Muhammad Yunus, Grameen Bank, Founder

Winner of 2006 Nobel Peace Prize

What is Microfinance?

Microfinance is the supply of small loans and other basic financial services to the poor. In most poverty-stricken areas, the poor do not have access to formal banking systems and are therefore denied opportunities simply because the system they live in. They usually address their financial needs through a variety of informal financial relationships where “money lenders” take most the returns.

Why do banks ignore poor people?

Most formal banks do not provide microfinance products as it is seen as an expensive, “risky” enterprise – if you can make a lot more money on large loans, why would you give to the poor who are not credit worthy?
“We have created a society that does not allow opportunities for those (poor) people to take care of themselves because we have denied them those opportunities” - Muhammad Yunus, Grameen Bank, Founder

Why are microfinance interest rates so high?

For microfinance to work, interest rates on loans need to be high to return the cost of the loan in the first place: the cost of the money that it lends plus the cost of the loan defaults – they need to be proportional to the amount lent. Transaction costs must also be factored into the loan, through interest, and when loans are small these costs seem larger.

When does microfinance not work?

Microfinance usually struggles when conditions hinder loan repayment. The clients must have the capacity to repay the loan under the terms by which it is provided. In war zones or where there is much disease or communities are widely dispersed, for example, microfinance may not be the best tool.

The changing microfinance industry in India

The microfinance in industry in India has quickly, over the last 3-5 years, become a commercial, competitive market. A metric consistently quoted regarding market scale is that of the depth of India’s poverty. With approximately 600 million individuals living on less than USD 1.50 per day, it is the raw scale of extreme poverty that appears the salient growth feature of Indian MFIs. We are seeing the larger players getting larger and being compensated for this aggressive growth and despite their PR, social impact coming second to financial inclusion and profit for shareholders.

Some major changes include:

The growth and dominance of commercial Microfinance Institutions in India has taken off. Not only has the whole microfinance industry expanded hugely - there are now over 3,000 Microfinance Institutions (“MFIs”), NGOs and NGO-MFIs in the sector of which over 400 have active lending programmes - it is the MFIs that have seen the most aggressive growth rates in loans disbursed, with a CAGR of 90% between 2005-9. And amongst these MFIs, the 5-6 largest ones are dominating the markets already. They have projected growth rates nearly 2.5 times that of the next ten most sizeable groups and with new technologies and the ability to scale up further by raising monies from the capital markets (rather than ad hoc donations), this trend is set to continue.

Commercial MFIs have business models based on these strong growth rates i.e. number of loans disbursed rather than the quality or social impact made by each loan. It is thought that the average loan size of an Indian MFI is growing too implying a change in the end consumer. Microfinance gateway reported average loan size for MFIs with greater than USD 25mn growing from USD 161 to USD 201 between 2004 and 2007 alone.

The IPO of India’s largest MFI in July 2010 was a landmark event in the microfinance industry since it was the first of its kind in India and only the second in the world.

Hand in hand with these changes in the industry are problems. Firstly, the recent debate over the IPOs is “who benefits”? The moment shareholders are involved and expect returns, the emphasis goes away from alleviating poverty towards making a profit, not to be ploughed back into wider community development (further training, health care and education) but to end up in the pockets of shareholders.

The models themselves are so deeply focused on growth rates and financials that they lack “customer care”. Larger MFIs foster relationships with loan recipients more akin to a traditional moneylender than that of a longer-term partner seeking lasting social change.

And some important regulation has been introduced.....

After a spate of reported suicides in 2010-11, mainly in the state of Andhra Pradesh, borrowers were instructed by politicians to stop repaying their loans. In October 2010 the Reserve Bank of India appointed a committee, to study issues and concerns in the microfinance sector, under the chairmanship of Shri Y H Malegam, which reported in January 2011, recommending industry wide regulation. At the end of June, India’s Ministry of Finance published The Microfinance Institutions Development and Regulation Bill, 2011 which is hopefully to be passed by India’s parliament soon and become law. It builds on the Malegam Committee’s recommendations as well as comments from a range of stakeholders in the industry. The new bill is particularly encouraging as it includes all forms of microfinance institutions, providing a comprehensive legislation for the sector and puts the Reserve Bank of India as the sole regulator with the formation of State Advisory Councils to oversee microfinance at the State level.