A LiveMint article provides edited parts of a transcript from a Mint Clarity Through Debate event, in which the Indian microfinance sector was the subject. Topics discussed ranged from the role of savings and deposits, shortage of credit in many areas across India despite saturation in others, the ability of MFIs to connect with the last mile, and legislation for microfinance banks. Panellists on the discussion included the Reserve Bank of India (RBI) Deputy Governor, K.C. Chakrabarty; Director of the Centre for Advanced Financial Research and Learning, Usha Thorat; Basix Group Chairman, Vijay Mahajan; Chairman and Managing Director of Small Industries Development Bank of India, Sushil Muhnot; International Finance Corporation’s Regional Manager, Financial Markets and Private Equity, Manoj Prashar; and Bandhan Financial Services Pvt. Ltd Chairman, Chandra Shekhar Ghosh.

Microfinance institutions are still struggling for recovery after a crisis triggered by an Andhra Pradesh law in October 2010

Mumbai: Microfinance institutions (MFIs) are still struggling for recovery after a crisis triggered by an Andhra Pradesh law in October 2010 that reined in MFIs, which lend small sums of money to poor borrowers; the state is India’s biggest market for such loans. The MFI sector was the subject of a Mint Clarity Through Debate event in Mumbai last week. Responsible lending is is key for the sector’s revival, according to the participants. Reserve Bank of India (RBI) deputy governor K.C. Chakrabarty; director of the Centre for Advanced Financial Research and Learning Usha Thorat; Basix group chairman Vijay Mahajan; chairman and managing director of Small Industries Development Bank of India Sushil Muhnot; International Finance Corporation’s regional manager, financial markets and private equity, Manoj Prashar; and Bandhan Financial Services Pvt. Ltd chairman Chandra Shekhar Ghosh were the panellists in the discussion. Mint’s deputy managing editor Tamal Bandyopadhyay moderated the discussion. Edited excerpts:

Chakrabarty: Microfinance is a very emotional word and small credit plays an important role in taking small farmers and entrepreneurs out of poverty. But microfinance cannot bring the financial inclusion because in our system we don’t allow microfinance firms to accept deposits. For financial inclusion there should be three services together—deposit, transfer of money and credit. But in my view microfinance firms can definitely facilitate financial inclusion at least in the next 10-12 years because the access of the banking facility is very limited. The limitation of microfinance institutions is that they can work very efficiently in a small and mid-market set up but if they are talking of growing at the rate of 50-60% year after year and having a return on equity 15-20 times, they cannot survive. They are very efficient in small market but cannot work in a large one.

Since they cannot accept deposits, how can they scale up their balance sheets? A major part of this lending goes for consumption purpose. So long as it is not linked to productive purpose, they have a problem. You cannot eat credit.

Mahajan: A nation which has 1.2 billion people and 300 million out of them are under the official poverty line, any alternative that is emerging must be encouraged. If you look at RBI’s data, the proportion of credit to small borrowers which had reached the peak of about 20% in 1989, steadily declined all the way throughout the 1990s because the banks turned their back on the poor. Two models that originated from the NGO sector—self-help group (SHG) bank linkage model and the direct microfinance institution model—rose as alternatives to take credit to the poor. RBI was encouraging this throughout the 1990s and all the way to 2008-09…most importantly, in 2000 RBI said that if banks lend to MFIs, it would be treated as part of the priority sector. In this process various types of people came into this sector, some of them came with the poverty alleviation motivation, some of them with growth motivation and others with a profit motivation. We talk about Andhra Pradesh but it’s only in five or six districts where there was a saturation of credit to the poor. Even today if you go to the districts of Telangana and Rayalaseema, where we work, there is still a shortage of credit. Now if a state government chooses to take one incident and demonizes the whole class, what can we say?

Prashar: I think microfinance institutions (MFIs) have been able to connect the last mile and very efficiently. They have been able to do it where the traditional delivery channels such as banks, cooperatives and regional rural banks have not been able to. The industry has also been able to give returns to shareholders and prove its viability. The Indian model got focused a lot more on credit and certainly less on diversifying its stream of products, such as insurance and savings products. There are certainly issues of transparent pricing that everybody realizes but from an investors’ perspective, one needs to acknowledge that the microfinance system is an efficient way of delivery despite its lacunae. Now what we need to do is to ensure responsible financing and the immediate task is to determine how to bring back the credit flow into the system. The needs are still there. The borrowers are getting money but that is coming from moneylenders where the interest rate is sometimes 100%.

Ghosh: We are working very closely with the poor people and understanding their needs. We are giving financial, livelihood as well as emotional support to the poorest of the poor. We hope to create values in the community level so that they can help us run the microfinance programme. We feel the need is huge and there is no alternative so they come to us. For the past 7-8 years a borrower has been dependent on us and if we don’t give him money, he will go back to the moneylenders.

Muhnot: We have moved to the next level as far as financial inclusion by MFIs are concerned. Almost 30 million people have been covered by MFIs and another 50 million by SHGs. Why MFIs have been able to do it is because they are the most suitable to do it. To reach the bottom of the pyramid you need to have a system which is cost effective. The banking system is also effective but the question is the cost. MFIs and SHGs emerged as the cost-effective solution because they have much lower salaries and overhead costs. There have been issues on the path followed by them. RBI has given a good road map on the path that needs to be followed. After the Andhra Pradesh incident, the best thing to have happened is RBI guidelines on the road map for the sector.

Medium-to-large MFIs will be able to survive in the long run and the smaller MFIs may have to merge to emerge as a bigger entity, because their cost of operation is going to be huge.

Thorat: Even today the coverage of the SHG is larger than that of the microfinance in terms of total outstanding credit. A very important point is that financial inclusion is not just about credit, it is also access to savings and payments system. Yes, microfinance is a very important measure for financial inclusion but it’s not the only thing. The real issue is that the banking system has not really scaled up, but SHGs and microfinance have—these are the entities that have been able to enable the outreach.

What our experience shows is that chasing return on capital or chasing profit, especially when it is dealing with the vulnerable groups of the system is not something that can really be sustained. So we come back to this issue of responsible lending and borrowing. It is very clear, especially in Andhra Pradesh, the kind of multiplicity of borrowing that has happened. The number of poor households in Andhra Pradesh is 2.5 million and the number of MFI clients is 27 million. So about 10 times of poor households were MFI clients and the average credit was something about Rs. 71-81,000 per account while the average credit in the rest of the country was much smaller.

Mahajan: There are 40 countries around the world where there are legislations for microfinance banks. One of the largest is BRI (Bank Rakyat Indonesia) of Indonesia, which is as big as State Bank of India. As a result, the rural penetration of micro credit in Indonesia was far ahead of India many years ago. On top of that, Indonesia has a category called private rural banks. There are six thousand such banks compared with four local area banks in India.

The US has a system of unit banks, or community banks. Even after the financial crisis, there are still 8,500 unit banks that take care of the local economic development. So it is just a mental block that microfinance should be a one-legged race and deposit taking should not be allowed to MFIs which has led to other conclusions that it cannot be scaled up. Tomorrow, if there is one microfinance bank legislation then let’s put it all in place. In this nation, even after 50 years of bank nationalization, we have such inclusion numbers, what’s the answer to that? There are 400 million people who deserve access to financial services.

Chakrabarty: We are biased to protect the interest of depositors. What microfinance institutions have done to the lenders, we have seen. I don’t know, what would have happened, had we allowed them to access the deposits. The way they have exploited the poor people who are borrowing the money, what would have happened had we allowed them to access deposits?

Protecting the interests of savers is the constitutional responsibility of any banking regulator. This is a debate whether we should allow MFIs to access deposits. If we allow them to access deposits, they have to be regulated as banks. Then they are no longer microfinance institutions. They will have to meet the regulatory requirements of CRR (cash reserve ratio) and SLR (statutory liquidity ratio) set for banks.

Our entire financial inclusion model is a bank-driven inclusion model. Even the banks selling insurance products are dangerous. Because, the poor doesn’t understand what insurance is all about. So far as microfinance is concerned, insurance is governed by a different regulatory authority. We would definitely not recommend insurance products should be sold lightly.

Thorat: This debate is on whether only large banks with deep pockets can deliver products at an affordable cost to the masses or we should have more regional institutions. The experience in India is that we do have both. We have large number of urban co-operative banks many of which are really doing microfinance. They provide loans, remittance services and savings products to the small communities.

The issue is about the local area banks and there is a dichotomy. When banks have to scale up and grow, then they become pan-Indian. But these banks started with an idea that they are going to be local area banks. So, there is an inherent problem. The other experience is that when you look at regional banks, which are focusing on certain initiatives, it is not necessary that they ensure financial inclusion or they get into the segments which are not otherwise covered. That is the experience of many private sector banks in India which are focusing on certain initiatives. They are making money but it is not necessary that they will be very successful in financial inclusion.

Then, there are cases of non-banking financial companies, which also focus on specific segments of business or initiatives. But again, there is a certain amount of concentration risk. So this whole issue of deposit taking is really at the heart of the issue. That is why RBI has been careful about restricting deposit taking activities to banks.

Muhnot: Even MFIs should diversify into different geographies. By doing so they get better opportunity and risks come down. We also feel that MFIs should of course look at income diversification. From a banker’s point of view, I can tell you that banks have been hesitant to lend to MFIs because there is a lot of provisioning. After the Andhra Pradesh crisis, banks have undertaken restructuring in the sector. Unless 50% of funds come back in the form of repayment, things will be difficult.

Prashar: Diversification as an investor is a very important aspect in any industry. We have started looking at sectors like technology. There are models like MFIs which have learned to work around the customer in a cost-effective way. If we look at the non-performance in the sector and if we take away the political risk, which has come recently, and that would eventually go away by geographical diversification, what we are seeing is that there is a role for microfinance institutions based on their core competency.

Ghosh: When we talk about poor people, they need not only credit but also like to deposit some money. Microfinance companies lend especially to poor women borrowers. If you look at Bangladesh, they have $2.6 billion as loan outstanding and $2.2 billion in their savings account. They are charging 27% interest to the client, we are charging 26%. We are collecting money from bank at 13% and their cost of money is 3.5%. So if we collect deposits, we can slash our interest rates.

Chakrabarty: We cannot run a system where microfinance institutions lend the money to the poor at 24-25% and take deposits from them at 4-5%. You surrender your lending part and become a business correspondent (BC) company. As a BC you can become the agent of a bank and can do both lending and borrowing on behalf of it. My suggestion to some of the microfinance companies, who are finding it difficult to raise the resources, is that you look into this particular model.

Mahajan: I have also set up a BC company but this is the most inefficient way of serving the poor. Because, there are four-five regulatory entities. By law, you are not allowed to share the distribution channels. This means I have to set up four different companies.

Ghosh: The RBI regulations have helped and banks are now coming forward to lend to MFIs. I hope in another three to four months things will improve further. There are other positive initiatives in the sector like setting up a credit bureau, which can help issues like overlending. Also, a common code of conduct being implemented, which will gain give the comfort to the sector.

Thorat: I think it is important for any financial system that the credit culture is not eroded. What is worrying me is that the whole debt restructuring process is dependent on 50% recovery. The excesses happened in lending should also be kept in mind when we talk about such kind of reaction. There is a clear case of overlending and there is a clear case of forgiving that borrowing as well. So the message should be there has to be some kind of responsibility. Otherwise, how will the mainstream lenders will come and start lending again? Even if banks take these loans are part of their NPAs, what is going to happen in future and where is the sustainability?

Chakrabarty: We have to change the structure. May be for the vulnerable sections, you need to standardise the product. What I am saying is that you need to innovate new type of regulatory structure and product delivery structure if you want the MFIs to succeed.