Need for Microfinance and its Models

Need for Micro finance

Micro finance is needed at the household, community and regional levels. But a

greater need for 100% financial inclusion is being felt because poor people are

trapped in poverty. The reasons being:

Commercial banks not lending them money as they are often neither in a

position to offer collaterals nor are they considered “creditworthy” enough

Local money-lenders, who are often their only source of credit, charge

exorbitantly high interest rates, thereby depleting them of whatever little

possible savings they can manage.

Generally microfinance is sought by small and marginal farmers, the economically

weaker sections etc. Women constitute a vast majority of users of microcredit and

micro savings facilities.

India’s rural poor are dependent on agriculture as their primary source of

income. The majority are marginal or small farmers, and the poorest households

are landless. Thus they have uncertain and irregular income streams and

expenditure patterns. Here the need for micro finance is felt.

In Urban areas, people have a very temporary address and are mobile

because the slums being evacuated. Also, unsteady livelihoods lead to migration

from one part of the city to another or from one city to another. The KYC norms

require a proof of identity and residence, which urban poor cannot provide- They

remain excluded from formal finance unless a voter identity card or a migrant

identity card is issued to them.

Housing loans are not taken off in a big way because of large volume of loans

required and long period of repayment.

Models of MFI

Differ on basis of

Lending model:

Here the micro finance institutions lend to groups such as the self help groups

(SHG) and the Joint reliability groups (JLR) and also to the individual

Loan repayment structure:

Weekly or fortnightly repayment structure (JLR model)

Monthly repayment structure (SHG model)

Mode of interest rate calculation:

JLR model charges flat 12-18% interest on loans.

SHG model charges 18-24% interest on reducing balance method

Product offering:

Micro credit, investments, insurance, saving, etc.

Legal structure:

Cooperatives, NBFC, unregistered, societies, trusts, for-profit, non-profit.

Bottle Necks in Microfinance

Traditionally, banks have not provided financial services, such as loans, to clients

with little or no cash income. Banks incur substantial costs to manage a client

account, regardless of how small the sums of money involved. For example,

although the total gross revenue from delivering one hundred loans worth $1,000

each will not differ greatly from the revenue that results from delivering one loan

of $100,000, it takes nearly a hundred times as much work and cost to manage a

hundred loans as it does to manage one. The fixed cost of processing loans of any

size is considerable as assessment of potential borrowers, their repayment

prospects and security; administration of outstanding loans, collecting from

delinquent borrowers, etc., has to be done in all cases. There is a break-even point

in providing loans or deposits below which banks lose money on each transaction

they make. Poor people usually fall below that breakeven point. A similar equation

resists efforts to deliver other financial services to poor people.

Heavy dependence on banks & FIs

MFIs are dependent on borrowings from banks & FIs.

For most MFIs, funding sources are restricted to private banks & apex MFIs due to

risks involved & as huge amounts of funds are required.

Available bank funds are typically short-term (max. 2 years period)

Also, there is a tendency among some lending banks to sanction and disburse

loans to MFIs around the end of the accounting year in pursuit of their targets.

This leads MFIs to draw and deploy the funds sub-optimally for a period, till they

find better avenues for deployment in loans to the needy clients.

High Interest rates

Reports tells us that SKS Micro-finance is charging approximately 24 per cent rate

of interest in Orissa, Karnataka and Andhra Pradesh; in southern India, Equitas

Micro-finance is seeking 21-28 per cent interest rate and Basix Microfinance is

providing small loans at 18-24 per cent interest rate. There are numerous other

players, and they all rake in money. Sewa in Gujarat and the Grameen Bank in

Bangladesh too thrive on a similarly high rate of interest.

People went on borrowing from the money lenders or sahukars because they

needed the money and it must have and still is making a difference to them

otherwise the entire business of moneylending would have collapsed and become

unsustainable. All that micro-finance institutions are doing now is to replace that

class of moneylenders. Micro-finance institutions are also extracting their pound of

flesh. The sahukars were using their own capital for lending and therefore

charging a very high interest of 60 per cent or above. The micro-fianance use the

bank finances and therefore charge a little less at 20-24 per cent.

Weak structure

The majority of the MFIs are structured and registered as societies, cooperatives,

trusts and not-for-profit companies. Companies account for just 22% of CRISIL's

MFI grading assessments. The governance practices of these MFIs are to some

extent comparable with the good governance practices of mainstream corporations.

The legal structure and attendant regulatory requirements of an MFI have a strong

bearing on governance practices

because they influence management practices and the level of transparency. Other

than a formal company structure, All other legal structures, such as trusts and

societies, suffer from the lack of any meaningful regulation and disclosure

standards. This also creates a virtuous cycle/vicious cycle phenomenon: MFIs that

have the willingness and minimum capital funds to embrace a corporate structure

as a nonbanking finance company can more easily attract outside investors, which

in turn encourages better governance and disclosure standards. In contrast, MFIs

that are either unable (for lack of adequate sponsor funding capacity) or unwilling

to convert to a corporate structure tend to remain "closed" to transparency and

improved governance standards, and therefore continue to be

unable to attract outside capital.

Competition

Poverty has literally become a big and organised business. There can be no better

business opportunity than starting a micro-finance institution with assured returns

and 100 per cent loan recovery. With high interest rates & proper resources it is

easy to make huge profits.

This has resulted in the huge amount of increase in the number of MFIs in India

today.

India's microfinance sector is fragmented, having more than 3,000 MFIs, NGO-

MFIs present.

Also commercial banks are slowly coming into the picture and many are

partnering with regional microfinance institutions.  Increasingly, loans as small as

$100 are being made by mainstream Indian banks such as ICICI, HDFC, and UTI,

and often contain unconventional covenants typical of microfinance transactions.

Founded in 1977, HDFC had net income for 2005 of about $200 million and 24

rural partners.  Recent partnerships include: Ujjivan, Bellwether microfinance

fund, Avishkar-Goodwell Fund, Lok Capital, and Activists for Social Alternatives.

Another example of a commercial bank that has partnered with local MFIs is

ICICI, which has 72 such partnerships.  ICICI Bank had net income in 2005 of

about $500 million, and operates 614 branches and 2200 ATMs.  Through about

100 rural partnerships, its portfolio of microfinance investments stood at $227

million and 1.2 million clients at year end 2005.  A prominent partner of the bank

is Spandana. The Andhra-Pradesh-based microfinance institution disbursed loans

of $3.4 million in 2004 at an effective rate of 30%, of which 9.25% went to ICICI.

In addition, in November 2005, ICICI tied up with the Grameen Foundation USA

to create microfinance lender Grameen Capital India.  ICICI has been micro

lending since 2001. 

Mumbai-based UTI began in 1994, and is 72% publicly-owned.  It had net income

in 2005 of $104 million, and operates 450 branches and more than a thousand

ATMs throughout India.  In its Annual Report 2005-2006, reference is made to

increasing microfinance activities by offering new services to rural clients.  UTI

works closely with the Grameen Koota program, which has outstanding loans of

$3.2 million, as well as SKS Microfinance of India.

A Case Study on SKS MICROFINANCE

Introduction

SKS Microfinance, promoted by Dr. Vikram Akula, was originally founded as

Swayam Krishi Sangam or SKS Society in 1997 and functioned as a non-

governmental organization (NGO) that provided microfinance in Andhra Pradesh.

SKS Society transferred its business and operations to SKS Microfinance as a

newly incorporated private limited company in India in 2003. SKS Microfinance is

the largest Microfinance Institution (MFI) in India in terms of total value of loans

outstanding, number of borrowers (called members) and number of branches.

SKS Microfinance is a non-deposit taking non-banking finance company (NBFC-

ND), registered with and regulated by the Reserve Bank of India (RBI). It is

engaged in providing microfinance services to individuals from poor segments of

rural India.

Core Business

The company's core business is providing small loans exclusively to poor women

predominantly located in rural areas in India. These loans are provided to such

members essentially for use in their small businesses or other income generating

activities and not for personal consumption.

Types of Loans

Borrowers take loans for a range of income-generating activities, including

livestock, agriculture, trade (such as vegetable vending), production (from basket

weaving to pottery) and new age business (photography to beauty parlours). SKS

also provides members with interest-free loans for emergencies as well as life

insurance and loan cover insurance to borrowers.

Business Model

The Company utilizes a village centred, group lending model to provide unsecured

loans to its members. This model ensures credit discipline through mutual support

and peer pressure within the group to ensure that individual members are prudent

in conducting their financial affairs and are prompt in repaying their loans. Failure

by an individual member to make timely loan payments will prevent other group

members from being able to borrow from it in the future; therefore the group

typically make the payment on behalf of a defaulting member or, in the case of

wilful default, use peer pressure to encourage the delinquent member to make

timely payments, effectively providing an informal joint guarantee on the

member's loan.

Distribution Channel

The company also uses its distribution channel to provide other services and goods

that it founds that its members need. For instance, it also distributes and

administers life insurance policy products for its members and has pilot programs

to provide loans to its members to purchase select consumer products that increase

their productivity.

Operational Statistics

The operational statistics of SKS are nothing short of phenomenal. SKS has

recorded a growth of around 200% ever since it has become a NBFC in 2003. The

statistics below speak for themselves.

Operational Information Mar 06 Mar 07 Mar 08 Sep 09

Total no. of Branches 80 275 771 1,676

Total no. of Districts 19 102 217 345

Total no. of Staff 574 2,389 6,425 17,520

Total No. of Members

(In Millions)

0.20 0.60 1.87 5.30

Amount Disbursed

(INR. In Millions)

1,525 4,454 16,789 31,994

Portfolio Outstanding

(INR. In Millions)

921 2,756 10,506 32,080

Financial Statistcs

Similar to the operational statistics of SKS, financial statistics of SKS too are

outstanding. Their revenues and profits too have been shown to grow by leaps and

bounds.

Financial Information Mar 06 Mar 07 Mar 08 Sep 09

Incremental Debt

(INR in Crores)

88 277 1,063 1,247

Total Revenue 10 46 170 385

(INR. In Crores)

PAT

(INR. In Crores)

0.44 3.67 16.64 55.60

Total Assets

(INR. In Crores)

98 332 1,083 3,643

ROA 0.48% 1.00% 2.51% 4.09%

ROE 3.08% 18.1% 16.3% 15.15%

Cost Structure

SKS charges interest sufficient enough to cover its costs.

Yet, SKS is among the ones which provide the lowest cost to the borrowers.

SKS Capital

SKS has been a sector leader in sourcing capital. In July 2009, Bajaj Allianz made

a strategic investment of $ 10 million(INR 50 crore) in SKS Microfinance which

was the first-ever investment by an insurance company in an Indian microfinance

institution. In November 2008 SKS raised equity worth $ 75 million(Rs 366 crore),

the largest equity raised by an MFI in the world. The third round of equity worth

Rs 147 crore was raised in January 2008. In March 2006, SKS closed its first

round of equity investment; the largest microfinance investment in India to date - $

3.2 million from some of the world’s leading microfinance investors, and then

eclipsed this accomplishment with a second round equity investment of $11.5

million in March 2007.

It leverages its equity to raise debt from public sector, private sector and

multinational banks operating in India. This capital has helped the organisation

scale up operations and reach out to millions of poor households across the length

and breadth of India.

To meet future capital requirements arising out of growth in business, SKS came

out with an IPO in july-Aug. 2010, worth Rs.1653.97 crores.

Strengths

Huge gap in Microfinance demand and supply: According to the 2008 Inverting

the Pyramid Report by Intellecap, an independent industry research firm, the total

estimated demand for micro-credit in India was approximately Rs. 2,39,935 crore

with estimated total loan disbursements at approximately Rs. 20,072 crore.

As of March 31, 2010, the company had 2,029 branches in 19 states across India

with no state accounting for more than 28.8% of its outstanding loan portfolio.

Capital adequacy ratio as of March 2010 stands at comfortable 28.3% compared to

the EBI mandated minimum of 12% as of March 2010 and 15% as of March 2011.

Gross NPA and Net NPA are just 0.33% and 0.16% respectively at the end of

FY'10.

The company lends to micro enterprises who earn returns in the range of 29% to

246% mainly due to use of family labours, low infrastructure costs and no taxes or

legal costs. This helps SKS Microfinance to charge higher interest rate from its

customers.

Weaknesses

Currently there is no interest rate cap on the lending by the microfinance

institutions. MFIs typically charge high interest rate to its customers ranging

between 26% to as high as 31%. There is risk perception that regulator may pitch

in and put a cap on interest rate charged and regulate the sector. As the costs and

risks in this business are also high, any unreasonable cap will severely impair the

business prospects.

Microfinance as a business is still in the evolution stage.

Due to the unsecured nature of advances and very low income earning capacity of

the borrowers with little savings, the default risk in this business is high.

Natural calamities like floods etc, political instability, social strife in certain areas

can severely impair the borrowers' ability to pay and lead to mass defaults in

particular areas/states.

Due to the nature of operations, large amount of cash is handled with attendant

risks of theft, fraud, misappropriation, violent crimes against its employees etc.

Microfinance has been traditionally met through informal sources including non-

government organizations, or NGOs; cooperatives; community-based development

institutions like Self Help Groups, or SHGs, and credit unions. Better flow of

funds to these institutions, or more involvement of banks in direct financing of

small borrowers or government sponsored schemes for facilitating flow of funds at

lower cost to the poor segments of the society can pose stiff competition to the

company as it charges comparatively high interest rates.

 

A Case Study on ICICI BANK

Innovations in Microfinance

An Introduction to ICICI BANK

ICICI Bank was originally promoted in 1994 by ICICI Limited (a development

financial institution for providing medium-term and long-term project financing to

Indian businesses), and was its wholly-owned subsidiary. After consideration of

various corporate structuring alternatives the managements of ICICI and ICICI

Bank formed the view that the merger of ICICI with ICICI Bank would be the

optimal strategic and legal structure for both entities. Consequent to the merger in

January 2002, the ICICI group's financing and banking operations, both wholesale

and retail, have been integrated in a single entity.

ICICI Bank has a network of about 610 branches and extension counters and over

2,000 ATMs. ICICI Bank offers a wide range of banking products and financial

services to corporate and retail customers through a variety of delivery channels,

specialised subsidiaries and affiliates. ICICI Bank set up its international banking

group in fiscal 2002 to cater to the cross border needs of clients and to offer

products internationally. ICICI Bank currently has subsidiaries in the UK, Canada

and Russia, branches in Singapore and Bahrain and representative offices in the

United States, China, United Arab Emirates, Bangladesh and South Africa. ICICI

Bank's equity shares are listed in India and its American Depositary Receipts

(ADRs) are listed on the New York Stock Exchange (NYSE).

ICICI Bank-An Entry into Rural Market

Banking with the poor is a challenging task as the nature of demand requires

doorstep services, flexibility in timings, timely availability of services, low value

and high volume transactions and require simple processes with minimum

documentation. The nature of supply however involves high cost of service

delivery, rigid, inflexible timings and procedures and high transaction costs for the

customers. With these features on the supply side, traditional banking is not poised

to meet the requirements of the demand side. The reach of the banking sector in

the rural areas was as low as 15% in terms of credit potential, and 18% in terms of

population with physical access to a bank branch.

ICICI Bank chose to pursue the unreached rural markets as part of its strategy of

being a universal bank. However, instead of taking the conventional branch

banking model for increasing its outreach, the Bank decided to work with models

which would combine the strengths of intermediary forms of organization with the

financial bandwidth of a banking institution.

Innovations in Microfinance

To enable its foray into the rural markets, ICICI Bank merged with the Bank of

Madura (est.1943), which had a substantial network of 77 branches in the rural

areas of a South Indian state – Tamil Nadu. The Bank of Madura had an expertise

in catering to the needs of the small and medium sector and had a strong network

of SHGs. At the time of the merger the Bank of Madura had 1200 SHGs.

However, the program was not yet sustainable. To reach profitability ICICI Bank

devised a three-tiered structure. The highest level was to be a project manager,

who would be an employee of the bank. Six coordinators would report to each

project manager and would in turn oversee the work of 6 promoters. The target for

promotion of groups was 20 groups within 12 months, upon which the promoter

would receive financial compensation from the Bank. The coordinator would

usually be an SHG member who would coordinate the activities of the promoters.

The women who had finished a year of promoting the requisite 20 groups were

given the designation of Social Service Consultant. These would travel within a

radius of 15 kilometres, in order to promote as many groups within their area as

possible. Strict guidelines were set for selection of SHG members and SHGs

would focus on those who were illiterate and below the poverty line so that there

would be homogeneity in the socio economic background as well. The SHGs

followed the normal pattern of saving until they had internally collected an amount

of Rs 6000 in a bank account held in the group's name, through a weekly payment

of a small amount by each member of the group. After this, the amount collected

would be lent internally at 24% p.a. This rate of interest was much less than was

available from the informal lenders, and the entire groups stood to gain as the

interest was churned back into the group.

ICICI Bank achieved a high rate of growth, reaching 8000 SHGs in March 2003,

with its team of 20 project managers. Within three years of the merger with Bank

of Madura, ICICI Bank had extended its reach to 12000 SHGs. However, the pace

of outreach was still slow, and the Bank began to experiment with other models of

reaching the unreached. This was because existing branches could be leveraged for

outreach, but in areas where there were no ICICI Bank branches, it would not be

viable to set up branches solely for the purpose of rural outreach, as such branches

would have a very long gestation period and would costly in terms of overheads.

ATMs were also costly proposition and the infrastructure required was not in place

in most of the remote areas.

It was felt that in the case of the SHG formation, there was no risk sharing or

financial stake/ performance stake of the social intermediary (NGO) in the process

of group formation. Once the groups were formed and linked to Bank credit, there

was no more responsibility on the part of the NGO. The SHGs had been repaying

at very good rates, above 95%, yet there was a need to control the quality of group

formation and link it to credit discipline. ICICI Bank also worked with Self Help

Promotion Institutions to outsource the work of group formation institutions whose

core competence was in social intermediation. In this case, the alignment of

incentives remained the same, as the bank staffs were replaced by an external

entity, who albeit with the best of intentions and competencies, would not be able

to vouch for the quality of groups created by it. Thus, despite having good increase

in outreach, the model failed to scale up further.

Intermediation Model

ICICI Bank began to experiment with the micro finance institution (MFI) as a

substitute for the more granular Self Help Group. The MFIs were willing to take

on the risk of the financial performance of the groups/ individuals that were being

lent to. Therefore the stake in good quality group formation was also built in. Also,

this channel was better for leveraging large amounts of funds without necessarily

having a grassroots level presence of the bank staff. The MFI would undertake the

processes and operationalization in terms of group formation, cash management,

disbursal and recovery, and also record keeping. The Bank would lend to the MFI

on the basis of its balance sheet and portfolio performance and the MFI would

repay the bank.

The MFI-Bank linkage model paved the way for taking a wider range of services

to the financially underserved populace. These financial services include provision

of micro insurance tailored to the cash flows and insurance needs of the low-

income clients. The micro insurance ensured the end client a support in case of

accidents/ disablement as well as loan insurance in case of death. This was a

significant step towards reducing household vulnerabilities.

The intermediation model at first looked scalable, but there seemed to be

constraints in this model as well. For instance there was a double charge on capital

created, once at the level of the Bank lending to the MFI and secondly at the level

of the MFI on lending to the client. This seemed to be a sub optimal lending

structure due to the double counting that also, because the small balance sheet size,

unduly affected the risk perceived about the MFI, even if it had very robust

systems and processes. Other key challenges to performance were that the MFIs

could not grow and scale as fast as their capabilities would permit, because of

severe capital constraints. Most MFIs had potential access to large debt funds, but

because of their small size balance sheet (which would represent the very limited

initial capital of the promoters); they were constrained to operate with limited debt

funding. In the complete absence of equity investors in the microfinance

institutions, there was hardly any scope for the MFI to scale up rapidly.

MFIs on the other hand, were exposed to the entire risk of lending to the end

clients, despite their constrained risk appetite. Most MFIs were operating in a

single geography, and the systematic risk that they were exposed to was large. This

put undue risk bearing on these organisations, especially in the light of their

limited geographical risk diversification capabilities. Banks, which were lending

ostensibly to the end- clients, could not get access to any information regarding the

repayment capacity, or repayment behaviour of the end clients, as the MFI not only

acted as an operating and servicing agent, but also assumed the entire risk. If the

MFI collapsed due to any internal organisational issues as opposed to client

default, the entire client segment which had demonstrated credit-worthiness would

be deprived of a service provider. On the one hand were the competencies of the

Bank (which had a large amount of finances waiting to be channelled into the

sector) and on the other, the social intermediation expertise of the MFI (which had

a grassroots presence, customer outreach and contact, and could also achieve better

economies of scale if it scaled up and extended outreach faster). There was a need

to combine the strengths of both players, while also building in the correct

incentives and using capital parsimoniously to leverage the maximum value and

client outreach from it. Furthermore, there was a need for close supervision and

information tracking so that at no stage would rapid expansion lead to undetected

default due to slackness in monitoring. Costs would have to be recovered to

ensure sustainability. The model would also have to incentivize growth and

preserve the incentives of the originator (of the portfolio) to maintain portfolio

performance.

Issues

Both the SHG Bank Linkage model and the MFI-Intermediation model hit the

ceiling in terms of scale up. In the case of the SHG Bank Linkage model, there was

lack of incentive alignment and in the case of MFI Intermediation there was “no

capital” on the balance sheet of MFIs to lend on. Despite impressive results by

2004, the ICICI decision-makers faced further challenges to scaling up their

outreach and service. New solutions were required. Should ICICI modify their

existing models in some way? Is a new structure altogether required? What kind of

structure would be able to use capital parsimoniously and be scalable in the long

run? How could incentives for the originator of the portfolio (MFI) be structured?

How can ICICI ensure that the new model be commercially viable and incentivize

growth?