Hard for MFIs to go it alone
MFIs can operate as subsidiaries of banks, using a bank’s access to low-cost funds to lend cheap to the poor.
In 1995, Bank of Madura had 95 rural branches that were generally unprofitable. Deposits in these branches were too low and defaults on loans too high to justify the cost of servicing these communities. Besides, the bank’s staff disliked rural postings and it was difficult to attract talent into these areas.
The then Chairman & CEO, Dr K. M. Thiagarajan, in his bid to develop a profitable model of rural lending, pioneered the model of Self Help Group (SHG) lending, that was a hybrid between the Grameen Joint Liability model and mainstream banking.
Lending was done to a group of 15-20 women, who were co-guarantors for one another. They would meet locally to pool their dues once a month, and two of the members would take the money in rotation and remit it at the branch.
The group lending model worked well from the point of view of asset quality. However, when trying to scale up this model, the bank ran into two significant problems.
First, it was necessary to have field staff to facilitate these group meetings in the field and it did not make economic sense to employ regular bank staff for this purpose. Second, since the products and customers were different, the branches had to look, feel and operate differently from the rest of the bank.
Bank of Madura’s solution was to create a separate Rural Banking Division, which operated quite independently from the rest of the bank.
Employees were recruited from the rural areas and, in particular, the field staff were recruited largely from the SHGs themselves — women who had successfully borrowed and repaid a loan.
In this manner, Bank of Madura created a highly cost-efficient operation that allowed it to lend profitably in the rural areas at 12 per cent. This is less than half the rates that MFIs lend at today — even after the RBI imposed the interest rate cap of 26 per cent.
If a bank can carry out microfinance lending at lower rates, why cannot microfinance institutions (MFIs) become banks?
Today, MFIs typically follow an onward lending model, where funds raised through bank debt are parcelled into ‘micro’ loans. The consequence is that unlike a bank, which has a cost of funds of approximately 6-8 per cent raised largely through deposits, the cost of funds here — the interest charged on loans by banks — is 12-15 per cent. That results in a much higher lending rate to the poor.
While banks may be well-placed to create effective microfinance lending arms, MFIs are not well-positioned to become banks. Here’s why. The benefit of being a bank is really the ability to take deposits, which lowers the cost of funds and would thereby allow lending at lower rates to the poor. But the poor — the MFIs’ existing customer base — are an abysmal source of deposits.
Poor people use their income as it comes, for day-to-day expenses and to repay their debts. So they don’t have much money to keep in a bank account (if they have one).
By my estimates, taking deposits from the communities served by an MFI would hardly amount to 15 per cent of the total amount that is given out as loans. Moreover, the cost of servicing these bank accounts is very high. So, a self-contained bank for the poor is not an efficient solution.
SUBSIDIARIES OF BANKS
For banks, the lowest-cost funds come from the current accounts and savings accounts of high net-worth individuals (HNIs) and large businesses and today account for approximately 50 per cent of deposits.
So, to benefit from becoming a bank, MFIs would have to go about building their deposits from an entirely different group of customers.
And why would a big business or a HNI open a bank account in a ‘bank’ that deploys its assets largely as unsecured microfinance loans? What can the MFI offer HNIs and businesses that a more established, diversified bank cannot?
From the point of view of the MFI that has newly become a bank, this will pose a dilemma. To compete with other banks, should the efforts be directed towards lending to other types of customers, taking the focus away from microfinance? This requires a whole different organisation structure.
The story of the erstwhile Bank of Madura, however, is clear evidence that there can be a happy marriage between mainstream banking and microfinance that benefits all involved — the Bank, the microfinance operation and the poor borrower.
Strategically, the best relationship is for MFIs to operate as subsidiaries of banks, retaining their own cost-efficient operational models and ‘priority sector’ customer focus, but with the benefits of low-cost funds flow of the parent bank that can be passed on to the poor at lower rates.
If it is a good microfinance operation, it will not just add to the bank’s bottomline, but also provide a pipeline of customers with established credit history into mainstream banking.
Originally published in The Hindu Business Line