In India, commercial banks, both public and private, are required to direct a large chunk of their net credit to designated “priority sectors” seen as having a positive impact on India’s economy, and wider society – to ensure funds flow into areas the government deems important, but might otherwise be neglected.
These sectors – designated by the Reserve Bank of India – currently include broad areas of agriculture, small scale industries, small business, housing, education and lending to the poor and vulnerable – all areas that could otherwise find it tough to access credit.
Banks traditionally struggled to fill these priority sector lending requirements – 40 per cent of net credit for local banks, and 32 per cent for foreign banks – especially to meet the minimum thresholds for loans to agriculture and the poor, or “weaker sections”, as they are quaintly called in official jargon. Failure to meet the targets meant that banks had to buy low-interest bonds from the government’s National Bank for Agriculture and Rural Development to make up the shortfall.
But in recent years, India’s commercial banks have been turning to specialised microfinance institutions such as SKS Microfinance, a publicly listed company, Spandana, Share Microfin, Basix, Asmitha, and others to meet their obligations to push out credit to the “un-bankable” poor in remote rural areas, or urban areas.
Together, Indian banks – including public sector forces such as the State Bank of India, private domestic banks such as ICICI and HDFC, and foreign banks such as Standard Chartered and Citibank – now have around $6bn in outstanding loans to the country’s 44 for-profit oriented microfinance companies.
With field staff travelling into remote rural areas, these dedicated microfinance operations – most of which began as non-profit, non-governmental organisations before transforming themselves into for-profit companies – have served as the “last mile link” that pushed commercial banks’ money onwards to about 30m hard-to-reach borrowers.
“The actual risk assessment, collections and implementing was outsourced to the microfinance institutions,” says Jahangir Aziz, chief economist in India for JPMorgan. “It was relatively cheap, relatively easy and far less cumbersome than doing it directly.”
Initially, the arrangement suited everybody. Microfinance companies, which were prohibited from taking deposits, needed liquidity to make the millions of tiny loans they claimed would allow poor borrowers to start micro-enterprises and lift themselves from poverty. The banks, meanwhile, could fulfil priority lending targets with loans to a handful of large microfinance companies, rather than trying to establish rural network lending themselves.
That mutually beneficial relationship helped fuel a surge in micro-lending, with the industry’s outstanding loan portfolio growing at a blistering pace of 70 to 100 per cent a year for the past five years. But today, microfinance institutions are under serious regulatory pressure, grappling with a backlash against what policymakers and critics are calling their “usurious interest rates” and “coercive” debt collection tactics.
What regulators have cast a disapproving eye on is the spread between the rates at which microfinance companies borrow from commercial banks – usually between 11 and 15 per cent – and the nearly 30 per cent rate at which they lend.
Simmering official dismay reached boiling point in August when SKS, India’s largest microlender, raised $350m in an initial public offering that valued the business at $1.5bn – and focused attention on the fortunes being amassed in a sector ostensibly dedicated to public well being.
A month later, Pranab Mukherjee, India’s finance minister, wrote to Indian state-owned banks, asking them to consider a covenant in future loan agreements with microfinance institutions, mandating that interest rates be capped at 24 per cent.
The RBI also debated whether to remove microfinance from the approved forms of priority sector lending, citing concerns about high interest rates and over-lending, with companies extending loans to the same borrowers, paying little heed to their repayment capacity.
Yet the situation erupted into a full-blown crisis in October, after a spate of suicides among heavily indebted micro-borrowers in the southern state of Andhra Pradesh – a hotbed of micro-lending. In a hurried Cabinet meeting, the state government adopted an emergency ordinance last month that brought collections to an abrupt halt.
Besides putting the banks’ portfolio at risk, regulation has raised questions about whether microfinance companies will be able to operate, raising questions about to what extent they will be able to serve as the “last mile link” for banks.
“At a big picture level, the RBI and the government in its way have been trying to tell the banks to go direct,” says Alok Prasad, former India country director of the Citi Microfinance Group, and now the chief executive officer of the Microfinance Institutions Network (MIN), a body representing 44 for-profit MFIs. “The belief is that if the banks are able to go direct, they can lend at lower rates, and that over time is fundamentally a more stable system,” he says. “But going from past experience, the banks seem to lack the DNA to achieve that.”
It remains to be seen how the whole crisis will play out. The MIN has said its members would cap interest rates in Andhra Pradesh at 24 per cent, a move it hopes will persuade authorities to allow companies back to doing business and collecting outstanding debt.
Meanwhile, the RBI has established a committee to look in depth at the practices of microfinance industry, and recommend a possible regulatory framework. But it could take months until the political and regulatory uncertainty is cleared up, during which time many banks may be reluctant to extent further credit to the sector.
“The form in which microfinance institutions will survive will be very, very different than what they are right now,” says JPMorgan’s Mr Aziz. For now, though, “banks are back into this problem of trying to meet priority sector lending requirements again”.