Microfinance crisis in India: Pakistan can avoid spillovers through proactive approach

The Andra Pradesh (AP) microfinance crisis is in many ways a setback to the microfinance movement and will require a lot of internal reviews to restore confidence with global stakeholders.
Allegations of coercion related to collection practices, lack of transparency in terms of interest rate disclosure to clients and irresponsible lending practices with a singular objective of growth and generating abnormal profits on the part of some of the microfinance institutions (MFIs) following reports of multiple suicides caused allegedly by the pressures of over-indebtedness and aggressive loan-recovery practices have drawn a lot of negative attention towards the sector.
While there is no empirical evidence that proves the causality of suicides with microfinance, the fact remains that there is public outrage at the perception of microfinance becoming a money-making venture. Double bottom line industries like microfinance, face the uphill task of balancing their financial and social performance.
The two can sometime conflict in the short run but have been proven to compliment one another in the longer term. MFIs in India have managed the commercial side of their business well, with deals being done on a regular basis between MFIs and commercial banks for debt and securitization and equity deals through initially microfinance vehicles and most recently with mainstream private equity firms.
The recent IPO by one of the fastest growing MFIs in the region if not globally, SKS, is another instance of the rapid commercialisation. The singular focus on growth, however, resulted in corners being cut leading to lax internal controls, high staff turnover at field level, reduced relationship with clients and multiple lending leading to over indebtedness, lending for consumption, etc.
As has been seen in India, Bolivia and Pakistan such incidents lead to a vacuum and result in entry of different pressure groups that exploit the situation. This exploitation is easy with microfinance - the service/sector has political underpinnings because it lends to the poor and politicians and other pressure groups have long been using loan write-offs as a tool for political mileage in their constituencies.
In early 2010, Vijay Mahajan, founder of BASIX and the current chairman of Microfinance Institutions Network (MFIN), pointed out that the level of multiple borrowings was rising alarmingly in AP and a large number of individuals used microloans to repay old microloans. His contention was that rarely were the loans utilised for productive investments. Thus, the use of microcredit to fund consumption would mean that no additional income is generated from the loans and the clients are increasingly indebted as a result, (Source: http://www.mifireport.com/2009/06/microcredit-loans-used-to-buy-food-2/).
The momentum of the sector drove individual players to consistently attempt to grow,largely recklessly. While the sector propounded the traditional mantra of microfinance - that microfinance helped the poor - the high growth rate of the sector translated into financially unviable microenterprises and economically inactive individuals being lent money that they had no hope of returning. The problems were compounded by the fact that there is limited regulation of the Indian microfinance sector and an absence of industry level infrastructure in the form of a credit bureau that helps in removing information asymmetries at the client level.
Moreover, there is also no dispute resolution system where clients can lodge their complaints and their grievances can be heard and addressed. An analogy can be made with the subprime mortgage lending in USA which resulted in the implosion of the financial sector in 2008.
Suicides allegedly linked to microfinance prompted the AP State, without going into the causality, to issue an emergency ordinance that requires microfinance institutions to register with the state and bans loan collectors from visiting people's homes. It has asked immediate stoppage of lending and recovery till registration is completed.
This has resulted in a virtual moratorium on loan recoveries. Initial reports suggest that recovery rates have plummeted to 10% - they were above 95% prior to this State action and microfinance in India in general and AP in particular is going through its toughest time. Since the state's emergency ordinance, commercial banks - which provide 80 to 85 percent of capital at most microfinance companies - have stopped approving new loans nation-wide, which would lay the foundation for a liquidity crisis in the Indian microfinance industry.
The Reserve Bank of India oversees only those companies, generally the largest, which are registered non-banking finance companies. They cover 80 percent of the business by loan volume, but constitute a small percentage of the total number of India's lenders. This lack of regulation has exacerbated matters.
Debate has ensued in India on possible short and long term solutions. Consensus seems to be emerging that effective regulation and client protection lies at the heart of any solution. Bringing the wide range of microfinance institution types into some sort of regulatory framework will benefit both clients as well as the MFIs themselves - clients will be served by institutions that are supervised and answerable to the state machinery and operate by set standards; MFIs will be protected against ad-hoc intervention or exploitation by political elements and have a more level playing field.
The industry must redeem its image by being more transparent about prices, practices and governance. A small minority of institutions that may engage in coercive recovery practices create trouble for the entire industry. Self regulation in the form of industry codes for lending and client protection need to be enforced visibly.
Pakistan remains insulated from the backlash of India's crisis. Analysis of the crisis reveals that Indian MFIs have been ineffective in implementing controls, and maintaining viable procedures which may have prevented the situation. In Pakistan there have been sectoral interventions both at the macro and the meso levels to manage potential laxity of controls.
At the macro level this includes putting in place a legal framework that allows setting up of Greenfield MFBs and transformation of MFIs in to MFB. We also have a regulatory framework and supervisor that understands the business of microfinance and ensures that the thin line between risk management and market facilitation is maintained through high quality regulation and supervisory oversight.
Pakistan has also been allowing innovations in a well-guarded environment allowing branchless banking and models of lending to the poor for commercial banks. In the recent Economist Intelligence Unit publication Pakistan's legal and regulatory framework has been declared as the best along with Cambodia and Philippines.
At the meso level all three major players in the microfinance industry in Pakistan have joined hands to launch an exclusive microfinance Credit Information Bureau and discussions are underway to roll this out at the national level; this initiative is being regularly monitored and will follow with the development of a code of conduct for lending.
Effective use of the CIB will help deal with problems of multiple borrowing that often leads to issues of over-indebtedness, allegedly the main reason for the recent suicides in AP, India. The sector in Pakistan has also developed a code of conduct that promotes transparency and truth in lending practices and we have a strategy for setting up of a complaint cell that addresses client grievances.
This system can help protect both clients and institutions: clients have access to an independent third party complaint resolution mechanism thus alleviating their need to approach politicians or other pressure groups in case they have a grievance; it thus mitigates the risk of political interference for MFIs while allowing an industry view of any issues in the field before they become systemic. These initiatives are being strengthened through a consumer education or financial literacy initiative that will increase client knowledge of their rights and obligations and help in promoting innovation responsibly for the industry.
At the retail level, unlike India, Pakistan's microfinance sector is neither highly commercialised nor profitable. The sector is still dominated by non-profits. Although outreach has grown significantly, the macroeconomic environment coupled with limited access to liquidity has stifled the rapid pace of growth in recent years. Institutions that were growing fast have consolidated considerably and we foresee a slower pace of expansion in the coming years.
The crisis in India is not unique. Similar situations have erupted in other commercialised or competitive microfinance markets across the world. But spillovers can be avoided through adopting a proactive approach and realising the systemic risks that arise from a combination of rapid growth, concentration of lending and a sole focus on the financial bottom line. Pakistan's sector has woken up to these risks at all levels and this could save it from a crisis like we see in India today.