situation where initially, the equity capital held
by foreign donors exceeds 51 percent of the total capital. This is not allowed under
the Foreign Investment Promotion Board norms for financial services, unless the
investment exceeds $ 5 million. Most donors would not put in $ 5 million in a
single mFI. Thus this limit should be reduced to $ 1 million for mFIs.
• The government should consider extending the "sweat equity" scheme (wherein
the promoters' contribution of effort and experience is counted in monetary terms)
to the microfinance sector. This is very apt since most mFI promoters have little
money of their own, though lot of developmental experience.

5. 5.Organisational Constraints

Certain organisational attributes are necessary for microfinance institutions in becoming

sustainable and increasing access. These are discussed below:

Organisation Leadership and Governance

 • There is an absence of a supportive framework for encouraging entrepreneurs and
entrepreneurial organisations to enter microfinance and contribute to increasing
outreach and sustainability of financial services. This largely stems from the
barriers to entry in rural financial services due to government monopolies. Further,
the attitude of apex FIs and donors supporting mFIs is also based on a view that
microfinance should be done by non-profits, rather than by for-profits.
• Non-profit mFI leaderships usually do not have any incentive to adopt best
practices related to managing financial service organisations. Governance and
accountability are limited in case of non-profits. (This is not to deny that there are
some high performing non-profits in microfinance, but they are exceptional). The
current lenders to non-profit mFIs are just beginning to acknowledge this.
• In case of mutual benefit type mFIs, the assumption is that member control would
ensure good governance. Member control gets seriously limited as soon as the size
and distance of an mFI grows beyond a few hundred members and a few villages.
Differences in income, literacy and exposure levels can lead to the problem of
control by a few in coops.
• In the case of for-profit mFIs, of which there are very few so far, the issue of
investor benefit vs. user benefit remains. This can be resolved partly by making
depositors and borrowers also shareholders.

Human Resource and Management Information and Control Systems

• The lessons from some of the best mFIs around the world show that it is possible
to provide microfinance services to the poor at reasonable cost provided use is
made of certain methodologies – group lending, peer guarantees, step-ladder
lending, matching repayment terms with borrower cashflows, etc. Moreover, use
must be made of information technologies and performance linked incentives for
staff. However, all these ideas are unacceptable in the current regime of
mainstream FIs, which are largely government owned, with unionised employees
and officers, resistant to computers and performance incentives. Like mainstream
FIs, many non-profit and mutual benefit organisations are averse to idea of
incentives and performance linked payments.
• In mainstream FIs, though there is no shortage of qualified staff, they require
exposure to microfinance and a shift in attitude and behaviour towards this
market. Many mFIs are already performing this role of exposure and training of
bankers. However, in mFIs themselves, there is a shortage of good quality staff at
all levels, from village level barefoot accountants to back office systems
administrators. The more senior level staff usually have better alternative
opportunities in the mainstream. Finally, in mutual benefit type of mFIs, staff
problems are acute, particularly when they grow beyond the level of one or two
villages.

Some Suggestions to Mitigate Organisational Constraints

Organisation Leadership and Governance

• A major mentoring program should be started in microfinance. Donors/funders

should demand this as the "dividend" for their investment. Pioneer mFIs should be
asked to spawn new mFIs every few years along with experienced human
resources to lead them.
• The government should offer a golden handshake to the staff of non-viable rural
and urban bank branches by allowing them to run the branches as independent
 mFIs, with lower costs and better spreads. The government equity can be
transferred to the staff volunteering for this, over a period of time, through an
employee stock ownership plan.
• Governance and accountability are limited in case of non-profits and need to be
improved. Their Boards must be made aware of their financial liabilities in case of
failure. The lenders should be more stringent and insist on nominating a few
directors.
• Non-profit mFI leaders should be given proper incentives in the form of bonuses to
adopt best practices related to managing financial service organisations.
• In case of mutual benefit type mFIs, member control must be ensured by
institutional investors/lenders. Repeated election of the same office bearers should
be discouraged.
• In the case of for-profit mFIs, institutional investors/lenders must insist on Board
positions if they are taking a stake of more than 10 percent.

Human Resource and Management Information and Control Systems

• Performance linked incentives for staff should be encouraged.

• In mainstream FIs, exposure to microfinance and a shift in attitude and behaviour
towards this market, should be accelerated. Many mFIs are already performing
this role of exposure and training of bankers.
• In mFIs themselves, the shortage of good quality staff at all levels needs to be
overcome by converting the pioneer mFIs into training institutions.
• Use of computers and telecom equipment must be encouraged by mFIs and
institutional investors/lenders should conduct sample checks of operating data.
• Customer satisfaction audits by independent agencies must be conducted from
time to time.

Conclusion: To return to the title, the microfinance movement in India has got stuck in a
mire of legal, policy and organisational constraints and needs a "dhakka" to get along its
way. We have argued for adopting a three track strategy in this paper: re-orienting
exiting FIs in favour of microfinance, encouraging new specialised mFIs who see this as
their business, and establishing a network of community-based financial institutions
(CDFIs). Eventually, it is this category of institutions which would ensure that both state-
controlled and market-oriented mFIs work for the benefit of microfinance users.

Appendix 1: Apex and Wholesale Institutions Supporting Microfinance in India:

A Preliminary Estimate

Background Cumulative Cumulative

Disbursement Intermediaries
Institution (Rs million) (Number) Access
(Number)
National Bank An apex refinance Mar 98: 214 Mar 98: 260 Mar 98:
for Agriculture institution set up in 250,000
and Rural 1982. Has promoted Mar 97: 118 Mar 97: 220 (SHGs linked
Development linkage of self help 14,283)
groups with banks
(NABARD) since 1992. Data for Mar 97:
SHG linkage 150,000
programme only. (SHGs linked
 8,598)
Small Set up in 1990. Micro May 98: 57 Mar 98: 116 Mar 98:
Industries Credit Scheme (a 89,000
Development small portfolio) (Sanctions Mar Mar 97: 79
Bank of India started in March 1994. 98: 166) Mar 97:
(SIDBI) Mar 96: 47 61,600

Mar 96:
20,900
Housing Mainly involved in Jun 98: 1020 – Jun 98: 75 Jun 98
Development housing finance- sanctioned 118,000
Finance including to low
Corporation income groups 808 – disbursed,
(HDFC) through NGOs since all of it except 8,
1992. Started support for low income
to Micro-finance housing
initiatives in 1997
Rashtriya Department of Women Apr 98: 353 April 98: 257 April 98:
Mahila Kosh and Child (Outstanding in 250,462
(RMK) Development (Govt. of Mar 98: 160)
India). Set up in
March 1993 with
corpus of Rs 310
million.