Microfinance: Capping interest rates

India’s embattled MF industry, reportedly being unfairly blamed for a spate of farmer suicides, brought about by poor and marginalised Indian farmers being indebted to rapacious money lenders and State-sponsored micro lending schemes, has under pressure, been forced to cap interest rates on its loans in Southern Andhra Pradesh at 24%.

Critics of MFI claim that the suicides have been caused by lender malpractice, heavy handed debt recovery and high interest rates.

Imposing interest rate caps is contrary to every known principle of microfinance, which has evolved over time. In Sri Lanka historically, generating the savings of village self help groups through seetu schemes, savings and credit groups, thrift and credit cooperatives and Death Aid Societies have a long and honourable history, going back over 100 years.

‘Know Your Client/Borrower’

The dictum ‘Know Your Client/Borrower’ was the basis of operations of Microfinance Institutions (MFI), long before it became the fashionable cry of so-called ‘anti money laundering’ commercial bankers.

MFI’s collected monthly savings from groups of cohesive, synergetic, homogenous, poor and marginalised people, mostly women, whom, when they had some experience of managing their own funds, were lent small amounts of money for their own income generating activities on an inter se guarantee basis, so that group members guaranteed the repayment by members of their group, if any one of them defaulted.

The micro lenders’ agents knew each family , intimately, their habits , were they spendthrift or wasteful, was the ‘pater familias’ ( head of household) a drug addict or an alcoholic, were the children attending school, was a parent a migrant worker out of the village, were they healthy or sick, suffering from malnutrition , bad sanitation or lack of food, etc.

Interest rates were fixed on the basis of a number of factors: The cost of money, how much the MFI had to pay as interest to depositors, at how much could the MFI raise funds from other sources, (either subsidised sources such as donors or apex government agencies like Sri Lanka’s Janasaviya Trust Fund and its successor the National Development Trust Fund or at commercial rates from banks or investors), the reliability of the borrower, the nature of the income generating activity and the estimated return on investment, the resources of the family, etc.

In this kind of environment, it is an anathema to imagine capped interest rates. It is contrary to every known principle of microfinance which has evolved through the ages.

Change in motive

The Chief Executive of the Kingdom Bank in the UK has expressed the opinion that this situation in Andhra has developed due to a crucial change having taken place in microfinance that has contributed to the allegations of exploitation of borrowers, the change being of the motive, from non-profit to profit.

Initially MF was launched with the intent of benefiting the poor by using a commercial mechanism. Soon it became apparent that, firstly, the poor are good borrowers who repay on time, unlike more up market individuals, and that if groups of poor people can be persuaded to assume joint and several liability for their individual debts, the probability of default drops sharply.

This is why bankers seek a third party guarantor for debts, an income tax payer, a government servant or a family member with assets. When this is coupled with an environment where the only competition is exploitative and usurious money lenders and loan sharks, demand for micro loans goes through the ceiling, naturally, and MFIs scrambled to raise more capital from government, from banks, from donors, from high net worth individuals, investment funds and venture capitalists.

Many Indian MFIs converted to for-profit companies and raised more that $500 million in private equity from foreign venture capital players. Most of these investors expected a reasonable return on their capital, comparable to other investment opportunities available in the market environment.

Just ahead of SKS Microfinance’s $350 million IPO, its founder Vikram Akula sold shares in SKS worth nearly $13 million. This happened with many more Indian MFIs such as Share and Spandana.

Political backlash

Indian policy makers and politicians have become increasingly uncomfortable with these large profits and personal fortunes being amassed in an industry ostensibly dedicated to the alleviation of poverty.

They conveniently forget that this rapid growth of micro lending which has been expanding in India at about 70% a year for the last five years, has boosted rural liquidity, helping to fuel a rural consumption boom, which kept India’s domestic consumption high through the world economic downturn, India kept ‘shining’ when the rest of the world economy, except China and Australia, was going downhill.

Before the cap on interest rates was imposed, Andhra’s MFI’s offered their 6.7 million borrowers the option of restructuring their outstanding loans totalling some $2.7 billion in an effort to defuse the political backlash caused by the farmer’s suicides. Under the plan borrowers whose total debt service burden to all creditors, including the government and informal money lenders, exceeds 40% can restructure their outstanding debts to the micro lenders.

Alok Prasad, Head of the Indian Microfinance Institutions Network, said that the MF industry wanted to address the borrower woes and diffuse the state authority’s hostility towards microfinance. However, due to the intense hostility and interference at the grassroots, the MFIs were forced to agree to the cap on interest rates to counter the intense political backlash against the sector.

Bangladesh

In Bangladesh too, Dr. Q.K Ahmad, the Chairman of PKSF, a body that monitors microfinance has described microcredit as a death trap for the poor. He explains that poor people often borrow money without thinking of the consequences and that 60% of Bangladesh’s poor borrowers have taken loans from several sources.

Further, field officers of Bangladeshi MFIs are judged on repayment rates; they sometimes use coercive and even violent ways of collecting instalments. However, some MFIs like Grameen bank and BRAC in Bangladesh have a policy whereby loans are rescheduled when clients face natural disasters, like floods, which are endemic in the country.

Prof. Yunus of Grameen Bank, the Noble Peace Prize winner of 2006, has labelled MFIs that do not do so, as ‘the new loan sharks’! While the Nobel Peace Prize may not bestow infallibility, there might be a point in his criticism, as Dr. Ahmed points out: “There are some agencies which even take their payments from flood relief material!” Prof. Yunus has been advocating a cap on interest rates in Bangladesh.

The latest news from Bangladesh is the regulator has placed a cap of 27% on the rate at which MFIs could lend to their borrowers. The 1,200 MFI in Bangladesh, which have an estimated 40 million clients, must implement the cap by 30 June 2011.

Indonesia

In Indonesia, the leader in the burgeoning microfinance market is Bank Rakyat. Readers may be interested to know that it was President Barak Obama’s mother Anne Dunham, when she was working in Indonesia, with young Barry by her side, on a Ford Foundation grant, who did the basic research for Bank Rakyat to make its first micro loans to Indonesia’s traditional craftsmen and artisans to help preserve their traditional crafts, which has led Bank Rakyat to evolve into the Indonesia’s major MF player.

The loans are not capped and commonly carry an interest rate of over 25% as administrative costs are high, loan sizes are tiny and transactions are administered by armies of barefoot bankers visiting clients on foot, bicycles or motor scooters.

Sri Lanka

In Sri Lanka, the State-funded apex fund provider for MFIs, the National Development Trust Fund, the successor to the Janasaviya Trust Fund, has recently imposed a cap of 15% on their MFI partners on lending rate to beneficiaries. The apex provider lends to the MFI at 7%. This spread is considered by most MFIs to be inadequate to cover their costs, risks and cost of money, particularly as there are restrictions imposed on the MFIs taking deposits.

The draft law on microfinance regulation presently being discussed in Sri Lanka has a provision which would allow the regulator to cap interest rates. The regulator for licensed commercial banks and financial institutions has similar powers, but this power has never been exercised.

However, with developments in Andhra fresh in our minds, a cautious approach to such an enabling provision is sensible. Farmer suicides in Sri Lanka are supposed to have taken place due to the inability of indebted farmers to sell their crop, especially paddy, for a reasonable price and thereby redeem the debts taken for cultivation, land preparation and purchase of seed material, insecticides and fertiliser, etc.

It is not over borrowing per se, as seems to be the case in Andhra. In any event in the Sri Lanka situation there are many safeguards both cultural and legal which work against over borrowing.

Excessive indebtedness

Culturally, people with high indebtedness are looked down upon in Sri Lankan society. The Buddhist philosophy of minimising needs, the Christian ethic is based on the dictum of ‘neither a borrower nor lender be,’ which is the advice Polonius gives his son, in Shakespeare’s Hamlet; the Old Testament at Proverbs 22.7 says ‘The rich rule over the poor and the borrower is tenant to the lender,’ Hinduism extolling simple living and the Islamic dictum against usury – all militate against borrowing per se and especially borrowing beyond your means and excessive indebtedness.

Legally the Debt Conciliation Ordinance of 1941 provides a legal process for a debtor to go before a legally constituted panel to effect a settlement of all debts owed by him. Also in Sri Lanka today, competition among MFIs, Government lending programs, commercial banks and finance companies for our literate ( our education level being higher than the rest of South Asia’s) micro borrowers business is intense and the micro borrower has the option of shopping around looking for the best deal; it is not only interest rate which is the clincher, other ‘convenience and efficiency’ factors such as access within a reasonable time frame, and quality service, etc. are also among other determining issues.

On the present evidence, serious indebtedness is not an issue among clients of Sri Lankan MFIs and it may be premature to try to impose remedies implemented in Andhra Pradesh and Bangladesh in Sri Lanka at the present time. It would be more sensible to build up a data base of micro borrowers based on their NICs soon, to avoid over borrowing.



(The writer is a lawyer, who has over 30 years experience as a CEO in both government and private sectors. He retired from the office of Secretary, Ministry of Finance and currently is the Managing Director of the Sri Lanka Business Development Centre.)