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November 1, 2010

On governing microfinance

Blunt regulation of microfinance is a bad idea

The travails of the micro-finance industry is a throwback to one of the oldest debates in development policy-making—how do we channel the creative energies of capitalist enterprise as bootstrap for the poor? In present context, the government’s regulatory response could become a test case for the future of business-driven social welfare in the country.

A number of high-profile suicides, allegedly driven by harassment from usurious micro-finance institutions (MFIs), and revelations of unsettling governance issues in the industry have offered the government the perfect reason to intervene and seek to tame the micro-finance industry with some stern regulation. The realisation that super-normal profits are being made by MFIs, exemplified by a recent spectacularly successful Initial Public Offer (IPO), has only added grist to the mill of those calling for strong government action.

In recent years, MFIs have proliferated in response to the huge, un-met credit demand among the poor, arising partially from the government’s own inability to provide universal access to formal credit mechanisms. Unlike the bureaucracy-layered loans grudgingly given by the scheduled banks as part of their priority sector lending to government-managed self-help groups (SHGs), MFI loans come with the red-carpet rolled-out.

While SHG members are forced into making multiple visits to bank branches, MFIs offer loans at the doorstep with minimal paper-work and procedural formalities. The always-available nature of these MFI loans, as opposed to the still-distant nature of bank micro-loans, ensures that they fulfil the critical timeliness requirements of poor people.

These deficiencies of SHG bank-linkage program are typical of the last-mile gaps that characterise government programmes and contribute towards what Narayan Ramachandran, fellow at the Takshashila Institution, describes as an Implementation Deficit Disorder. Despite all the right intentions and well-conceived implementation plans, governments have repeatedly fallen short on achievement of outcomes with these welfare schemes.

Their growth though has come with several concerns—illegal strong-arm tactics to recover loans, unethical practices that conceal the true cost of loans from unsuspecting borrowers, and so on. However, MFIs are only the latest in the long-line of businesses that have seized the opportunity to exploit the massive profits that characterise virgin markets and left important corporate governance issues to be addressed. The task now should be to get MFIs to shed their predatory and unethical business practices and start to function like normal businesses.

The public policy discourse on MFIs should therefore address the issue of separating the obvious benefits of micro-loans and the capitalist efficiency of micro-lenders from the corporate governance failures that bedevil the industry. Unfortunately, instead the debate is being formulated in terms of ideological shibboleths that excoriate greedy money-lenders for profiting from poor people’s misery. The instinctive answer to such questions is stringent regulation—interest rate caps, severe punishments and maybe even outright bans.

Photo: Kalyan Neelamraju

But, as experiences elsewhere show, strangulating regulations are not the answer to complex problems, especially when the state neither has the capability nor the commitment to enforce them. Regulations have to be supplemented with strategies that can align the profit-maximising incentives of micro-lenders with achievement of the desired public policy objective of expanding access to formal credit mechanisms.

Over three decades after Mohammad Yunus revolutionised the micro-credit model, for-profit MFIs have become important stakeholders in the space that caters to the bottom of the pyramid (BoP). Over the last decade, several private companies have entered the market in India and it is estimated that there are about 13,000 MFIs functioning in the country. The top three alone serve over 13 million customers and having cumulatively disbursed thousands of crores of rupees.

While functioning on a scale as large as this and that too without any regulation, it should hardly have come as a surprise of certain corporate governance failures. After all, as recent financial market events have shown, even the ostensibly well-regulated financial market institutions have not shied away from adoption of unethical business practices.

However, governance issues are not reasons enough for policy makers to hit the panic button and bring the hammer down on an entire industry. There are several small MFIs, working in the spirit of entrepreneurship, who contribute towards providing credit in some of the remotest areas. In any case, the role played by MFIs and their continuing importance in taking forward the agenda of financial inclusion cannot be overstated.

A possible approach would be to either regulate or, preferably, use moral suasion to encourage MFIs to reimburse the borrowers a share of profits beyond a pre-defined and acceptable bound as interest subvention bonus. This would also enable transparent price-discovery on interest rates which reconciles both the commercial imperatives of the MFI and the reasonableness of the interest rate borne by the borrower. Another strategy would be to capture some of the super-normal profits in the form of a graduated system of taxation. The administration of both these strategies could become dramatically simpler with the coming of Aadhaar, the Unique Identification (UID) and the introduction of UID-linked bank accounts.

Ironically, the prevailing development discourse restricts “inclusion” to the demand-side—the welfare receiving citizens—and the supply-side is serviced only by the government. It overlooks the important role that non-profits and private sector can play in partnership with the government in addressing the poverty eradication challenge. In view of the scale and magnitude of challenges facing us, the increasing ability and resolve of non-government actors to cater to the BoP, it is important for the government to not kill the spirit of the private sector that is driving inclusive growth in its own way.

It is imperative, therefore, that instead of being the sole harbinger and implementer of inclusion, governments shape public policy so as to encourage those in the private sector willing to act in a socially responsible manner. Given the pervasive last-mile failures, it is important that we imbibe appropriate lessons from the bright spots in service delivery within the private sector. Public policy choices must account for the important role that the private sector can play and should be designed to align incentives of all stakeholders towards the achievement of development objectives.


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