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In microfinance, big is beautiful

September 29, 2010 12:35 IST

Subir Roy explains how to make microfinance more robust and socially useful.

MoneyThere is an inevitable good fallout from the government's recent proposal to limit the interest rate levied by large microfinance institutions getting priority sector loans from banks.

A controversy and a vigorous discussion are emerging which will help clear issues and point towards how to make microfinance more robust and socially useful.

A research study, put out by ACCION International, compiles experience of countries as far apart as Peru and the Philippines to provide highly useful international benchmarks.

A cardinal insight that emerges is: smaller the loan size, higher the yield needed to break even, as administratively it costs about the same to make a loan, big or small. And what really works is removing barriers to entry, promoting competition and, above all, greater transparency.

To get to responsible pricing, you need standardised data.

Regulators, networks and investors should ask for data from MFIs on total cost of credit so as to study how costs and interest rates work at the bottom of the pyramid which has till now received scant analytical attention.

Also, it is necessary to determine what is the return on investment for the poor.

A 50 per cent interest rate may look high but not so if the client earns a 100 per cent return from deploying the loan.

The overall aim must be to lower indebtedness, not raise it as a result of microfinance. (Beware of multiple lending!) Prices should not be subsidised, be market-oriented and  competitive.

Both the MFI and the customer should earn a reasonable return. The norm should be to reinvest as much as possible to increase value to customers (lower interest rates).

And penalties should be minimised so as not to prevent customers from changing lenders.

To promote responsible pricing, various devices have been used so far.

Around 30 countries use interest rate caps. But they can make giving short-term loans (which cost more to deliver) unattractive. This can be counterproductive for the poor.

Some suggest margin caps. Muhammad Yunus outlines three categories -- green: interest rates not more than 10 per cent above the cost of funds; yellow: 10-15 per cent above; and red: 15 per cent or more above.

But this does not take into account the cost of delivery, aside of the cost of funds.

So, trying to make one size fits all can work against small loans that cost more to offer.

Another device suggested is a cap on return on equity. This can discourage commercial investors who come seeking higher returns and end up rewarding inefficiency.

Further, it does not look at how the profit is used -- distributed or ploughed back. High profit distribution can even be acceptable as in the case of credit societies which pay out their profits to members.

Some institutions like MicroFinance Transparency lay great stress on transparency. If you know the reality, solutions become obvious.

But data, which are points-in-time, take long to gather and the poor can't understand and use them on their own.

Even promoting competition, which is time-consuming, and welcoming market forces and instruments can result in unintended consequences.

The report says: "In an age of IPOs and stock options, market forces can also encourage financial service providers to maximise short-term profits over long-term, sustainable relationships with clients.

This has been the case recently in India, where intense competition has led to a rapid increase in clients (from one million in 2002 to 15 million in 2009).

While the market theory would suggest that this increasing competition would lead to a decrease in prices, the opposite has been true.

Average portfolio yield has increased from 19 per cent in 2002 to 31 per cent in 2009. MCRIL, an Indian microfinance rating agency, suggests that this increase in price has been driven by some of the country's largest MFIs seeking to increase profits in order to boost their equity valuations."

The cardinal Indian reality, going by the 2010 report of Sa-Dhan, the umbrella association of microfinance organisations, is that size matters.

The biggest, those with the largest loan portfolios (exceeding Rs 500 crore), have the highest yields or interest rates (33 per cent), the lowest expense ratio and high return on equity and assets.

The 10 largest MFIs hold nearly 80 per cent of the total portfolio but only 7 per cent of MFIs are very large. Very large MFIs account for 76 per cent of clients. Eighty per cent of negative net worth MFIs are small and no large or very large MFI has a negative net worth.

Very large MFIs have the lowest portfolio at risk. Nearly 70 per cent of MFIs have PAR of less than 1 per cent. Indian MFIs are thus healthy.

Twenty of the 30 MFIs having a negative return on equity have an yield higher than 20 per cent, while 17 of these 20 have a spread of more than 10 per cent.

 This shows that a high yield does not necessarily translate into a high ROE. MFIs have a return on assets way above that of banks, with 62 per cent earning 2 per cent or more.

MFIs are more or less (78 per cent) operationally self-sufficient. The capital adequacy ratio or CAR (capital to asset) of MFIs is quite good; nearly 70 per cent have a CAR of over 10 per cent. So, MFIs will be able to sustain growth.

Since loans from banks are an issue, let's look at MFI debts. Large and for-profit MFIs account for a lion's share of the sector's total debt.

Nationalised banks account for the largest share of MFI debt, 43 per cent. Non-profits record the highest debt whereas for-profits owe nearly as much to private as to public sector banks.

These statistics tell us that a few large for-profit MFIs, which are healthy, dominate the scene.

Promoting transparency and regulating them should not be difficult.

Subir Roy
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