CHAPTER-1

INTRODUCTION

1.1 Research Background

1.2 Growth of Microfinance in India

1.3 Structure of Microfinance in India

1.4 Role of Microfinance and Self Help Groups in Financial Inclusion

1.5 Need for measuring financial sustainability of MFIs

1.6 Statement of Problem

1.7 Objectives of the study

1.8 Significance

1.9 Scope and Limitation of the Study

1.10 Structure of Thesis

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 CHAPTER-1
INTRODUCTION
1.1 RESEARCH BACKGROUND

Poverty has been a topic of discussion both for the academia and government across the
developing countries. Many initiatives like subsidies, insurance, health benefits etc have
been taken since independence to help the poor and alleviate poverty but inspite of the steps
taken the figures quoted are shocking. According to Rangrajan committee, after revisitng
Tendulkar's formula for estimation of poverty line population in India stated that still 363
million people are living below the poverty line which is 29.5 percent of India's population.
It shows that the poor do not need subsidies but need credit to be able to sustain a basic
livelihood. One tool among many has been microfinance which has gained importance in
past decade after the success of Grameen Bank, Bangladesh and United Nation declaring
2005 as the year of Microcredit. Microfinance Institutions (MFIs) provide small loans and
savings facilities to those who are excluded from commercial financial services.
Microfinance is seen as a key strategy developed for reducing poverty throughout the
world.

The work presented in the thesis is significant and important because it examines the
determinants which impact the long term financial sustainability of MFIs. As without
financial performance there is no sustainable outreach. Without outreach the MFI is just
another credit granting institution. By examining in detail, this research shows how various
variables like return on assets, operational self sufficiency and portfolio at risk contributes
to the long term financial sustainability of MFIs in India which is still categorised as
developing countries. Developing countries‟ including India has millions of people living
without access to financial services and thus MFIs are important as they are service
providers of finance for the poor termed as “unbanked people”. Demand for financial
services exceeds the available supply (Barr, Kumar, & Litan, 2007; Imboden, 2005) and in
developing countries, the formal banking sector serves approximately 20% of the
population (Berenbach & Churchill, 1997; Robinson, 2001). It is the microfinance
institutions which came to the rescue of the unbanked by building a financial market to

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meet the diverse financial needs of the poor (Armendáriz de Aghion & Morduch, 2004;
Hermes & Lensink, 2011), especially in the developing countries.

Empirical studies which determine the variables of financial sustainability and contribute
towards formulation of an index are few across the world and even lesser found in the
Indian literature on MFIs. Also the literature found is inconclusive and ambiguous. Though
empirical evidence is relatively scant and inconclusive, there is a conventional wisdom
among microfinance practitioners that there are certain variables which as per accounting
practices lead to improved profitability. This thesis has made an attempt to consider those
variables and measure their impact on long term financial sustainability of MFIs in India.

1.2 GROWTH OF MICROFINANCE IN INDIA

Poverty alleviation has been the main focus for the planning process in India. Government
has considerably enhanced allocation for the provision of education, health, sanitation and
other facilities which promote capacity building and well being of the poor. The focus to
provide financial services to the poor and under-privileged has been there since
independence. The commercial banks were nationalized in 1969 and were directed to lend
40% of their loan at concessional rate to priority sector. The priority sector included
agriculture and other rural activities and weaker section of society in general. The poverty
alleviation programmes launched by government of India did not achieve their desired
goals due to poor implementation and manipulations done by government officials. Public
funds meant for poverty alleviation were being misappropriated or diverted through
manipulation by the locally powerful or corrupt (Mehta,1996).

Even the private sector took initiatives to offer microfinance in India, which can be traced
back to steps undertaken by Shri Mahila SEWA (Self Employed Women‟s Association)
Sahakari Bank in 1974 for providing banking services to the poor women employed in the
unorganized sector in Ahmadabad in Gujarat. In India, initially many NGO microfinance
institutions (MFIs) were funded by donor support in the form of revolving funds and
operating grants. But it is only after intervention of National Bank for Agriculture and
Rural Development (NABARD) in 1992 in the field of microcredit, the movement of
microfinance got a boost in India. There is a huge potential of microcredit in rural India.

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The Reserve Bank of India has advocated for financial inclusion of majority of population
for economic development of our country. Access to affordable financial services specially
credit and insurance enlarges livelihood opportunities of poor. Apart from social and
political empowerment, financial inclusion imparts formal identity and provides access to
the payment system and to saving safety net like deposit insurance. Hence financial
inclusion is considered to be critical for achieving inclusive growth (U Thorat, 2007). The
RBI Governor, Y.V.Reddy (2007) gave a simple definition of financial inclusion as
“Ensuring bank account to all families that want it”. He said it would be the first step
towards reaching the goal of bank credit as a human right as advocated by Nobel laureate
Professor Mohammed Yunus.

Though RBI advocated financial inclusion, banks failed to meet the expectations as
financing the very poor seemed to have high transaction cost in reaching out to a large
number of people who required very small credit at regular intervals. The same held true of
the costs involved in providing savings facilities to the small, varied savers in the rural
areas. Both small savers and borrowers in the rural areas viewed banking as an institutional
set up for the wealthy; even if they tried to reach the bank branch the long distances and
loss of earnings on being away from work while visiting bank branch were hurdles and they
were never sure whether they would get any service or not if they did approach the branch.
The levels of mutual inconvenience and discomfort made the poor look at banking as an
almost inaccessible service, and the banks felt that banking with the very poor was not a
„bankable‟ proposition.

Keeping the above in view NABARD conducted studies in the mid-eighties that brought
out the simple fact that the most important and immediate banking needs of the

poor households, in the order of their priority were:

 Opportunities to keep safe their occasional small surpluses in the form of thrift
 Access to consumption loans to meet emergent needs and
 Hassle-free access to financial services and products, including loans for micro-
enterprises

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Now the microfinance service providers include apex institutions like National Bank for
Agriculture and Rural Development (NABARD), Small Industries Development Bank of
India (SIDBI) and Rashtriya MahilaKosh (RMK). At the lower level we have commercial
Banks, Regional Rural Banks and cooperatives to provide microfinance services. The
private institutions that undertake microfinance services as their main activity are generally
referred to as Micro Finance Institutions (MFIs) in Indian context. There are also some
NGOs which lend credit to SELF HELP GROUP (SHGs). The NGOs that support the
SHGs include MYRADA in Bangalore, Self Help Women's Association (SEWA) in
Ahmadabad, PRADAN IN Tamilnadu and Bihar, ADITHI in Patna, SPARC in Mumbai.
The NGOs that are directly providing credit to the borrowers include SHARE in
Hyderabad, ASA in Trichy, RDO LOYALAM Bank in Manipur (Tiwari, 2004).

1.3MARKET STRUCTURE OF MFIs IN INDIA

With the failure of co-operatives, the Indian government and state provinces focused on
nationalisation of commercial banks (Zhang & Wong, 2014), expansion of rural branch
networks, establishment of Regional Rural Banks (RRBs) and the setting up of the Apex
institutions. This was the time period between 1960-90 and the concept was known as
subsidised social banking, which stressed the social objectives rather than commercial
purpose or profitability (Mohan & Prasad, 2005). This 30-year period was characterised by
large scale misuse of credit which created a negative perception about the credibility of
micro borrowers among bankers, which further hindered access to banking services (Basu
& Srivastava, 2005).

The SHG-BLP and the NGO-MFIs became effective during 1990 to 2000 (Zhang & Wong,
2014) due to the failure of subsidised social banking and increased competition in the
banking sector (Basu & Srivastava, 2005). The failure created a paradigm shift in delivery
of rural credit with the National Bank for Agriculture and Rural Development (NABARD)
forming the SHG-BLP, aiming to connect informal women‟s groups to formal banks
(Sinha, 2009). The programme helped to increase the banking system among low income
people, unbanked people, and initiated a change in the banks‟ outlook towards low-income
families from beneficiaries to customers (Kumar & Sahoo, 2011). Commercialisation of

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microfinance became a key concept in the first decade of the new millennium reforms
(Zhang & Wong, 2014). NGO-MFIs increasingly began transforming themselves into more
regulated legal entities, such as NBFCs, to attract commercial investment (Srinivasan,
2010; Zhang & Wong, 2014) and mobilise deposits (Basu & Srivastava, 2005). MFIs set up
after 2000 observed themselves less in the developmental model and more as businesses in
the financial services space, catering to an untapped market segment while creating value
for their shareholders (Sriram & Rajesh, 2004). On September 28, 2006, the RBI arranged
broad guidelines on fair practices that are framed and approved by the boards of directors
of all NBFCs. This guidelines state that relevant provisions of fair practices to be
incorporated in the Customer Protection Code those NBFC-MFIs should adopt (RBI,
2011).

1.4 ROLE OF MICROFINANCE AND SELF HELP GROUPS IN

FINANCIAL INCLUSION

“Financial inclusion is the process of ensuring access to financial services and timely and
adequate credit where needed by vulnerable groups such as weaker sections and low-
income groups at an affordable cost” Dr. C. Rangarajan Committee (2008).

Lack of accessibility to banking and financial services impediments the social and
economic development in the lower income group. The problem of financial exclusion is
not only due to lack of financial services designed specifically to meet the needs of the poor
but also due to the lack of awareness of services available to them. To achieve financial
inclusion it is important to make the banking services available to the unbanked and to
provide awareness of the steps taken by the government and other financial institutions to
cater to the needs of the poor.

Financial inclusion can be possible through MFIs whose main objective is to provide small
amount of loans to the people having low income without collateral securities. Thus
through various models they can aid in fulfilling the purpose of financial inclusion.

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Micro finance plays a very important role in financial inclusion in the following ways:

 Credit is offered to SHGs in remote areas where traditional banking services cannot
reach which is the target audience for the facility. The recovery of the credit is
spread over a long period of time and the installments are small in nature and hence
it does not burden the customers.
 MFIs not only offer credit but also literate the customers on the various
microfinance products available to them.

Thus, Microfinance plays a important role toward social and economic development of
poor.

1.5 NEED FOR MEASURING FINANCIAL SUSTAINABILITY OF

MICROFINANCE INSTITUTIONS

Robinson (2001), defines Microfinance as small-scale financial services for both credits
and deposits– that are provided to people who farm or fish or herd; operate small or micro
enterprises where goods are produced, recycled, repaired or traded; provide services; work
for wages or commissions; gain income from renting out small amounts of land, vehicles,
draft animals, or machinery and tools; and to other individuals and local groups in
developing countries, in both rural and urban areas (Robinson,2001).

Throughout the world there are success stories attributed to the role of Microfinance in
providing access to financial services to the people living at the bottom of economic
pyramid, living in rural areas and women. But sustainability of Microfinance Institutions
(MFIs) is often questioned. MFIs need to be economically viable and sustainable in long
run, however economic implications of long term sustainability are not being considered
(Srinivasan et al., 2006 as quoted by Agarwal and Sinha, 2010). Research has been done in
measuring the social performance of the MFIs but very few researchers have focused on the
financial sustainability of the MFIs. It has been said that the “Unsustainable MFIs might
help the poor now but not help the poor later as they will be gone” (Schreiner, 2000).
Ganka (2010) even says that it is better not to have MFIs than having unsustainable ones.

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This goes to show the importance of sustainability of the MFIs for long term existence and
thus contributing to poverty reduction.

Financial sustainability of microfinance institutions is the key dimension of microfinance

sustainability. It refers to the ability of MFIs to cover all its costs from its own generated
income from operations (Thapa et al., 1992) without depending on external support or
subsidy. Dunford (2003) also defines financial sustainability as the ability to keep on going
towards microfinance objective without continued donor support. These definitions imply
that the MFIs should reach a point of self-sustenance. Self-sustenance can be measured by
measuring two things namely: operational sustainability and financial self-sufficiency.
According to Meyer (2002) operational sustainability refers to the ability of the MFI to
cover its operational costs from its operating income regardless of whether it is subsidized
or not. On the other hand, MFIs are financially self- sufficient when they are able to cover
long term investments from their own generated income, both operating and financing costs
and other form of subsidy valued at market prices. The above definitions of financial
sustainability imply that a loss making MFI (MFI with poor financial performance) will not
be classified as financially sustainable. Again a profit making MFI, whose profitability is
determined after covering some of the operating costs by subsidized resources or funds,
will also not be considered as financially sustainable.

Vinelli (2002) provides five interesting arguments supporting the quest for sustainability in
the microfinance sector:

(1) to ensure organizations survival to cater to financial needs of micro business

owners;
(2) to attract and serve the unserved market who do not have access to cheaper
products;
(3) to keep check at competition from traditional lenders;
(4) to raise capital from variety of sources; and
(5) to consciously manage the costs of serving the high risk borrowers.

Microfinance became a topic of major discussion in India after 2010 when the Andhra
Pradesh crisis happened due to high interest rates charged by MFIs from the poor due to

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lack of security and mortgage which lead to an increase in the default rate. The inability to
repay, led to suicides of farmers. The root cause of the situation was lack of regulations
which still has not firmed up in India and the challenges faced by MFIs to sustain the
business. Thus it was felt by academicians and practitioners that it was time to move from
the concentrating merely on social impact, it was time to focus of financial sustainability
too.

Keeping the above background in view, in this research an attempt has been made to study
the trend in the microfinance industry in the past eight years. Further the focus has been on
studying the variable which affects the financial sustainability of microfinance institutions
leading to ranking of the MFIs on the basis of their performance on those variables.

1.6 STATEMENT OF PROBLEM

MFIs provide financial service to low income borrowers who look for relatively small
amounts of money to finance their businesses, manage emergencies, acquire assets or
smooth consumption (CGAP, 2003). These borrowers frequently lack credit histories,
collateral, or both, and thus, do not have access to financing from mainstream commercial
banks. For this reason, MFIs are seen as playing a role in the creation of economic
opportunity, and in poverty alleviation (CGAP, 2003).

To achieve the prime objective of alleviating poverty, MFIs require being able to provide
financial services to the poor in a sustainable way for which they need to generate enough
income so that they can cover their financial costs, administration expenses and should be
able to have a loan loss provision. Thus an MFI can be compared to a bank except the
nature of clients they serve. Hence it will face the same challenges which a bank does in
achieving its objectives (Hartungi, (2007)).

Profitability cannot be overlooked for long term sustenance of the microfinance industry.
Also, it has been felt that to be sustainable, MFIs need to do away with grants and
donations and hence it is imperative for them to generate their own funds as it is the
cheapest source of fund and also help attract investors and hence external capital.

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In India, the profitability of MFIs is far from true and most of them have a status of an
NGO which does not allow them to view it as a business. They still rely on grants and
donations from the government and other institutions to be able to cover the cost of serving
the poor. As a result of which the research on financial sustainability of MFIs in India are
few. The first step towards financial sustainability is to focus on the determinants which
contribute towards it and the next step is to know the level each contribute towards the
same. Finally a need for an index is felt which will guide the MFIs their position in the
industry. To the regulators and government, the index will provide a framework to
formulate regulations which aids in long term sustainability of MFIs.

Hence, the problem statement of the present study can be stated as

“To study the long term performance of financial sustainability of

microfinance institutions in India and to identify the significant
determinants influencing their financial sustainability”

1.7 OBJECTIVES OF THE STUDY

The main objective of the research study “To study the long term performance of
financial sustainability of microfinance institutions in India and to identify the
significant determinants influencing their financial sustainability” In addition to the
main objective of the research study, the research study attempts to identify various sub-
objectives of the study stated as follows:

Objective 1: To study the long term performance (trends) of financial sustainability

of MFIs in India.

Objective 2: To examine determinants which affect the financial sustainability

scores of Indian MFIs.

Objective 3: To develop an index to measure Financial Sustainability so as to

obtain scores of Indian MFIs

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1.8 SIGNIFICANCE

Although there have been few studies on measuring financial sustainability of MFIs in
other countries where they are relatively developed as compared to MFIs in India. In India
the studies are few and scanty. This research is an attempt to investigate the trend of
financial performance of MFIs in India, assess the determinants of financial sustainability
of MFIs in India and suggest an Index for measuring financial sustainability of MFIs.
Analysing and understanding the impact of various variables on the financial sustainability
is a contribution to the research for the industry to understand as to which variables to focus
to attain long term financial sustainability. The index of sustainability is a useful tool to
rank the MFIs on a multidimensional construct of sustainability. The finding of this study
will also benefit practioners, donors, managers and other financial institutions. The study
also attempts to provide guidelines to MFIs to take appropriate actions to increase the
financial performance and help them outgrow the need of grants and subsidies. Lastly, this
study is an attempt to provide an insight of the microfinance industry to other researchers.

1.9 SCOPE AND LIMITATION OF THE STUDY

This results of this research are exclusively based on the data which was available on the
MIX Market website and hence the data is limited to the one provided therein. Though
many MFIs have been listed for the period under study but the study was confined to only
30 due to lack of consistency in data across the time period. Secondly, the study focuses
exclusively on Indian MFIs and hence the result cannot be generalized. There is further
scope to expand the research by doing a cross country analysis and comparison of
sustainability scores and variables that affect financial sustainability across the globe.
Lastly, MFIs have contributed to the women empowerment not only in India but
throughout the world which has not been the focus of research in this thesis as the main
focus has been kept as financial sustainability of MFIs which is measured through
accounting ratios. Although the data has been taken from a official database of MIX market
but to increase the richness of the data, it can be supplemented by primary source by
collecting data directly from MFIs.

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1.10 STRUCTURE OF THESIS

This thesis is divided into seven chapters. The first chapter introduces the concept of
microfinance and gives the overview of microfinance industry in India. It also explains the
background of research problem, the objective of the study and main research questions
problem guiding this study. It further discusses the significance, scope and limitation of the
study. Chapter 2 presents a review of literature explaining theoretical considerations;
Chapter 3 discusses the methodology. The chapter describes the data and the empirical
models used for analysis; Chapter 4 focuses on the trends of various variables which impact
the financial sustainability of MFIs in India across the chosen time period 2005-13; Chapter
5 discusses the impact of determinants on financial sustainability of MFIs in India; Chapter
6 attempts to formulate the weights of the determinants to know in what percentage do they
impact the financial sustainably and further develop an index to rank the selected MFIs.
Lastly Chapter 7 offers the conclusion and key contribution made by this thesis. It also
highlights the area for future research.

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