The understanding that providing financial services to the poor is essential is not new in India. Since independence, the Indian government has made various efforts from encouraging expansion of the commercial bank branch network into rural and semi-urban areas, creation of local subsidiary banks known as regional rural banks, and promoting lending to key disadvantaged economic sectors. Despite much progress, the socio-economic impact has not been as powerful as expected because commercial banks were not able to cater to this market in a cost-efficient and sustainable fashion. Instead, bankers continued to view such lending as a social and more pertinently, a regulatory obligation. Thus, financial organizations that were meant to serve the poor did not do the job to the extent originally planned.
Providing financial services to the poor, especially in rural areas, is difficult and costly: Bankers lack the requisite information on their clients. While this is true in any transaction, this is exacerbated in the case of poor people because of the absence of collateral and personal credit history—information that usually allows bankers to estimate the creditworthiness of clients to a reliable degree. Poor clients also require usually a high frequency of small transactions in inaccessible geographic locations, making this clientele base unappealing to traditional bankers. Furthermore, most poor clients being illiterate, they are unable to cope with the usual paperwork and formalities of the banking system. All these unique features of the clientele weigh negatively in a typical cost benefit analysis. In addition, traditional financial institutions do not promulgate the sort of outlook or policies that would encourage their staff to lend to the poorest clients.
The "microfinance promise" brought innovations in all these aspects—contracts, management structures and attitudes—that made banking for the poor not only possible, but also a viable business proposition.
Microfinance, which as a term has traditionally and until recently been synonymous with micro-credit, has been growing fast in many countries, most notably in Bangladesh since the 1970s when it was initiated by organizations such as the Grameen Bank and BRAC. In India the movement appeared only in the 1990s due to the advent of financial sector reforms that encouraged policy makers to devise and encourage new solutions with a focus on repayment and sustainability. The movement started with the idea to connect a group of villagers, usually a group of 15-20 women, to commercial banks, which became widely known as the SHG-Bank linkage model. In recent years, a new model of microfinance has emerged, closer to world famous Grameen model—financial intermediation by so-called "Micro Finance Institutions" (MFI), specialized institutions created specifically to distribute credit to the un-banked population.
So where are we now?
The microfinance sector in India, largely unfettered by tedious regulation and interference is young and dynamic. While there are very few reliable aggregate data available for the Indian microfinance market, a lower bound on supply of credit from the formal sector can be estimated at Rs.37 billion (US$822 million) in 2004-05.
Currently, roughly 75% of the credit supply is via the Self Help Group-Bank linkage route largely financed by the National Bank for Agriculture and Rural Development (NABARD) and the rest comes from MFIs, increasingly backed by commercial banks. However, the difference in market share is decreasing, as the increase in credit flow to SHGs over the previous year is 61% while growth of loans originated by MFIs is well beyond 100%.
KAS foundation (KAS), a MFI operating in Orissa and Chattisgarh, is a good example of this phenomenal growth. Registered as a Section-25 company, KAS started operations in the year 2003 and provides savings, credit and other financial services to the poor in rural, semi-urban and urban areas. Set up with the help of Rs.4.0 million grant from the corporate responsibility wing of ICICI Bank, KAS has grown phenomenally in the last 2.5 years, disbursing more than Rs.1.0 billion to 250,000 borrowers from 20,000 SHGs and 20,000 JLGs by the end of the 2005-06 fiscal year featuring a portfolio at risk (PAR) of not more than 1.25%. The root factors of the KAS growth story lies in its willingness to enter into the hitherto unappealing territories of Orissa and its innovative delivery channels, the continuous financial support of ICICI Bank and agile leadership and management abilities of the charismatic founder CEO, Mr. Kathiresan.
Despite such valiant efforts from KAS and other key players in the microfinance sector, the World Bank estimates that Indian microfinance activity currently reaches only 4% of the poor. Furthermore, microfinance tends to be concentrated in rural areas as opposed to urban areas and in South India as opposed to North India.
If microfinance is such a lucrative proposition, why are so many parts of India under-served?
The biggest obstacle until fairly recently was little access to commercial markets and the forbidding cost of capital funds. As private banks, spearheaded by ICICI in 2003, entered the microfinance sector, this barrier partly disappeared and microfinance activity is now accelerating at a break-neck pace, whether we speak of loan outstanding, client outreach, product and service diversification or geographic spread.
Today, concerns have shifted to growth management issues such as skilled human resources, flexible product design, reducing transaction costs, ensuring adequate management information systems, standard credit information, better use of advances in technology, accessing alternative financing, and dealing with regulatory hurdles and political risks. There is a clear need for structured long term financing to the sector to fully address these important issues and smoothly transition into a well functioning mature industry.
As microfinance activity evolves into a full fledged industry, a multitude of issues must be urgently addressed. The pool of skilled microfinance professionals in India is still quite small, turnover is high and microfinance is still not perceived as a viable business opportunity and professional workplace by qualified graduates. It is estimated that a minimum of 20,000 executives are required across the sector over the next four years, particularly at middle management positions. Another critical issue faced by MFIs is the very high operational costs, especially at loan origination and during monitoring because of doorstep service and little or no deployment of technology solutions. This is a critical concern in the face of rising competition, public scrutiny and political interference. Technological innovations such as smart cards, biometric IDs, and rural kiosks that can help control costs are crucial for a safe and rapid scale up. In terms of financing, capital infusion is no longer a problem in India primarily because of short term bank loans and off balance sheet financing via the partnership model initiated by ICICI Bank. However, MFIs are lacking in some forms of capital, especially access to long-term debt from banks, equity and possibility of loan portfolio securitization. The lack of information sharing represents another challenge that will be become increasingly so with the growth of the sector. One of the main impediments to the creation of a standard credit bureau is the lack of a unique identifier e.g. a national social security number. Finally, the sector is faced with a challenge of political nature. Two of India's largest MFIs recently faced government action in Andhra Pradesh prompted by public complaints against them of misbehavior, malpractices and usurious interest rates, following which most Indian MFIs have formally adopted a uniform code of conduct that addresses these issues including forbidding unethical practices by loan officers. Such incidents highlight the sharp need to regulate unknown start ups and ensure that larger MFIs adhere to consistent good governance, transparency and accountability standards.
In terms of regulations, the Reserve Bank of India and the Ministry of Finance are strongly supportive of the microfinance movement. For example, a big step forward for the sector was in January 2006 when RBI permitted deposit mobilization by MFIs appointed as Business Correspondents. Such policy milestones are shaping the fast paced thriving sector today. Yet there is much to be done. A stable and conducive policy environment is necessary for initiatives such as a single credit bureau, biometric IDs or smart cards and weather stations. We believe that while the sector at this stage needs a laissez-faire environment, policymakers should be on a continuous vigil and deliver concurrent improvements in policy and regulation.
While the question of access is of immediate concern, it is also essential to improve the quality of financial services that poor people have access to. "The full promise of microfinance can only be realized by returning to the early commitments to experimentation, innovation and evaluation". For this, we need to understand the true impact on poverty alleviation and develop new products that are more suitable for the needs of the poor. We also need to find ways to combine microfinance with other types of development interventions so as to achieve the end goal of microfinance: to serve the poor in a cost efficient and sustainable fashion and to help improve the lives of the poor. The Centre for Micro finance (CMF) in Chennai is undertaking a large number of research and pilot projects with the objective to shed light on precisely both of these aspects—increase access and quality of financial services to the poor.
As we go forward from here, the most salient point to remember is not past successes or present impediments but the future economic potential of this market. According to an April 2006 McKinsey India survey, rural India has the potential to become a US$500 billion market by the year 2020. It remains to be seen whether today's MFIs, banks, lenders and investors have the tenacity, dexterity and wit to retain and build on their first mover advantage.