Can Micro Finance Attain Industry Status

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    Can microfinance attain industry status?

    Ganesh Sankaran

    As long as the fortunes of the sector are inextricably linked to the performance of a select group oflarge microfinanciers, achieving industry status could prove elusive.

    April 10, 2011:

    We all know that the target market, competition characteristics and the model itself expose

    microfinance to specific risks, over and above the financial services industry. Hence, for microfinance

    to achieve industry status, it is imperative to measure and mitigate these risks.

    And herein lies the crunch. One of the two approaches poverty alleviation or commercialsustainability is likely to have a direct bearing on the measurement of risks as well as itsmitigation. Currently with a larger play from the only-for-profit equity investors, the equation is

    skewed towards commercial sustainability (read profitability) alone.

    The industry (if we can call it that) and its players are facing four key dilemmas profit,

    relationship, managing risk and the best business model. Before delving deeper into each dilemma, letus quickly take a snapshot of the imperatives.

    At a juncture when the microfinance sector aspires to access diversified sources of funds and is poised

    to integrate with the formal financial system, sector leaders must choose between commercial

    sustainability as advocated by the Washington-based Consultative Group to Assist the Poor (CGAP, a

    consortium of 33 development agencies that support microfinance), or the social goal of poverty

    alleviation.

    Alternately, there is a hybrid model at hand: judiciously blend both in an efficacious mixture thatworks for all stakeholders.

    Current discourse on microfinance-risk focuses on refinancing, over-lending, falling underwriting

    standards in pursuit of high growth, an inadequate management information system (MIS), unhealthy

    competitive and recovery practices, regulatory risks and concentrated geographies of operations,

    among others.

    Instances in Kolar district in Karnataka and in Krishna district in Andhra Pradesh have confirmed that

    these risks are interrelated and sometimes manifest in the form of no-payment movements by

    borrowers.

    The focus on financial parameters is not bad in itself, and a time-bound goal orientation to meet

    commercial expectations is critical in the growth phase. The adverse cost structure facing the service

    provider has rebounded on consumers in the form of a large unmet need for microfinance products, be

    it credit, insurance or savings.

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    The financial inclusion initiative of the Government potentially could address the policy level

    framework on provision of these services. Hence, it is quite obvious that anyone who targets this

    market segment will have to innovate to surpass the adverse cost structure barrier and, given the

    political sensitivity associated with the target market, it is important that entrepreneurs communicate

    this adequately to external stakeholders to manage risks.

    Microfinance leaders have certain key issues to resolve, if the sector is to mature into an industry in asustainable way.

    The profit motive

    There has to be a distinction between profit motive and profiteering. While the former contributes to

    the growth of entrepreneurship and better deals for the financially excluded, the latter will lead to

    exploitation. Micro-financiers should be able to boldly articulate profit as a legitimate motive and

    build necessary credibility through spirit and action to distance themselves from being perceived as

    profiteering.

    Relationship approach

    Another dilemma which needs resolution is that of relationship-building with the end borrower.

    Application of a retail banking framework with its almost hard-coded cycle of origination,

    underwriting, collection and recovery may not be suitable for microfinance, where enforcement oflegal contracts is more illusionary than real.

    The cookie cutter model' and McDonald's style' of highly standardised functioning might yieldbetter efficiency ratios in the short-term, which aids valuation but in the long run it has to be

    relationship oriented. Given that in delivery of services the deliverer is not distinguished from the

    product itself, this relationship can be built only by a well-trained front-end field force adept in

    managing relationships.

    Therefore, the larger question is in pursuit of higher valuation and operational goals whether the focus

    on human resource (HR) development is diluted and, if so, what would be the impact on portfolio

    quality. With a substantial percentage of the field force having low vintage, this aspect deserves farhigher attention that what is being accorded today.

    Ironically, the relationship management-led model of financial services delivery that is generally

    believed to be viable for wealthy clients, is the model that is deemed most effective in servicing

    microfinance clients.

    The DNA change from faceless banking to relation-based banking is undoubtedly costly, and

    microfinance service delivery would need a viable cost structure. This would mean that the sector

    should constructively convey that business can be run only on a commercial basis, if it has to be

    scaled up in a meaningful manner.

    In a high-growth scenario that focuses on ever-greater efficiencies, by reducing transaction time and

    cost, the relationship aspect takes a backseat and this can significantly impact portfolio quality in the

    medium-term. The need for improving profit and growth targets through higher efficiencies, without

    sacrificing the relationship with end borrowers, is a challenge to be traversed by microfinanciers.

    Managing risk

    Conceptually, microfinance has its own unique ways of managing risks. Direct application of retail

    banking practices without adequate consideration of market nuances could lead to dilution of credit-

    risk management features reflected in its processes. There are inadequate incentives for putting in

    place an appropriate risk management system in microfinance mainly due to the availability of debt

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    due to the regulatory influence. This system should have a well-designed, documented and efficient

    fraud-control mechanism.

    As long as the fortunes of this sector are inextricably linked to the performance of a select group of

    large microfinanciers, achieving industry status could prove elusive.

    Managing industry risk at a larger level requires purposive creation and nurturing of a pipeline ofMFIs at different lifecycle stages, so that the crowding of equity and debt investment in the top MFIs

    ebbs. This is a puzzle that remains to be resolved at the investor-lender levels.

    Grant-led model?

    Due to perceptions of poverty alleviation, the microfinance sector has its base built on donor money,

    the significance of which dwindles once commercial money flows in. Given the debate in the public

    domain about the nature of the initial funding of many MFIs (similar to that which followed the

    Compartamos IPO), and the RBI Annual Report which has raised a concern that the interest rate

    advantage provided by the PSL classification of bank loans to MFIs is not being transmitted to end-

    borrowers to the extent desired MFIs need to introspect whether a return to a grant-led model is

    possible.

    In other words, minus the money currently flowing into the sector from commercial or banking

    channels, are microfinance operations sustainable? If not, the sector will fall under its own weight as

    the grant-led model cannot cater to the continual and incremental nature of end-borrower loans.

    This appears to be the most critical risk the sector currently faces, especially in the post -Malegamreport' era, which is likely to influence the quantum of credit flow from the banking system to the

    MFI sector.

    The Ultimate Goal

    Resolution of the aforementioned dilemmas will be critical to the maturing of the sector and becomingan industry where fixed income players such as mutual funds, insurance and pension funds find

    investments attractive; which, in turn, leads to true integration of microfinance into the formal

    financial sector.

    Resolution of these dilemmas would also take care of symptoms such as multiple lending and

    unhealthy market practices at front-end operational levels to a great extent.

    This would further release microfinance chief executive officers (CEOs) from daily crisis

    management, providing them adequate time to pursue growth plans, ambitions and aspirations allessential to unlock innovations that may lead this sector into sustainable transition and its emergence

    thereafter as a full-fledged industry.

    (The author is Mr Ganesh Sankaran is Executive Vice President (Credit and Market Risk), HDFCBank. His views are personal.)

    Keywords:Microfinance, industry status, diversified sources, no-payment movements

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