Current Microfinance Crisis & major fault lines

The microfinance business has been susceptible to systemic risk, whether due to the A.P. crisis, demonetization, or the COVID-19 lockdown. However, the current microfinance crisis is unique. It is not triggered by any external factor but by various internal issues within the sector and the natural course of its evolution.

Here’s a detailed breakdown of the core problems:

1.RBI Deregulation and Easing of Lending Practices: The RBI's expectation to deregulate multiple lenders and interest rate margins in the microfinance business and to make it based on underwriting with income assessment (FOIR <50%) relied on market economy principles.

The RBI presumed that lenders with better processes, efficiency, and lower interest rates would achieve better outreach and market share, allowing clients to choose the best options. However, this did not happen. Instead, deregulation led to higher interest rates, a higher number of lenders, and overborrowing by clients.

2. Inadequate Income Assessment and BRE (Business Rule Engine) Based Loan Disbursement: Microfinance lending used to rely on JLG-based underwriting. Although MFIs conducted household verification and other due diligence processes, JLG members were effectively the underwriters of the loan. If the JLG group members approved the loan, the lender would disburse it. However, things have changed.

Most larger players now use rule-based digital front-end systems for client onboarding, which are also used for income assessment. This process has become highly subjective, often relying on individual evaluations and serving to showcase compliance with RBI regulations.

Also, API-based bureau integrations, particularly when dealing with Know Your Customer (KYC) processes, can encounter issues if KYC documents are tampered with or otherwise compromised. This can lead to serious problems such as approving loans for clients who has defaulted and overborrowing.

Additionally, the lack of seriousness toward Loan Utilization Checks (LUC) and proper recourse has led to loans being used for consumption rather than generating incremental monthly income.

Many smaller MFIs even ignore basic bureau-based parameters.

In sum, Lending sprees, business pressures, and higher incentives have led to imprudent disbursements.

3. Societal Evolution and the Ineffectiveness of JLGs: Society is evolving; we are becoming more individualistic, and families are shifting from joint to nuclear structures. The way we behave and connect with society is changing. Today, even siblings within a family may be unwilling to guarantee each other. The JLG model has also evolved.

Previously, MFIs would not disburse loans to a JLG if any of the clients had defaulted. With the increase in lenders, if some MFIs stopped disbursing to defaulting JLGs, other lenders would step in. Today, loans are given to JLGs with defaulting members, disrupting the JLG system. Another reason for the weakening of the JLG model is the higher ticket size. As the amount increases, so does the contribution required from individual members. In cases of default, members have stopped contributing.

At the same time, JLG model of microfinance, while designed to encourage collective responsibility and support, can indeed have unintended negative consequences. One key issue is that when a member defaults, it can impact the entire group, including those who have been consistently responsible with their repayments.

Microfinance has served the bottom of the pyramid, a relatively more vulnerable strata of society. However, there is no provision for treating defaults caused by genuine, unavoidable reasons such as illness, accidents, business failures, or natural calamities. Assessing these reasons at an institutional level is challenging, and generalized treatments may further deteriorate credit culture. Smaller family issues may be escalated and amplified as excuses for non-repayment, leading to a lack of provisions within the MFI system to handle such cases.

As a result, JLGs are either non-existent or very weak.

4.Higher Interest Margins for Lending Institutions: RBI deregulation allowed MFIs and banks to set their own interest rates.

However, regarding the financial literacy of microfinance clients and interest rate calculations, they remain largely insensitive due to various reasons.

Higher net interest margins (NIM) for banks and MFIs have led to complacency regarding credit costs and discipline. The microfinance business has become a numbers game. Institutions have set aside higher provisioning with higher interest rates to maintain margins, rather than focusing on building underwriting processes, credit discipline, and systems to reduce long-term credit costs.

Also, Higher margins have led to a proliferation of MFIs and the entry of small rogue players, further deteriorating the situation.

Additionally, higher interest rates have also led to indifference toward high operating and collection costs, which has subdued efforts toward efficient cash/cashless collection and operational efficiency. As a result, the operating model has remained largely unchanged even after years on the ground.

5. Microfinance Business Model: The evolution of microfinance has leveraged social capital and community leadership. The role of SHG/JLG center leaders was crucial for discipline and collection. Over time, however, center leaders and their spouses have become problematic, with growing influence over JLG members. Center leaders are now becoming "Bhasmasurs," who are keen to destroy the very creators. In various cases, they have become commission agents and ringleaders.

The connivance between loan officers and center leaders for collection and client addition has further complicated the situation.

Also, Poor JLGs have led to door-to-door collections, and with poor contactable ratio of clients both physically and telephonically, the entire system has become highly dependent on loan officers, resulting in poor control and monitoring and, ultimately, fraud and cash embezzlement.

6.Unavailability of Suitable Products for Graduating Microfinance Clients: Despite achieving better yields, higher per-unit branch and staff productivity, and faster growth through the JLG business model, microfinance institutions (MFIs) have not evolved to offer new individual loan products for their clients.

Many microfinance clients have benefited from loans through the JLG system. However, as they progress economically and their credit needs increase, most MFIs do not provide products that address these new requirements. Furthermore, other non-microfinance institutions have also not stepped in to meet these needs.

This situation has created a double whammy: despite the increased loan amounts, clients face higher interest rates and larger EMIs, which impose a greater financial burden relative to their incremental income. This gap has also led some clients to borrow money from other JLG members or pseudo members, further complicating their financial situation.

7. Poor Staff Quality After COVID-19 Mass Attrition: Microfinance has been a human-interface-driven business model. The role of the loan officer (field-level staff) has been indispensable for maintaining collection and credit discipline. Most MFIs have experienced mass attrition of staff during COVID-19. Although institutions could hire field-level staff afterward, they could not train them effectively as before. This has created a gap where new staff lack the experience and mentorship of the old, experienced staff.

As a result, the quality of staff has deteriorated, affecting their ability to manage JLGs and community situations effectively and leading to defaults and increased fraud and commission issues.

8. High Attrition Due to Poor Work Culture: A typical day for microfinance staff starts early in the morning aligned with rural economies and client availability for group collection meetings. Pressure on collections has made middle-level management insensitive to staff's organizational connection and work-life balance, forcing staff to work beyond regular hours and on holidays.

It is evident that MFIs with a good working culture and strong employee connections perform better.

Microfinance has not evolved its work culture over time, and high payouts and incentives alone are not sufficient.

9.Management’s Understanding and Empathy: Many MFIs are led by individuals at various levels who may not have first-hand experience or empathy toward the microfinance business. Sometimes, decisions are driven by numbers without considering the susceptibility of clients and field staff.

For instance, a banker’s mindset may focus more on systems, compliance, and documentation, while a sales-focused attitude might apply review calls, collection rigors, sales campaigns, and strong pressure sometimes disregarding the field challenges.

Microfinance is a unique business that requires field-oriented leadership with empathy toward the team.

10.Bigger is Not Always Better: Many large MFIs have developed bureaucratic systems with a focus on numbers and centralized decision-making, leading to reduced ownership and control within support functions and core business teams.

Also, the larger geographical distribution of big players often results in senior management ignoring issues limited to specific districts, states, or localities, especially if the impact on the overall portfolio is minimal. This ignorance leads to portfolio losses and impacts the bottom line. These issues could have been resolved more effectively with greater attention and local leadership.

11.Reduced Middle-Level Management Ownership and Connection with the Organization Middle-level management has always acted as a crucial interface and connection between the field and the organization, building loyalty and control. The growth of the sector has provided more employment opportunities, leading to substantial attrition and churn at the mid-management level. New entrants in the sector offer better salaries, contributing to this churn.

Additionally, centralized decision-making and system-driven approaches have reduced middle-level management's connection and ownership.

In summary, addressing the current microfinance crisis requires a thorough understanding of these core issues and implementing collective actions to resolve them.