I n the financial year 2016, the Indian microfinance sector finally appeared to have shed the baggage of the 2010 crisis. The sector had faced a significant test of its existence in 2010 when the government of Andhra Pradesh introduced an ordinance that effectively banned collections. In the resulting mayhem, liquidity dried up for the sector, aggregate assets under management (AUM) shrank by nearly 50% and the largest microfinance institutions (MFIs) were forced to seek cover under corporate debt restructuring. Smaller MFIs, those outside of Andhra Pradesh, spent the next few years in crisis mode for want of debt.
In 2016, however, evidence mounted that the shadow was lifting. The Government and the RBI awarded banking licenses to prominent MFIs across the country — a universal banking license to Bandhan and small finance banking licenses to eight MFIs. During the year, equity inflow was significant — and from a much wider variety of investors, debt issuances to mutual funds and insurance companies picked up, indicating in both instances wider acceptability among mainstream investors.
At the same time, the cumulative AUM of the sector crossed INR 60,000 crores while portfolio at risk held steady at an average of 0.5% of AUM.
The lending infrastructure had improved as well. Standard KYC, in the form of Aadhaar, was more ubiquitously available. Multiple credit bureaus had come up, improving the quality of data and end-customer assessment. MFIs had adopted technology at the last mile to enable digitisation of data at source, monitoring collection, controlling frauds and reducing turnaround times. Some were experimenting with cashless disbursements and collection models as also with mobile applications that could connect end customers with financial services such as deposits and investment products.
Amazingly, less than 18 months later, the sector has witnessed a fresh crisis. Growth has stalled in this period for NBFC-MFIs. Portfolio at risk is at 12% on an average, the highest since the 2010 crisis. Lenders have become nervous again, some have pulled back fresh exposure entirely. As with any crisis, questions on the viability or sustainability of the model have appeared again.
The delivery of microfinance through private or non-governmental sectors appeared in India over two decades ago. The objective of employing the group-lending model was to enable access to credit for borrowers with no income proof in a cost-efficient manner with low credit loss. The fundamentals of the model were simple:
- Keep ticket sizes low so that repayment amounts are low
- Use social collateral as a surrogate for credit underwriting
- Lend in groups to keep costs in check
- Maintain frequent touchpoints with the client and instill process-discipline in both employees and borrowers
The last two decades have seen several iterations and changes to corporate structures (culminating in advent of NBFC-MFIs and SFBs), as well as debates around concentration, scalability, and governance. The model itself has seen some tweaks as well — for instance, post the 2012 regulations governing NBFC-MFIs, several MFIs transitioned from a weekly repayment model to a monthly repayment model, ostensibly from the perspective of managing costs better, but perhaps without regard to impact on employee discipline as also higher installment amounts in an increasingly competitive environment that emerged a few years later.
Nevertheless, what is undeniable is that the group-lending model of microfinance, as practised by NBFC-MFIs, has been a resounding success. This is evident from the outreach indicators — MFIs have reached out to more than 5 crore customers in almost all states of the country, covering an overwhelming majority of districts. It is safe to say that barring geographies with difficult terrain, such as the upper reaches of the hilly north-eastern states for instance, MFIs have reached everywhere else in the country. It has not been an easy model to replicate either. Banks for instance, not including the MFIs who transitioned to banks, have not had nearly as much success in using the same model for delivery of credit. And it therefore follows that both NBFC-MFIs as well as the group-lending model of delivery of microfinance are here to stay and thrive as they deserve to.
If lending models are to be categorised on first principles, one would broadly divide them into operational and credit models.
- A credit-lending model is one that stresses on credit underwriting to manage delinquency, with a distinct credit team and centralised decision making. Small business lending/affordable housing finance would fall into this category.
- An operational lending model is one where there is minimal underwriting of the credit risk. The focus is on distributing a standardised product and having a collections-led approach to minimising delinquency. Joint liability group lending/two-wheeler finance would fall into this category.
Based on extensive field coverage spanning several districts at the peak of crisis, we feel that the group-lending model merits a closer look against the very characteristics that make it an operational model.
Core strengths of the group model — observations from the field:
We conclude from the above that commodification of the microfinance product and employee, both of which came about in a bid to manage operating costs and both of which have played a huge factor in the growth of the sector in the years gone by, has in fact now made MFIs more susceptible to shocks.
Into the Future…
We believe that it is time microfinance moved towards becoming a credit-lending model. We feel that the sector needs to move on from focusing on access to finance and look towards making this access efficient. In other words, MFIs should expend energy in identifying ways and means to understand the customer better and introducing nuance to the products on offer as well as managing the risk of this unsecured exposure. In doing so, MFIs will fundamentally start creating differentiation in the mind of the customer, which is critical from the perspective of retaining the customer.
Diversification of this nature, in our opinion, will entail the following:
- Embracing technology: The infrastructure afforded to microfinance institutions today is unparalleled. Borrowers with no income proof today create a digital footprint through a combination of Aadhaar, massive penetration of mobile telephony and their linkage to payments banks. With their regular connect with the client, MFIs are uniquely positioned to facilitate and create a habit of online transactions that will make this footprint deeper and more prominent. The advent of GST will, in the coming months, create a digital lock and key of the entire value chain or economic ecosystem of informal businesses. MFIs therefore sit on a goldmine of this massive volume of data, coupled with the data that they have already captured over the last several years on income sources (number and variety), residence stability, demographic change, etc.
- Moving from a product view to a customer view:
- Product design: MFIs can therefore improve their understanding of client behaviour in terms of repayment culture, income, expenditure and savings patterns — capturing the vagaries involved in the same. This understanding should feed into product design that optimises disbursements at the time the client needs the money the most and affords repayment options when the client has the money to repay. In theory, an MFI can therefore offer a whole range of products including working capital, consumption finance, crop finance, etc. These products can realistically match the cash flows of customers and not be a vanilla-term product.
- Client retention: Demonstrating to the client a deep understanding of their ecosystem is a sure way of creating differentiation in the mind of the borrower and thereby retaining the borrower. Improvement in qualification and training of staff only adds further to the client’s confidence in the lender — as also better equips the MFI to handle stress situations — including political intervention. This is already evident in the fact that individual loan portfolios of MFIs which offer the product have done much better than the group lending portfolios even in worst affected states such as UP, Karnataka, and Maharashtra.
- Revenue maximisation — Taking a client view therefore enables the MFI to offer nuanced need-based products. This can extend similarly to non-credit products as well including non-financial products.
- Delivery: Digitisation of data and its optimal usage therefore facilitates underwriting a customer like never before — without adding substantially to costs. MFIs can therefore focus on hiring and training quality personnel whose sole purpose remains to put a face to the lender and maintain an individual relationship. The field intelligence that this staff can bring will only aid the underwriting. Additionally, the MFI does not require any more to deal with the client in groups and individual lending can take prominence.
- Risk management: Risk management in microfinance has primarily been in the shape of monitoring or auditing the process. Recent events have demonstrated that this too is inadequate. Data-driven risk management is the need of the hour here as well. For instance, MFIs should use the massive intelligence and knowledge they have stored offline to help build a model that enables effective remote monitoring of event risks, draws patterns and perhaps, in due course, predicts where the next event risk is likely to occur.
S everal MFIs have, in the past, tried to diversify product offering to their customers using what is commonly known as the “graduation” model. There have been varying degrees of success in managing portfolio quality in such models but very limited success in scaling this product up. We believe that the former is on account of inadequate or poor quality credit underwriting. In turn, this has been on account of the insistence of using the same employees who manage the group-lending model for credit in a bid to save costs. We feel that the lack of scale, in turn, has been on account of insufficient understanding of the client’s ecosystem, again on account of faulty data collection. Equally true is the fact that a substantial number of MFI borrowers use the loan amounts towards consumption and therefore graduating them to an individual loan is not prudent.
The digital approach we’ve outlined enables the lender to take a life-cycle view of the customer and offer different types of products at various points in time in this life-cycle. Therefore, if an MFI understands the customer’s economic ecosystem well, it may take an educated call to fund consumption. But fundamentally, the call should remain that of the MFIs.
There are, of course, challenges, foremost among which are regulations themselves, which prohibit “non-qualifying” assets exceeding a nominal proportion of MFI balance sheets. To remedy this, the regulator will have to take cognisance sooner or later, of the fact that the current regulations have killed innovation in microfinance in every respect except cost rationalisation.
In conclusion, we reiterate that the group-lending model of microfinance has done a phenomenal job in disseminating credit in remote pockets of the country. This is a job that it will continue to have to do. However, MFIs will need to ride the digital wave to understand individual customer better and not lose a customer to the group identity, retain the customer, offer multiple products, and more importantly, insulate their balance sheets from the bogey of event risk.
Originally published at www.vivriticapital.com on August 31, 2017.