Catalyst for progress
Microfinance is about small loans to those with low income in the informal economy. These three factors pose three unique challenges. The small loan size means a different kind of economics and business model from mainstream banking with distinct processes and cost-efficiencies, since the income per loan is particularly low. That the borrowers have low income means the risks are large; small shocks in the family or larger system can have devastating impact on a borrower’s means to repay. And finally, lending to the informal economy presents a different set of challenges in that there is no documentation to verify assets, occupation, income or anything about the person.
The microfinance industry is still grappling with these challenges, learning many of the lessons the hard way. With lending rates now limited to 26 percent under the new regulation, gone are the days of high interest rates of 40 percent to compensate for defaults and the lack of cost-efficiencies. Under these tighter circumstances, many have floundered while others have looked to technology and process improvements to find a profitable way forward. The industry’s health, going forward, will depend largely on technologies that enable efficiencies in the field of loan initiation, tracking and collections.
But that is not sufficient to compensate for the risks of low income. When borrowers have low incomes that are inadequate to satisfy their needs, and supply of debt is easy, there is a natural inclination to borrow beyond capacity. It was this that was at the core of the crisis that unravelled the industry in the last year. When supply contracted, the opportunity to borrow from one lender to pay another disappeared, setting in motion a wave of defaults. Commendably, the industry has rushed to remedy this with the establishment of credit bureaus. Coupled with regulation that does not permit an MFI to lend to a borrower with loans from more than two other institutions or totalling Rs. 50,000, there is now a mechanism to prevent overborrowing. MFIs are now working to ensure data compliance in uploading borrower data to the credit bureaus and integrating credit bureau verification into the loan process.
Challenges of an informal economy
Over the next year, with technology driven cost-efficiencies and better mechanisms to verify creditworthiness in place, the industry will soon settle in with strong, responsible lending practices and solid growth potential. In this new paradigm of microfinance, it is a different set of companies that will now lead the way.
However, while these remedies solve the commercial problems of the industry, they do not address the promise of microfinance as a catalyst for economic progress. In India’s banking sector, only 19 percent of all loans are for consumer lending. Contrast this with the Malegam committee study that showed that 75 percent of microfinance is consumer loans.
This is the challenge of operating in the informal economy where there is neither legal business entity nor any documentation to establish productive activity by the borrower. How then can one ensure that borrowed capital is productively deployed for economic gain and not simply consumed? This has to be tackled cleverly and will require building intelligence about individual behavior in the context of low income ecosystems. This is the big data problem of microfinance and acquiring the right data is the first challenge.