MICRO FINANCE INSTITUTION REGULATION:
CASE FOR HYBRID DNA INSTITUTIONS
This paper is positioned to discuss a ‘right-fit’ institutional arrangement for the microfinance sector in India. The discussion focuses on the underlying concepts and the importance of Hybrid-DNA microfinance institutions. It also examines the significance of the people-centric and calibrated response of NABARD, in creating such an institution. This paper does not analyze the merits or otherwise of the Microfinance Regulation and Development Bill. The more erudite in the realm of financial sector regulation will certainly ensure that a robust regulation will eventually replace the present vacuum. State may also come up with stringent enforcement and legislations to rope in rogue elements in the sector. The paper proposes to highlight that robust regulation, supporting legislations and stringent enforcement will not be the end of major threats to the sector. Several challenges that remain are a product of a non-sync between some of the more technical aspects of regulation and the demand side conditions in terms of the level of satisfaction possible from the regulated entities.
Need for Regulation
Typically, the regulatory framework for the microfinance sector or for that matter any financial sector is designed primarily taking the following interests of the larger financial sector into consideration.
The usual ingredients of robust regulation are:
The institutional ingredients required to meet the rigors of robust regulation are:
1 C.P.Mohan is Managing Director, NABARD Finnacial Services Limited. The views expressed are his own.
Demand Side Analysis
It is of greater imperative that the demand side dynamics and situation is well understood at the design stage of the regulatory pillars. In the case of microfinance, the predominant client protection requirement is of the borrowers and not savers as is usual in banking sector.
The target client base of the MF sector is largely poor, defined broadly rather than minimally. It may include a variety of poor - located in remote geographies, suffering from deficits such as limited market access or information asymmetry. Apart from these there are several characteristics of the potential clients which need to be taken into account such as:
Supply Side Response
The characteristics of the demand side as explained above sets the foundation for the supply side response. The evolution of the present day microfinance sector have its genesis in responding to the above demand side diagnostics resulting in two highly differentiated approaches within the sector: one taking lower risk based on Self Help Group (SHG) model and other involving institutions have high risk appetite with flexible approach and simple procedures.
The more entrenched and sustainable is the Self Help Group led movement which holistically looked at the demand side perspectives and sought to influence policy, products, processes, procedures and institutional response from such a holistic assessment. The movement involved a variety of stakeholders and galvanised the policy makers, the third sector, the delivery institutions and development agencies into responsive paradigm thereby encouraging the development of the largest microfinance movement in the world. It also facilitated the inclusion of massive numbers of the demand segment described above into formal, well regulated financial service providers constituting of banks in general.
The demand situation also provided enough space for the entry and growth of a class of institutions with high risk appetite willing to resort to coercion and even outright harassment in case of defaults. These institutions systematically innovated to leverage the concept of collateral substitute established though the SHG movement, enforce repayments and attract clients. The modern day Microfinance Institutions (MFIs) took advantage of the inherent rigidities of the formal financial sector and flourished in an environment nearly free of regulation. They capitalized on the high credit demand. Recognizing the inelastic nature of the demand, they took calculated risk to scale up at exponential rates often eating into each others client base. The clients, too, took advantage of the easy credit availability from competing sources, often arbitraging between the sources.
Most MFI’s identify door step delivery, timely delivery, small ticket products, extremely simplified processes, flexi-timing, etc., as their selling propositions. While on the one hand, the designs of the delivery mechanism responding to the above result is high transaction costs, the clients are fairly insensitive to the cost of credit as they do not have many options to choose from. The main alternative is the local money lenders who are even more usurious and provide lower quantum of credit. The potential for growth is high. Pricing freedom that allows easy cost recovery combined with high margins and large volumes drive up the profits.
Thus, the supply side response is primarily the result of a demand side pull. Regulation become exceptionally difficult in such cases as is amply evident from the prevalence and unbridled activities of the money lenders. The findings of the All India Debt and Investment Survey (AIDIS) 2002 which concluded that the share of informal sources increased when compared to 1991 bears this out.
The brief analysis of both the demand end and supply side responses sets the context for the regulatory mechanism that is needed for the microfinance sector. The argument, therefore, is that there are several aspects relating to the clients, delivery arrangements and products which need to be focused upon to get the ‘Right Fit’ institutional and regulatory framework into place. The main components to be considered are the context, characteristics and needs of the client, a holistic definition of microfinance, institutions and delivery mechanisms. The overall regulatory framework also includes ensuring compliance, providing proper oversight and avenues for disputes redressal.
The Context Characteristics and Needs
The necessity to invest significantly to increase the capabilities of the clients cannot be gainsaid in the context of the high degree of illiteracy, poverty, and several other difficult circumstances suffered by the potential clients of microfinance. There is also a growing community which has ever increasing aspirational demands. Empowerment typically leads to increase in consumption when large numbers of rural women, poor etc., are emboldened to increase domestic consumption for education, health, better food. There is also an increase in spend on cable TV, mobile phones, entertainment and non-essential travel. There is also increased spending on account of higher quality of life. Higher empowerment leads to greater aspirations. The greater empowerment needs to be matched by public policy response to raise purchasing power.
The SHG movement stands out prominently in this context. It empowers the masses, public policy response made it possible to mobilise resources both encouraging savings and leveraging credit. It helped to reduce costs and created much needed space for unheard voices to be heard. It helped to increase bargaining power and neither last nor least, produced a large number of village and panchayat level leadership, prominently from among poor women. On the whole, underprivileged sections are in a transformational phase demanding more of financial and other services.
A holistic definition of microfinance.
The bulk of the micro finance clients are marginal or small producers/ service providers with weak market access and lacking economies of scale. The need for creating aggregation effect, organizing value chains and interlinking communities with welfare services need to be factored. The approach to better the lot of he potential clients cannot be limited to mere delivery of credit. In fact, if seen as an acronym, MICRO, expanded as Management of Individual Capacities, Resources and Outputs will give a better understanding of a holistic definition of Microfinance. The institutional arrangements of microfinance need to look beyond the delivery of merely financial services; it must aim to bring convergence of a large number of players who enable the poor and build their capacities at different levels. This brings into sharp focus the relevance of Hybrid-DNA institutions which are necessary to bring in such convergence.
Institutions and Arrangements to Deliver Microfinance.
The service DNA can be defined as the value system with a degree of altruism. It looks at poverty and disadvantages as unacceptable and engages in activities that may directly or indirectly alleviate poverty, improve livelihoods, reduce the risks at the demand side and help in bringing socio economic sustainability. The service oriented microfinance organisations identified exclusion of the poor from financial capital as an important reason for their poverty and involved in providing low interest credit to encourage entrepreneurship and development. It has to be recognised that the poor has to be supported substantially through programmatic approaches and otherwise for capacity building before they can graduate to the effective use of such capital. The service oriented microfinance institutions shall have the business model enabling them to provide credit and financial services at low cost seen from a broader perspective than mere low interest rate. It shall also have to work in tandem with entities that engage in various programmatic initiatives of Government, civil society, donors and development agencies that seek to reduce multiple deficits of the poor and the disadvantaged. These characteristics can be termed as the service DNA institutional framework.
At the same time, large scale commercialisation, profit maximization and targets for exponential growth can be termed as the enterprise philosophy of a commercial financial institution. The commercial entrepreneurial institutions tends to focus on funding sources like commercial lenders, capital markets, venture capital etc to enable the exponential growth. High degree of competition is seen among these institutions as several of them operate in the same market formed of vulnerable clients. It has been seen that commercialisation focused on the goal of earning profits. These characteristics are deemed as the Enterprise DNA institutions in the context of this paper.
The hybrid DNA institutions are those which imbibe a balanced value system that includes both the service DNA and the enterprise DNA as explained above. This theme is discussed in the following paragraphs.
The service DNA is an essential ingredient for a microfinance institution. If this be the case, governance, products, processes and client base of that institution must reflect this. Once this percept is accepted, then all pillars of regulation will have to subsume the need for appropriate institutional compliance for this. History shows that the evolution of the Hybrid-DNA institutions is rare. Historical data confirms that hybrid DNA institutions started by entrepreneurs quickly transformed into Enterprise DNA institutions motivated by supernormal profits, unfair practices and poor governance.
How, then, can hybrids be created and sustained? It is important to look at diagnostic studies to understand why the mission-drift takes place. A blue print to create such institutions must be based on an understanding of this. Much work has already been done in area of diagnostics and some of the well documented reasons are:
While the above are reasons for MFIs to spawn, grow and exploit an easily accessible market with a high cost credit product, several reasons exist for the segments of the population to a very large access such financial products as already explained. From supply side constraints and demand side requirements as well as perceptions, there is a clear opportunity for sporadic growth of lending institutions that can service a large segment of the population.
The evolution of the concept of Non Governmental Organisations (NGO’s) is an example of how hybrid DNA institutions which combines the Enterprise DNA with the service DNA. The acceptance of Social Entrepreneurship is another indication of the recognition of the need for the hybrid DNA institutions. It is relevant to point out that most of the profit maximizing microfinance institutions also recognised the inherent need to converge service DNA with enterprise DNA as is evident from their mission and vision statements. However, over time, these microfinance institutions came to be constantly commented upon for Mission Drift. This contention is based on the reality that several players who got into high growth trajectory easily mutated into Enterprise DNA.
Hybrid DNA Institutions
Indian banking sector is perhaps the most shining example of engineering the Service DNA into financial institutions through mandates. Well structured oversight mechanism (LBS) and multilayered monitoring includes all stakeholders. We can vividly see several vertical structures involved in the monitoring.
The mission for doubling of agricultural credit, the policy for rural branch network, subsidized rates for farm sector loans etc., are examples of convergence of regulatory mandates, effective monitoring and the manifest will of the State. Presently the financial inclusion targets have been brought under the ambit of the multi layer monitoring structure. Through mandated target and well structured monitoring, the Indian banking system has been able to establish the hybrid DNA institutional genotype as distinct from Enterprise DNA seen elsewhere in the world.
The banking sector experience demonstrates that it is, indeed, possible to engineer the service DNA into robust financial institutions. Microfinance institutions must have Enterprise DNA to respond the demand side pulls while conforming to regulatory mandates that ensures tight integration of Service DNA. Going by the analogy of the banking sector, such institutions are probably better created with the help of large financial sector players. Similar role can be played by NABARD to enhance the spirit of Service DNA while providing capital resources and transferring Hybrid DNA into subsidiaries.
The hybrid DNA institution shall serve the overall regulatory concerns by ensuring sufficient compliance to all the statutory requirements. It shall ensure that there is no arbitrage threatening the financial system, provide good governance, and also support several mother initiatives that are required to effectively support the poor and the disadvantaged. The benefits deriving from such institutions are discussed below.
Systemic Importance of MFI’s
Systemic relevance of financial institutions can be broadly bifurcated into the impact on the Financial System / Macro economy and the impact on the clients. All MFI’s existing in the country are not big enough to impact the financial system / macro economy by its total top line size. Individually they form only a very small percentage of the total financial market. However, the total number of clients of these MFI’s is purportedly large, as well as vulnerable.
Another key parameter for assessing systemic importance is the concern for the safety of public deposits. This primacy of regulatory concern is globally well accepted. In the case of MFI’s, most of the savings are in the nature of compulsory savings linked for lending and not voluntary savings collected from general public. Typically, the loan in the clients hand is more than her savings in the MFI’s hand.
Yet another parameter is protection of borrower client from usurious rates and unfair practices. Traditionally it will be seen that these two infringements are sought to be controlled thorough state level legislations and the laws relating to crimes.
It will be seen that institutions that are linked to already well regulated entities shall tend to remain within the acceptable limits of regulations and will tend to be low on regulatory arbitrage.
Governance and Regulation
A new governance paradigm was started in the 1980’s. It was actively promoted by agencies like World Bank, UNDP, DFID and USAID. The World Bank identified four major areas of concern to be addressed in achieving good governance. They are:
The underlying ethos of good governance which evolved is steeped in features like legitimate exercise of power and the adoption of transparency, equity participation and accountability. Multiple institutions or agencies such as the state, market and civil society play important roles in this, making it necessary to have significant levels of convergence and harmonious relationship among them. In other words multiple tiers of the state, civil society and private agencies have to work in concert. The overall governance strategy has to embed in itself the characteristics of predictability, stability and efficiency.
In India, the new governance paradigm was applied to the financial sector. The realization that the financial sector plays a key role in achieving socio-economic development, helps to complement the economic reforms, and at the same time suffered from instability and in efficiency led the adoption of the new governance paradigms. This was broadly characterized by:
The design of the regulatory mechanisms must keep in mind the evolution of the good governance paradigm within the sector. Therefore, the development of delivery institutions needs to integrate the historical factors. Much success has already been achieved in the last two decades in implementing essence of good governance paradigm among the players in the Indian Financial System. The argument is to leverage these achievements into serving the most needy of our people by promoting Hybrid DNA Microfinance Institutions with the participation of the major players in the financial system that shall automatically carry good governance in their system.
Fragmented approach to micro credit
There is highly fragmented approach to deliver credit to the clients of the MF Sector. On the one hand the Micro Finance institutions provide credit at very high rates of interest, with minimum hassles to the vulnerable sections. On the other hand several State Governments offer highly subsidized credit at as low as 4% in certain cases to this segment. This poses systematic risks.
Another major collateral damage of the product and delivery innovations is that these institutions found a ready market for their products by breaking up SHGs into smaller mutual guarantee groups. Thus wittingly or unwittingly they cut at the very roots of the SHG structure. The classical SHG also flourished with the support provided by the Reserve Bank of India that favored the affinity group approach, which helped in the convergence of empowerment processes and access to financial services. During last two decades, the movement brought much needed aggregation effect. With proactive policy initiatives, a well regulated banking sector reposed great confidence in the SHG’s and helped in the inclusion of women as both depositors and borrowers.
A systematic approach to co-create microfinance institutions within the overall management and equity control of well regulated entities shall go a long way in improving and augmenting the availability of financial services to the needy. The flexibility of an MFI coupled with the benefits of subsidiarisation of a well regulated entity serve the demand end requirements through appropriate innovations, products, processes and service levels on the one hand and subject itself to continuous managerial oversight by the holding entity, thus mitigating regulatory concerns. It can also bring convergence in even State assistance by way of subventions as in the case of the interest subvention for agriculture administered by central government, if found necessary.
Other Financial Services
There is little attention paid to meeting the demands of the other financial services of the client constituency. In the absence of institutionalized and well regulated arrangements, these services shall play to high degree of arbitrage and exploitation as we saw in the case of micro-credit. We have to recognize that growing aspirations and new opportunities have pushed up the demand for a variety of financial services.
The development of large numbers of microfinance institutions under a co-creation framework involving the well regulated entities like banks and the State shall give raise to possibilities for strategic alliances between such MFIs, banks, insurance companies etc. Such institutions shall also have both the goodwill, competency and above all the managerial will to bring convergence of various development projects and services to the benefit of their clients. The hybrid DNA subsidiaries shall also operate as a synergic continuum of the inclusive policy.
Market Development Efforts:
The overall situation in the micro-credit market today continues to be ripe for unscrupulous elements to reap super normal profits. It is, therefore imperative to invest in market development of the microfinance sector. The initiative shall comprise of building appropriate institutions, developing products, simplifying processes and procedures of formal institutions, client centric delivery models, awareness creation among the people, increasing capacities of people to enable economic inclusion, developing and enabling critical accesses to rural population in general and the poor in particular such as information access, physical access, market access and access to services etc., establishment of information bureau on microfinance clients. Such initiatives can be better rolled out through holding entities with deep pockets, commitment to national goals and are well integrated within public policy implementation. This will ensure that these institutions grow with hybrid DNA.
Compliance with Prudential norms
At certain levels, the capital adequacy and prudential norms put considerable pressures on institutions to push for high levels of profitability. This phenomenon is evident in the case of rural banking in India as a whole wherein the typical institutional response has been gradual increase in average ticket size and reduction in transaction costs. The first decade of financial sector reforms probably can be defined as one dominated by these negative trends. The AIDIS 2001 confirmed the increasing dependency on informal credit. Interestingly, the second decade of reforms saw many largely successful proactive State policies and regulatory action to contain these tendencies. Constant and effective structured monitoring played a vital role in their success. The monitoring and compliance by the financial institutions was possible since they were well regulated entities subject to sufficient oversight including government level reviews. The hybrid DNA institutions have greater access to both equity and debt through appropriate arrangements. Such arrangements favor effective monitoring and compliance as compared to Enterprise-DNA institutions.
Hybrid DNA MFI’s: Two Examples
The objectives were not confined to financial intermediation. Over time Sanghamithra proved over time that the poor are bankable, helped to create confidence among banks that credit to SHGs is recoverable, and that there is space for an intermediary organization that would pay for itself. It also ran into several roadblocks when it tried to respond to client needs. For example when it sought regulatory and legal clearance to provide larger loans to needy individuals, the request was rejected with the explanation that it will constitute commercial activities as that of an Non Banking Finance Company) NBFC. The overall impact and success of Sanghamithra is a matter for more detailed study and analysis. The experience is invoked here to focus on the relevance of a more interventionist model of financial intermediation while dealing with the poor and deprived; the poverty and deprivation here are seen from far wider sense than minimalistic definitions of absolute poverty or deprivation bordering on destituteness (Sriram, MS: Building Bridges between the Poor and the Banking System).
The first three benchmark principles focus on the company’s governance, ethics and culture which are critical to keep the organization on track. With remarkable foresight, the NABARD Board sought to warn NABFINS against practices that we now know were mainly responsible for the crisis in the micro finance sector. NABFINS has endeavored to respect these benchmark principles and to design its organizational structure and supporting systems to promote them. The Board of NABARD also realized that for NABFINS to achieve its objective to support sustainable livelihood strategies of the poor and marginalized and to promote peoples institutions both at the base and at the second level (which can aggregate, add value to participants) provision of credit is critical but not enough. It therefore stated that the NABFINS business model requires “substantial amount of strategic alliances”; therefore it must “build synergies with other institutions involved in development in the area of operation”. This strategic direction, based on the understanding that credit alone would not suffice to include the target group into the growth process requires an organizational culture which promotes healthy partnerships rather than either cut-throat competition or cartelization. Partnership is defined as “sharing risks”. NABFINS decided that its client risks also should be shared as part of its core operational strategy.
NABFINS will try to balance Business with Inclusion of the marginalized in the growth process, not just in the financial system. It follows that its business model would have to ensure that it adheres to all the requirements of a business – mainly to break even as soon as possible and that it customizes its loan products and mobilizes support services, in a partnership mode, to meet the diverse needs of its clients and to remove the hurdles to their inclusion. Given the diversity of loan purposes and sizes required and the need to respond quickly to unexpected changes, the decision how to customize must be made by peoples institutions at the base which are able to assess each loan, provide support to members to cope with pressure from a male dominated society to divert the money for their purposes, exert pressure to repay and adjust the repayment schedule if required. These functions promote inclusive development. This is why NABFINS partners peoples’ institutions at the base like SHGs and JLGs as well as at the second level like companies and cooperatives in which people have an ownership stake and set the agenda.
Learning from the impact of the micro finance sector in general, that inclusion of the marginalized in the growth process involves considerable risks to the them, NABFINS decided to i) incorporate and address the risks of its clients in its business model and ii) work with partners to provide all round support to the client in its business model.
Reducing the risks of clients will be a structural part of its core strategy and not an add on through corporate social responsibility. This requires that the core of its business model does not adopt any strategies, systems and practices which increase the risk of the client in order to reduce the risk to NABFINS and maximize profits. Examples of these features which increase the risk of the clients which emerged from NABFINS analysis of the micro finance scenario are the following: Standardisation, a multiple lending growth model, exclusive focus on maximization of profits, high remunerations and incentives related to outstanding and recoveries.
NABFINS selects BCs as partners who are involved in reducing the risk arising from the nature of investments and creating value for its clients. For example, it partners BCs involved in watershed management (which reduces the risk of investment in dryland agriculture), those promoting productivity increase, agricultural diversification, health care for the client as well as for livestock/poultry, off farm technical and marketable livelihood skills and insurance. Resources for these programs will be raised by the partner as well as by NABFINS. The risk to NABFINS and the clients is higher in second level institutions like Companies and Cooperatives which aggregate, add value and market. Hence it propose to cover part of this risk through support from financial institutions. To lower risk for all partners and clients, NABFINS invests in improving the quality of the institutions it partners.
To summarise - NABFINS’ business plan which is taking shape endeavors to cover all costs of maintenance and growth without raking in excessive profits. It will invest in under banked areas even if it means higher transaction costs. It will provide competition to reduce the interest rates of moneylenders and financial institutions, which are not affordable by the poor. To reduce the clients’ risk, it will respect the diversity of several livelihood activities, which comprise a poor family’s livelihood strategy and not reduce this strategy to a single large so-called viable activity (which the family finds it cannot manage) or to a standardized product to fit into pre-designed software. It will endeavor to develop low cost delivery systems and organizational structure. (Fernandez, AP, 2011)
The two examples above are poignant. In the first, MYRADA, a well established, highly reputed Development NGO took to the “subsidiarisation” route to create an interventionist and developmental Financial Intermediary at a time of need. NABARD, the largest Development Bank in the country and the catalyst for nurturing the largest microfinance movement in the world, sought to do the same at a time of crisis in the microfinance sector by establishing a value based commercial subsidiary that will not only deliver financial services, particularly to agricultural and microfinance sectors, but also set standards in governance, ensure regulatory compliance, and adhere to transparent and fair practices. The equity of NABFINS is contributed by NABARD who is the majority share holder, the Government of Karnataka, and financial institutions such as Union Bank, Canara Bank, Federal Bank and Dhanalakshmi Bank reflecting a shareholding pattern for the proposed model.
Sanghamithra was able to break even and make fair amount of profit in its first three years of existence. It demonstrated that with appropriate procedures it was able to slash transaction costs and deal with the poor. Sanghamithra had a repayment rate of 98.9% and PAR at 60 days was 6.1% (2003). Sanghamithra achieved thereby proper customer identification keeping the procedures simple and also keeping both products and repayments simple. However, being a not for profit company under section 25, it has limited access to equity and thus have serious restrictions on the amount of money it can borrow for onlending.
NABFINS was able to scale up its operations both geographically and financially in a short period of two years since it started its operations in November 2009. It is able to reach a portfolio size of Rs.100 Crore with a small staff compliment of the 70. The model adopted by NABFINS involved the engagement of Community entrenched NGOs as Business Correspondents. This methodology enables to reduce transaction costs and ensure door step delivery of services thus reducing costs to clients. NABFINS too has simple processes, and client friendly repayment schedules etc. The organic link of NABFINS with NABARD enables it to bring convergence with provision of credit and several grant assisted developments of NABARD.
Both are Hybrid DNA Institutions. Both need to succeed. At the same time the NABFINS model is replicable through the subsidiarisation route by public sector banks, development financial institutions, and RRBs. Such institutions shall have access to both debt and equity funds by the very status of being a subsidiary of entities mandated to serve the defined client group of the microfinance sector. Over time, it can build strategic alliances with both the holding entity as well other major players to bring a bundle of financial services and other developmental services to the community. The Sanghamithra model may need highly motivated leadership backed by a developmental interventionist NGO or a strong corporate CSR initiative to replicate.
The Hybrid-DNA financial intermediaries with greater interventionist and developmental role is a relevant and workable alternative in the context of the evolving microfinance sector. They are better equipped to understand and respond to demand end realities. These institutions have a greater understanding about major characteristics of the potential microfinance universe such as the need to continue efforts for socio economic inclusion, the non-scalar, marginal nature of production of goods and services, the need for organizing the client segment into producers/services providers for aggregation and integrating them into a tubular supply chain etc. It recognizes the urgent attention necessary for multi agency convergence for strengthening institutional arrangements to perpetuate the Service-DNA and commitment to poverty alleviation. The proposed institutions shall also ensure effective regulatory environment in all crucial areas. In-house access to managerial talent, continuous oversight by the holding entity, easier supervision as a related entity of well regulated entities also finds argument in favour of such institutions.