In the later part of the year 2018-19, when the Indian economy and in particular financial firms were faced with liquidity crisis due to asset-liability mismatch(ALM), a certain related industry was showing robust growth, which was Indian MicroFinance industry. It grew by 40% in FY18 and 38% in FY19. I will discuss more about the industry in the blog “How does the Microfinance industry work?”
Of the 2 listed microfinance companies, CreditAccess Grameen has almost trebled while Spandana Sphoorthy has doubled in the last 1 year.
The concept of Microfinance was pioneered by Muhammad Yunus of Bangladesh. He wanted to make the credit available to the poor to whom the traditional banking channels refused to lend. The idea was to lend small loans to women for income generation activities. He was honored with the prestigious ‘Nobel Peace Prize’ in 2006.
Joint liability group idea was picked from NABARD.
Although Bangladesh was the place of birth of Microfiance and it started almost 50 years back over there while in India it would be 20-25 years old. But the growth & robustness of the business model in India is the best in the world. This is because of the strict guidelines specified by RBI and it's regular monitoring as well as lower interest rate in India. While Interest rate in Bangladesh for a MF loan exceeds 30%, in India it is around 18-20%.
How does the Microfinance industry work?
Micro Finance Institutions (MFIs) borrow from several financial institutions such as Banks, NBFCs, Foreign Institutions, FPIs. etc and then typically lend to rural women in groups with amounts ranging between ₹20,000-₹30,000 primarily for income generation activities.
The margins/profit is made from the difference in the interest charged and interest incurred.
Since the borrower profile of MFIs are quite different without any credit history, without much information & without any collateral, MFIs follow a very different approach of lending.
The borrowers are trained thoroughly for many days to feed the concept of microfinance in the subconscious as well as the group lending concept implying peer pressure or societal shame pushing borrowers to repay.
Loans are lent to borrowers in groups called Joint Liability groups.
- The first loan is always a very small amount. After the completion of each loan cycle, the amount is raised.
- Customers gradually move from income generation to consumption loans
- All members of a group can take different types of loans.
- Under the JLG model, at least 90% of group members need to be present during loan disbursement
- JLG groups are extensively trained to feed the concepts on their subconscious mind.
- And to bring societal shame in case they default.
- Idea is to bring moral suasion brought about by the JLG model, where an entire group suffers if a borrower defaults, makes the model relatively less risky for micro-lending.
- Higher borrowings in Q3 & Q4
How does the Microfinance industry work?
Microfinance Industry- Key Pointers
How does the Microfinance industry work?
Since the credit profile, in particular of a rural borrower is not available, once the credit of a customer is established, the idea is to give more loans to them and continue doing business with them. That reduces customer acquisition costs.
In terms of Non-performing assets, during the normal course of business GNPA(Gross Non-Performing Assets), stands between below 1% and Net NPA at 0%. Only if something out of ordinary happens, the NPAs spike up.
Most of the MFIs focus on Urban poor due to availability to better credit data. Because of which the competition is much lower in the rural areas.
Income generation loan is the highest of the total loans standing at above over 80% of total disbursal.
Loans include income generation, family welfare, home improvements, emergency loans, retail finance, 2 w loans, education loans etc. Retail loans are usually given to the customer who already has set the credit worthiness through JLG loans.
Diversified lender portfolio for the MFI is a must and the lower the cost of borrowing the better.
MFIs not only generate employment for others but for themselves as well. Of the 2 listed MFIs, CreditAccess Grameen employed 8000+ people and Spandana Spoorthy employed 6500+ people at the end of March 2019. The industry also has a high attrition rate of more than 20%.
8 of the 10 MFIs have got the Small Finance Bank(SFBs) license recently. These SFBs have access to lower cost of borrowing/funds(lesser by 1-5-2% than pure MFIs) but overall a costly structure in terms of offices, compliance, salaries etc. SFB does not have a limitation on the ticket size of the loan(For MFIs it is 1,00,000). In order to cover for the higher cost structure, if SFBs push for higher loan sizes, it might be against the set processes of small loan distribution.
But SFBs need to reduce their Micro finance loan concentration. Given that they were MFI before being converted to SFB, the focus would get diverted.
MFIs compete with SFBs and banks to lend to the poor.
How does the Microfinance industry work?
Microfinance industry: Key risks
MFIs have been growing very rapidly before they came under the scanner of Andhra Pradesh(AP) regulators after the mass suicide of farmers in 2010. Of the total deaths, the media focused on five dozen or so cases where indebtedness to a microfinance scheme. To soothe people, politicians introduced an ordinance in October 2010 which laid down strict regulations for MFIs. MFIs were asked to specify their area of operation, rate of interest and recovery practices. They were barred from collecting dues at the door of the borrower and were asked to go to local Panchayats for collections. In protest, MFIs went to the supreme court and the decision came in favor for them but that was 2 years later, till then the damage was already done.
Following the crisis, RBI came out with comprehensive guidelines to oversee all the aspects of MFIs. That will prevent AP like crisis. But like all other businesses, MFIs have their own set of challenges. They are susceptible to natural calamities like Floods, Droughts, Local political disturbances etc. Floods in Kerala also was a tough time for the MFIs.
According to whatever I havê heard & learned, the state-wise risk is now minimized and even rating agencies look at district level concentration now.
In order to reduce their risk, the ideal way they are trying is not to have more than 2-3% exposure to a single district. And minimize state-wise concentration.
Prior to the AP crisis, the lending was on the basis of relationships but post that it is more of a process-driven one. Because of which earlier there was lot of instances of misuse of force by agents to collect dues.
Microfinance industry: RBI regulation
Before the Andhra Pradesh crisis, there was no regulation governing the MFI industry. In 2011, RBI came out with comprehensive guidelines setting up strict guidelines on every aspect of operations. RBI mandated that 70% of MFI loans should be given to the income generation category to avoid debt cycle and the maximum loan limit was set to ₹50,000. In 2015, the max loan limit was increased to ₹1 lakh and loan to be given to income generation category to 50%.
Even the annual income limit is enhanced.
All these leads to bringing more people under the MFI umbrella, thus expanding the potential customer base.
To make sure that there is no excess of interest charged, RBI has mandated a maximum spread of 10% to be charged on Cost of borrowing. Cost of borrowing will be the weighted average cost of interest to be paid by MFI from the various institutions it borrow.
RBI allows MFIs to lend 15% of their total balance sheet assets to non-microfinance lending and there is no cap on the quantum. This particular segment behaves like a typical NBFC.
EMIs are calculated on a declining balance method i.e. The EMIs are calculated on reduced principal.
How does the Microfinance industry work? RECENT PAST
In the later part of the year 2018, NBFCs were struggling due to asset-liability mismatch. They used to borrow short-term and lend long-term to maximize their profits. When one borrows short-term the interest is lower as compared to borrowing long-term where the interest rate is higher. The logic behind lower interest during the shorter period of time is that things/macro-environment/business environment is not likely to change much and hence lower risk whereas for longer the uncertainty is much more.
In contrast, microfinance does the exact opposite i.e. borrow long terms and lend short term. They have the cushion or the ability to lend at much higher rates than other traditional channels.
I am sure many of us would have seen poor people going to moneylenders to borrow money to meet the needs of their lives. These moneylenders used to take advantage of the needy charging exorbitant amounts to the tune of 10% per month whereas microfinance loans’ upper limit is capped by RBI(Right now around 20-22%).
While there has been a lot of talks about the rural stress but the management of both the listed company’s have repeatedly informed that it in a way helps them grow as the need to credit grows in such periods. Also MFIs do not lend much to farmers for farming activities but for related activities such as animal husbandry. And loan waivers do not have any impact on these companies.
How does the Microfinance industry work? SOME CONCERNS
When I first read about the industry, a few questions came to my mind:
- Since most of the transactions would be happening in cash, there are chances of theft, misrepresentation of loans, etc
- Are these loans used for consumption by the poor rather than income generation activities?
- Is weekly collection mechanism too soon for the borrowers to repay?
- Is the industry growth rate of 40%+ sustainable?
My concerns were regarding cash transactions. Since employees can get greedy and or can be involved in siphoning off money. But there has been a significant shift towards cashless transactions post demonetization.
Borrowers’ bank account is linked to the microfinance account. Once the loan is approved, the amount goes to that bank account, which they can withdraw from the branch or by the debit card. But the collection of interest+principle is mostly in cash.
According to the quarterly presentation of Creditaccess Grameen, currently, 70%+ disbursements are on cashless mode and 100% cashless in the retail finance business.
While data sharing by the credit bureaus has enabled the MFIs to maintain good asset quality despite their high pace of growth, certain gaps have been observed at the industry level, which is being plugged by the RBI and the SROs(Self- Regulatory Organizations(MFIN)). But still the quality of data is not robust with single customer trying getting multiple loan from different institutions, leading to over-leveraging.
Aadhar hás have been made mandatory to avail loans from MFI. Customer credit tracking would be easier.
Based on a lot of research what I have come to the conclusion is that the understanding is that rural people don’t want to default especially women in any cases , as that would end their chances of getting another loan(Most important factor for low default rates). Since, now all the loans are Aadhar linked, even if someone defaults, he/she would be caught taking up new loans.
Also, there would be people in the group(very small percentage) that takes loan for personal consumption rather than business(via misrepresentation). If the credit of the borrower is established, it is not a major concern for the MFIs.
Gradually over time, MFIs have started to focus on district wise concentration from state wise as in the recent past the problems are more prone towards the district wise level.
Credit rating agencies rate MFIs on the basis of how diversified is the portfolio of loan disbursed, there should not be any district wise concentration of portfolio. Based on the credit rating, cost and availability of funds are decided.
According to a KPMG report, the penetration level has reached just 22% in the total addressable market by 2018, thus leaving a lot of room for further growth.
The Indian microfinance market is currently worth $19.5 billion and the prospect market stays at $274 billion. Source: CreditAccess Asia N.V. Annual report
West Bengal and Tamil Nadu contribute 34.7% of the top 10 states.
A lot of doubt was cleared with this article: Link
With larger numbers of players coming into the space, the competition is picking up which might put pressure on the yields going forward.
Indian Microfinance Industry- Key growth driver
- New kinds of loans
- Geographic expansion
- With growing awareness more and more women are getting attached to the MFI’s lending schemes
Performance of the industry depends on 2 factors:
- Demand- Robust demand from rural area. Still now credit is not available to people from lower strata
- Funding availability The current economic slowdown and NBFC crisis offer the MFI industry further headroom for larger MFIs to grow.
Microfinance Industry: Key financials
Gross AUM represents the total portfolio loans outstanding (gross i.e. without netting-off the related provisioning)
Disbursements represent the aggregate of all loan amounts extended to clients
MFIs generate revenue in the form of Interest on the loan disbursed.
NIM(Net Interest Margin) = (Net Interest Income less processing fees, interest on deposits, income from direct assignment )/ ( Income Generating assets)
NII= Net Interest Income= Interest earned – interest paid
Stage 1 portfolio (PAR 0+): Loans for which the required repayments are between 0 to 30 days past due
Stage 2 portfolio (PAR 31-90): Loans for which the required repayments are between 30 to 90 days past due
Stage 3 portfolio (PAR 90+): Loans for which the required repayments are more than 90 days past due. It becomes NPA.
Cost to income ratio: Lower the ratio the better
We need to look at the trend for multiple quarters as well as compare it with peers.
Cost= Employee benefits expenses, other expenses, and depreciation and amortization expenses
Income=Total Income plus our restated Other Income minus Finance Costs.
Cost of borrowing: It is always better not to depend on a single source of funding but rather have a diversified lenders base. Lower the better.
Marginal cost of borrowing: Fresh borrowing cost in the latest period/quarter. It may or may not be higher/lower than cost of borrowing(COB). This is because COB would be considering the average cost of borrowing which was raised earlier plus the current one.
Opex to GLP ratio: Operating Expense(Opex) to Gross Loan Portfolio(GLP) ratio.
Operating Expense represents employee benefits expenses, depreciation and amortization expenses, and other expenses
The lower the better. We need to look at the trend for multiple quarters as well as compare it with peers.
NPA: Non Performing Assets. If the repayment due is more than 90 days, the assets become non-performing.
GNPA: Gross Non Performing Assets
NNPA: Net Non Performing Assets
Provision: Increases expenses in and current liabilities. Provision is usually done to avoid sudden default shocks. It requires financial institutions to create a provision of a certain percentage of loans disbursed. Most of the MFIs create excess provision than the stipulated norms to be on the safer side.
Capital Adequacy ratio: (Tier I capital+ Tier II capital) / Risk-weighted assets. It required to be more than 15%.
TIER 1 CAPITAL: Share Capital, Retained Earnings, Non-redeemable non-cumulative preference share
TIER II CAPITAL: Undisclosed reserves Revaluation reserves, General Provision, Hybrid instruments, Subordinated term debt
The purpose of Tier I capital is to absorb losses without stopping the bank’s business and that of Tier II capital is to absorb losses while winding up of the bank.
CAR basically acts as a shock absorber in case of defaults.
The weighted risk of assets is the average of assets(loans) with the weight and the risk associated with it.
For example, a loan that is secured by a letter of credit is considered to be riskier and, thus, requires more capital than a mortgage loan that is secured with collateral.
ECL: Expected Credit Loss
Yield: Annual Average Yield on Gross AUM represents the ratio of Gross Interest Income to Annual Average Gross AUM. Higher the better. But again, customers would prefer to go to the MFI that provides a lower interest rate.
Credit Cost: Loan loss provision. CreditAccess Grameen Ltd sets it at 1.25% of AUM. In case there is sudden unwanted event happening that might dent the repayment, additional provision is created.
To summarize, the growth potential for the industry remains huge with high profit margin. NPAs are not because of the intent of the borrowers but due to the external factors such as govt actions, natural calamities etc. Most of the loans are for income generation activities.
Since the decision to chose the lender is totally on the basis of who provides the lowest interest rate, the risk remains of that of loan yield shrinkage due to increase in competitive intensity.
The falling interest rate scenario bodes well for the industry as lower interest rate will pull more customers towards MFIs.
What I understood after doing all the research is that it a highly process driven industry and if you deviate from the set processes and policies, it can create a lot of trouble in adverse times.