Profits through Harmful and "Harmless Fraud": The case of the Microfinance sector

The exploits of the microfinance sector never seem to stop. As the sector is under greater regulatory and public scrutiny (for the first time since its birth), more skeletons seems to fall off the cupboard. However, that itself need not surprise those well versed in the everyday dynamics of any business. A number of businesses often believe that the law can be interpreted in a very elastic manner. This is not unique to the microfinance sector, but is generally the norm. Most of the business owners would believe that this not fraud per se but only minor transgressions in their day-to-day business operations - most of which may have been necessitated by the claustrophobic business regulation that exists in India. This "Harmless fraud" (as I have called it in another context), may often involve very minor violations for most of the businesses. However, what is interesting is that a sector that till date has not been regulated (Microfinance sector) should indulge in such practices is rather unique and is probably indicative of the nature of the business and the way it makes its profits. Greater public scrutiny (including AP government inquiries) has exposed some very fundamental flaws in the Microfinance sector which go beyond a mere ethical issue (like high interest rates or hiring criminal elements to collect loans). Instead the business seems to have violated not just the spirit of the law but also the letter of the law. Ironically the banks seem to have been a partner in the violation of a number of laws.

The most recent violation that has come to light is that of SKS Microfinance having 'deviated' from norms in the sale and management of insurance policies laid down by the Insurance Regulatory and Development Authority (IRDA). Apparently, IRDA found that SKS collected higher agent commissions than the permitted 10 percent and instead of depositing the money with the insurer, it kept the money, thereby obviously inflating its profits. This should mean that the company will have to either pay a fine (which would be reflected in their next quarterly earnings that will be announced to the stock exchanges) or cancellation of license. They mean have to have to re-state earnings.

The AP government has a more important complaint against the banks and the MFIs which is far more fundamental. The AP complaint to the RBI clearly stated the banks and the MFIs had violated at least one RBI & NABARD guideline: (a) The Group should be in existence for at least six months apart from not helping in the promotion of savings, instead it encouraged indebtedness (all which the AP government attempted to overcome in its recent Ordinance).

In a 2009 report, RBI itself has found some issues in the nature of the MFI business, apart from the lack of transparency in the business. (). Interestingly all these issues have led to some of the recent problems. AP Ordinance once again attempts to bring transparency in this area (See our earlier Post on the features of the ordinance October 24, 2010).
(a) Some MFIs were focussing on relatively better banked areas
(b) "Competing MFIs were operating in the same area, and trying to reach out to the same set of poor, resulting in multiple lending and overburdening of rural households" (p.8)
(c) Many MFIs supported by banks were not engaging themselves in capacity building and empowerment of the groups to the desired extent. The MFIs were disbursing loans to the newly formed groups within 10-15 days of their formation, in contrast to the practice obtaining in the SHG - Bank linkage programme which takes about 6-7 months for group formation / nurturing / handholding. As a result, cohesiveness and a sense of purpose were not being built up in the groups formed by these MFIs (p.9).

As a keen follower of the business landscape, I always wondered how the microfinance companies could constantly improve their margins. Usually profit growth for a finance company always comes from either expanding the amount of money lent (by increasing the number of clients), by increasing the interest rates or simply by cutting costs. MFIs have expanded the volumes of their business and increased interest rates. Like any normal business instead of cutting costs, they have exponentially increased their executive compensation. It has now become apparent that the profits and increased margins came from high interest rates and an elastic interpretation of the norms. The case of SKS is illustrative. Its erstwhile CEO was given a compensation of about Rs.1 crore for his work in enabling the Initial Public Offering of the company. It is another matter that he was sacked very soon after that. (SKS is cited for two reasons: it has been in the eye of the storm as nearly 25 borrowers committed suicide, and secondly information about SKS CEO compensation is easily available because it is a listed company and it has to disclose these to its investors).

SIDBI (a major lender to the MFIs) seems to have recently realised that the sector has a number of structural deficiencies. It is reported to have only recently asked MFIs to provide a road map on when and how they plan to reduce interest rates and re-work their business model, including reducing their executive compensation, which at times are higher than a medium sized private sector bank.

Interestingly, the Microfinance sector seems to have woken up to the reality that while Andhra Pradesh may be a lost frontier and its most profitable one due to the culture of credit, it seems to be keen to see to it that other states like Karnataka where they have spread very rapidly over the past few years should not be effected. It is for this reason that the Association of Karnataka Microfinance Institutions (AKMI) has established a help-line for customers and an ombudsman for customer complaints.

The MFIs claim that they need central legislation in order to avoid a repeat of the AP crisis. One should be skeptical about these claims. MFIs have violated various provisions in different laws (not just the interest rate related clauses) so how is that going to make a difference. The former governor of the Reserve Bank of India, Y.V.Reddy has clearly stated that the MFI is nothing but a 'leveraged moneylender' and there should be very strict laws to regulate it. He adds that the MFIs should be regulated at the State Level for the simple reason that the conditions in each state differ.

The Government of India should not attempt to introduce a national level law that dilutes the provisions of the AP Ordinance, which has excellent regulatory features. It is imperative for the MFIs that the they need to welcome regulation first by changing the very culture of their business practices and importantly in their business model. Unless the MFIs come up with a clear cut business model that enables borrowers to redress their grievances through arbitration they will continue to problems. Importantly, the MFIs should stop thinking in terms of expanding their business by pushing credit to over-leveraged borrowers, instead they should think of a sustainable business model that would harness savings and providing credit only for productive purposes. A reading of F.A.Nicholson (the colonial administrator who inquired about the indebtedness of the people in the Madras Presidency) may be a good starting point.