Indian microfinance, the definitive investigation: Part 1, Prosecution

December 13, 2010 | Andhra Pradesh, David Roodman, Global news, India, Interest Rates, Microfinance, Regulation, Theory, Underwriting

By: David A. Smith


“Microfinance needs to be a supervised product but as it becomes larger, it can lose being a supervised product.”

– Babar Kabir, BRAC


Sitting in judgment?


Though it hasn’t made the front pages the way our global capital meltdown has, as I’ve previously written, the microfinance crisis in Andhra Pradesh, India, when measured in total lives likely to be affected by the outcome, is of equal global significance – maybe even greater. 


Boon or plague?


In making sense of it, I’ve been relying on Daniel Rozas, and even more, David Roodman of the Center for Global Development, whose most recent post, When Indian Elephants Fight, outdoes even his previous efforts.  Judicious, well researched (based on primary interviews!), investigative, logical, circumspect, even modest –


I’ve been pretty oblique in recent posts about my evolving opinions of the Andhra Pradesh (AP) crisis. I’ve been trying to share my thought process with you. But that seems to have left me open to misinterpretation and criticism for poor construction. Perhaps I have taxed your patience.


All these sober virtues we expect from quality journalism, and that make blogging someone else’s work so easy and satisfying – which I’m going to do, at length, because the Andhra Pradesh story is nothing less than a crisis in the whole value proposition of microfinance. 


1.     Is microfinance a boon to the poor, or just loan-sharking by another name? 

2.     Can the double-bottom-line ethos – profits and social impact – truly be sustained, or was it simply an illusion borne of the implicit subsidy of donating hundreds of person-hours and millions in grant funds?


Ever circumspect, Mr. Roodman does not reach a final answer. 


For one million dollars, what’s your final answer?


Instead, he takes us on an incredibly informative tour of the situation, starting with a critical fact:


So let me be clear:


In a week of talking to people in India about microfinance, I heard almost no one defend the behavior of the microfinance institutions (MFIs) in the villages and slums.


While tiny businesses can operate successfully with complex ethics, because they are controlled by a founder or CEO whose vision can span the whole organization and give it a personality, any business that scales relies on self-interest of the individual people who work within it.  That’s why business model and compensation system are so critical – what earns you profits, and what earns staff higher pay, is in fact what the organization values, and if social outcomes are not part of that equation, at some point in scaling they will be put aside.


Those actions appear indefensible.


All the lessons we learned the hard way in the subprime fiasco, Indian microfinance is now being forced to learn:


Loans were made too easily.


As in US subprime.


Interest rates were opaque, as they are in most of the world (though according to Chuck Waterfield, they are among the lowest in the world).


As in US subprime.


Collection practices were often aggressive.


Companies set targets – sales targets, volume targets, earnings targets – and those targets translate into commitments that individual executives and staff make, which are then quite logically tied to their compensation or bonuses.  In that deconstruction of the business into its constituent actions, morality is subsumed into the incentive system.  When a macroeconomic or exogenous shock hits, the organization’s instinctive momentum is to tighten the collection screws and hence entirely to miss the larger phenomenon.


Industrial-strength loan collection procedures at your service


Profits were disturbingly high.


(That’s what Bank of America thought about Countrywide.)


Who are you to say the profits were too high?


All characteristic of an industry with that needs regulation and management.


And that, I am now confident, is the core story.


Microfinance as a business, as a opposed to a social movement, has always rested on the premise that its ethics derive from giving people loans they can actually repay.  Indeed, all lending is an ethical business when people as a class repay.  It’s also ethical to foreclose infrequently when people don’t pay, because otherwise you can’t mitigate losses since the observant herd senses it can get away with murder.  But microfinance – indeed, any kind of lending – faces an ethical crisis when non-payment becomes rampant.


Whether the government response is ideal (when is it ever?),


It doesn’t help when the government shouts ‘boycott’ in a crowded delinquency.


Now you know


Whether MFI leaders were cartoon tycoons acting on pure greed,

The extent of the suicide link,

The role of politics,

The vested interests of the government-led self-help group (SHG) program —


All those are more complex issues on which I think I am increasingly getting a grip.


Time to stop teasing us, Mr. Roodman.


Who says I’m a tease?


The story behind the Ordinance

On Saturday, my last day there, I had an enlightening interview with B. Rajsekhar, the CEO of the Society for the Elimination of Rural Poverty. SERP, it turns out, was at the center of the Andhra Pradesh government’s smackdown of the microcredit juggernaut in the form of that October 14 Ordinance.


We’ll delve more deeply into the ordinance (including its maculate conception) later in the post.  For now, see it as a consumer protection statute, with these critical features:


·         The ordinance makes it compulsory for MFIs to register themselves with rural development authorities.  The institutions will have to register within 30 days. The registration will be valid for one year and the same will be renewed only if the MFIs adhere to the rules and regulations.

·         It has also been made compulsory for all MFIs to display the rate of interest on their boards. This has been done in view of the complaints by borrowers that MFIs were collecting higher rates of interest than those at which they agree to provide loans.

·         MFIs can’t send their agents to the houses of borrowers.


In the US, we have both the Home Mortgage Disclosure Act (HMDA) and the Fair Debt Collection Practices Act, which specifies what one can and cannot do in the way of pursuing a delinquent borrower.  It’s predicated on being able to reach borrowers on the phone and through the mails, however, two conditions not guaranteed to be present in Andhra Pradesh.


Customer interface, Indian-microfinance-style


SERP was created a decade ago to implement the World Bank-financed Velugu program [Andhra Pradesh District Poverty Initiatives Project – Ed.] that provides finance and many other services to self-help groups in Andhra Pradesh. Through a hierarchy that mirrors the geographic divisions of the state (district, mandal, village) it bridges between the government and about 1 million SHGs with 10–15 members each.


Evidently SERP is a Mission Entrepreneurial Entity, and apparently a well-designed one – last-mile counterparty – but with a particular awfully big advantage that can misused:


Formally it is non-governmental. But the state government funds it and the Chief Minister chairs its governing board.


This makes SERP sounds much more like a state housing finance agency, but with an interesting intermediary role.


Rajsekhar began with a soliloquy on intent. He pointed out that five years ago, before the MFIs had grown large, AP was already home to a huge number of self-help groups that help the poor save and borrow. If MFIs were truly committed to bringing financial services to those who lack, why didn’t they go to states with fewer SHGs? Clearly, the MFIs are driven by greed. “The intent is not poverty alleviation. The intent is profit maximization on the MFI side.”


I can’t quite buy the editorializing of intent.  Plausible but unproven.  This, however, makes perfect sense:


It was cheaper for MFIs to piggyback on SERP’s years of hard labor organizing a million SHGs:


We’re all part of the same ecosystemic team, aren’t we?


The MFIs could just poach the SHG members, who were already screened for creditworthiness, organized into groups, and accustomed to credit.


Again, I see nothing intrinsically wrong with this.  Government’s role is market creating and pump-priming – then, when a market has formed and stabilized, government should be able to exit in favor of opening another market space.  That is not SERP’s perspective, however, because SERP,  however much it may be an offshoot of government, is itself a business with its own survival imperatives. 


“It’s like SERP have cooked the food; it’s ready; MFIs can just come serve themselves and start eating.”


Just lift for customers


Again, that is what government is supposed to do – and having done that work, it should move on to another arena.  Of course, it is too much to expect SERP to see things that way.

He then told me the story of the Ordinance from his point of view. As early as the spring of 2010, local TV channels were broadcasting reports of microcredit-linked suicides. The coverage was sensational (whether sensationalized, I don’t know):


Almost certainly was – our media sensationalize, why shouldn’t other countries’?


Responsibility if for wimps


Women spoke on camera of being pushed into prostitution.


Regulation by anecdote is always dangerous – even if the anecdotes are true, which they likely area.


The media drumbeat intensified in July and August, focusing the minds of politicians and policymakers.


Intellectually secure in the belief that their work was benefiting the poor, the microfinance industry was slow to recognize how dreadful were its optics.


Bad optics


The industry may also have grown numb to the vulnerability of its borrowers:


One apparent reason was an unusually strong monsoon (think of the floods in Pakistan). Under the impressive National Rural Employment Guarantee Act of 2005, the national government promises 100 days of paid work to every rural adult in the country.  Most of the labor is unskilled and relates to public works, but it appears to have become a value source of security for the poor.


Admirable it may be – a kind of Indian Civilian Conservation Corps – but it amounts to a government funding stream no different, in writing terms, from a subsidy:


The National Parks thank you for your work, lads


It pays weekly, which is convenient for people with loans requiring weekly payments.


It’s a well designed implicit income subsidy that also builds the nation’s infrastructure.  And it’s seasonal:


Sowmya Kidambi, a former activist now working for the program in AP, praised NREGA for getting cash into the countryside and preventing hunger this year despite higher global food prices. But it’s hard to build earth works in a heavy monsoon. So some expected wages did not come.


People are poor partly because their lack of assets makes them more vulnerable to bad luck.  Income interruption, loss of home, loss of physical or financial assets – poverty gives you thinner shock absorbers.


No cushions for the poor


Other MFIs with whom we work incorporate insurance into the product.  That’s an additional cost, to be sure.  Conversely, if as a microlender you’re not going to require insurance, then you had better build in payment flexibility, otherwise you’ll be facing an unacceptably high rate of defaults.


In response—and illustrating the key role of the media—SERP constituted task forces in each of AP’s 23 districts to investigate such stories and file criminal charges where appropriate.


So SERP is not just an intermediary actor, it also has the power to round up its competitors, a valuable feature.


“Major Strasser has been shot! 

Round up the usual suspects.”


The big MFIs resisted however, arguing that they were regulated under national, not state, law.


A classic mistake, perceiving the problem to be technical when it is in fact political.  Every organization has an ethos, whether it knows that or not.  An outbreak of non-payment caused by force majeure is the kind of news that may be squelched on its way to the executive suite, or if reported, dismissed as so much scaremongering or rabblerousing.  Of course, there may in fact be some political motivation involved:


Another factor, which Rajsekhar did not mention but Sowmya did, is political unrest. [A traveler] into Hyderabad arrives at a huge and beautiful new airport, then rides into town on a divided highway through fallow pastures. On my way back to the airport, I traveled on the still-under-construction ring road. The flip side of all this investment catering to foreigners and the well-to-do, I was told, is the complete starvation of investment for the rest of the state, and that has stirred separatism.


In a world of immediacy, the visibility of inequality becomes all-consuming.  It is seen as injustice, as indifference, even immorality.  It must not be borne:


Activists want to split the state. Storefronts have been looted and buses set on fire. And political groups have called for bandh‘s—general strikes that shut down the region.


BJP bandh in Amritsar, July, 2010


Once a movement escapes from its consignment to the purely technical and becomes political, elected officials can not stand against it.  In truth, some of them like leading the charge, using the poor for their own political agendas, and against their constituents:


Once more the poor get stomped on: wage laborers lose days of work. (See M. Rajshekhar’s Economic Times article on both factors.)


Since intolerance for late payment is in the DNA of MFIs, pressure began to build on borrowers.


In microfinance, L – Loss given default – is nearly always 100%, lenders concentrate on minimizing default, partly through extreme frequency of collection and monitoring, and potentially through intimidation.


Probably, in fact, the pressure had been building on many people for months and been held at bay with new borrowings. But that of course had to end.


The microfinance industry failed to see that the Andhra Pradesh activity was a subprime crisis on the boil, partly because people had convinced themselves that microfinance was different from global finance.


Uh, boss –? 


Also in July, SKS went public. What was once cloaked was now spelled out with numerical precision in the papers: the investors and managers of SKS were making millions off the poor.


India, or at least Andhra Pradesh, was swept by the same populist ire that consumed Wall Street.


[Continued tomorrow in Part 2.]