Appreciating Micro-Finance

The Hindu dated 20th July 2016 published a news article titled “Due diligence by MFIs vital”, while reporting on the National Summit on Microfinance organised by Assocham in Hyderabad. While due diligence in any borrowing / lending situation is essential, the way MFIs go about doing this, which is much in variance to the practices followed by regular banks, is what makes them special. Not only are the practices developed and followed by MFIs different, they are cheaper and more effective. Let us see how this happens. 

In any borrowing / lending situation, if the lender (reasonably) expects the borrower to repay principal along with interest, the lender has to assess the ability and the intention of borrower to repay.  After the funds have been lent, the lender has to monitor the continued ability of the borrower to repay. Even with the best and most detailed appraisals / due diligence and other precautionary measures including insistence of collateral security, it is not necessary that the borrower would be in a position to repay the borrowed funds. And this is not because borrowers are inherently dishonest (in fact most borrowers are quite honest – at least more than the average banker).  The future is uncertain and circumstances change due to weather patterns, change in tastes, government policies etc. which often creates genuine difficulties in making repayments as per agreed terms.

Assessing the ability and the intention of borrower to repay and continued monitoring of loans is a costly and time consuming exercise (known as transaction costs). Moreover, where the loan size is small, the transaction costs as a proportion of loan size increases exponentially making small loans costly and unremunerative for regular banks.

Micro-finance seeks to solve this problem of high transaction costs by some innovative, by now well established techniques, which virtually does away from having the lender to do detailed (and costly) loan evaluations and monitoring. Some of these techniques include:

a)   Group lending: Small closed knit groups have a quality whereby the borrowers know each other well. So lending to groups who have self- selected themselves ensures that the group does both the appraisal and monitoring. Peer group pressure replaces due diligence by banks.

b)   Loan repayments aligned to the cash flows of the borrower rather than convenience of the lender, say through daily or weekly collections.

c)  Reducing costs to borrowers in terms of ease and reduced costs of transactions through standardized minimal paperwork, centralized collection points which is more convenient to borrowers, doing away with bribes or middlemen etc.

d)   Doing away with the distinction of loans for productive purposes vs consumer loans. One of the most interesting and useful characteristics of money is its fungibility (its raison d’etre). That is, command over money enables a person to use it for any purpose for which he desires. Therefore, after the money is lent it is difficult to trace its end use. Even if the loan draw-down is made directly for the purpose for which it has been approved, monitoring end used is difficult and costly. A borrower with a hungry child or a sick parent / wife cannot be faulted for using the funds at his disposal for his immediate pressing requirement than the purpose for which the loan was approved.

e)   Building incentives for regular repayment in the loan contract itself. Say by giving a small loan with promise that in case it is repaid regularly the borrower would become eligible for a (slightly) larger loan.

f)    Realising that making available safe, secure, reliable, and easy means of small savings are often much more important than making loans for large parts of the population.

Over time, MFI have developed a host of such techniques which have proved their worth in enabling larger flow of resources to the small and micro end of the financial markets. Traditional banks by temperament and structure have been unable to address this critical requirement. Reasons are many and complex, and this short monograph will not even attempt to address it!

It is sad that the news article did not reveal if the National Summit on Microfinance even discussed these very important and relevant aspects of this industry.