India’s micro financiers have struck gold while reaching out to the poor and vulnerable

By most definitions Bihar is one of the toughest places in India to do business. The state is unstable and its politics are often corrupt. Close to 90 million people live in an area little bigger than Portugal. More than a third live below the poverty line and only about one in 10 can read or write. The average person earns about US$160 a year.

Only one thing is certain in Bihar – just about everybody wants more money.

“Within a six kilometre radius of our office I could easily lend US$50 million,” says SR Sinha, a veteran financier. Seeing this need he started Saija Finance, a microfinance institution (MFI), in 2008 based in Bihar.

In about two years, Saija developed 10,000 clients, most of whom are poor and vulnerable and so cannot get bank loans. It acquired twice as many clients in a single month earlier this year. Sinha’s biggest problem is not repayment – Saija’s default rate to date is zero – it is finding the capital to lend.

Saija’s prospects improved when it caught the eye of Acción, a global organization that has developed MFIs around the world into large, viable businesses. Last November Acción paid US$500,000 for a 49.5% stake in Saija and took on one of the largest equity positions it had ever taken in such a young organization.

Now Saija plans to expand operations to the neighbouring states of Jharkhand, Chhattisgarh, Madhya Pradesh and Uttar Pradesh and grow its customer base to 400,000 by 2014.

The business model

For most microfinance lenders, capital is the only product on offer and the business model is scarily simple: Lend small amounts of money at high interest for a short period of time. So, an MFI that lends US$200 at 26% a year for half a year or 26 weeks gets back US$226. On the surface, this may not seem like a lot of money, but multiply the US$26 by 20,000 clients and do it over and over again quickly and suddenly there is a lot of money coming in.

Hyderabad-based SKS Microfinance has been doing just this. Rising from humble origins as a non-governmental organization, it is today India’s largest micro lender and has just raised a whopping Rs16.5 billion (US$350 million) in an unprecedented initial public offering. The shares, offered in a price band of Rs850 to Rs985 each, represented a 21.6% stake in the company.

SKS’s IPO, only the second in the world by an MFI, has turned the spotlight on the money being made by companies that meet the financial needs of those who have little or no access to bank credit. It appears that by focusing on the disenfranchised rural poor, India’s MFIs have opened up a new frontier for investments.

A 2009 report by Crisil, India’s leading ratings firm, suggests that many among the 120 million households that make up the ranks of India’s financially excluded, now depend on collateral-free loans provided by MFIs. Accordingly, Crisil estimates disbursements by MFIs have enjoyed compound annual growth rates of 90% during the past four years.

In most businesses, this kind of growth would seem incredible, but in India microfinance is a massive business that shows no sign of stopping.

Few rules for MFIs

Indian MFIs are relatively unregulated. While most cannot take deposits, they have the freedom to fix the interest they charge, open new branches and lend out widely.

MFIs come in different sizes and legal structures. While some are not-for-profit MFIs – either incorporated under the Companies Act or registered as cooperative societies under state or national acts – others are for-profit MFIs. The latter are mostly companies registered as non-banking financial companies (NBFC) with the Reserve Bank of India (RBI) and are the only MFIs that are caught by the regulatory radar.

With MFIs increasingly seen as commercially viable, they now attract investors. But, the RBI puts limits on where micro lenders can find capital and how much they can lend.

One of the most limiting restrictions is a ban on taking deposits for all MFIs, except those registered as NBFCs and licensed to do so by the RBI. Deposit taking MFIs are few in number, as with the licence comes more rules and regulations.

So, most MFIs depend on borrowings from banks and financial institutions and now that SKS has shown it is possible to raise money from capital markets, more are expected to follow.

A second lot of regulations limits how much MFIs can borrow in order to lend out. Leverage ratios are limited to about 10 times an MFI’s registered capital. In other parts of the world, that ratio can be as high as 30 times, which allows for much faster growth.

Indian MFIs are also limited to borrowing from the domestic market because the RBI forbids them from engaging in foreign commercial borrowings.

These restrictions appear to have managed the system while limiting abuses, but they have not held MFIs back. Most have found enough funds to grow rapidly.

In December 2009, almost 40 of the biggest MFIs set up the Microfinance Institutions Network, which developed a self-regulatory code of conduct to protect both the institution and the borrower.

A decade of great development

Micro lending, in one form or another, has always existed in India. But a little over a decade ago the rules changed with the emergence of institutional micro lenders who operated mainly in south India.

Many were commercial MFIs, which charged high rates of interest and sought out investors. As they grew and opened branches in other parts of India, these MFIs transformed micro lending. What started as an industry focused on the rural poor has today moved into the urban areas, where there are more customers who are more accessible but possibly less tractable.

This means that Saija, successful as it has been in Bihar, is hardly unique. Although Sinha doesn’t like to talk about competition, that is exactly what he has. India’s top three MFIs – SKS, Spandana Sphoorty and Share Microfin – have opened more than 100 branches in the state.

Countrywide Share has more than 1,000 branches and 3 million borrowers, while Spandana has 1,655 branches and 4.5 million clients. Together they have outstanding loans of Rs22.3 billion. SKS has a little over 2,000 branches and 6.7 million borrowers and has lent more than US$3 billion since it began.

SKS, like many other MFIs, lends only to women, who are better at repaying loans. As a result it boasts repayment rates of more than 99% on collateral-free loans and opened 55 new branches and attracted 200,000 new borrowers during each month of the last year.

Tapping the capital markets

There is little history of MFIs issuing shares. Before SKS, the only MFI that had gone down this path was Banco Compartamos in Mexico. In 2007 it went public and made a profit of almost US$80 million on a lending portfolio of US$400 million.

Acción, which was one of the original Compartamos partners and investors, did very well in that IPO and later started a grassroots MFI in China. But that proved to be an expensive experiment in a country that was not completely welcoming for the US-based organization.

Mohammad Yunus, a Nobel laureate and founder of the most famous micro lender in the world, Grameen Bank, was quick to criticize the Compartamos model. He pointed out that it was too much about commerce and not enough about social development.

Yunus weighed in again after SKS announced its IPO, telling the magazine Microfinance Focus that micro lenders are “taking money for themselves rather than worrying about what happens to the poor people so that goes into the same mentality as loan sharks”.

However, Yunus’ comments have not deterred investors. The SKS IPO, which closed on 3 August, attracted some heavyweight capital, including George Soros who bought 30 million shares through his Quantum fund. Sequoia Capital India and NR Narayana Murthy of Infosys have also taken up positions. Tree Line Asia, another hedge fund, bought a 2.3% stake.

Not easy money

Despite this, Sinha says making money with small loans is not always so clear cut. The returns look good in principle but require considerable discipline.

The typical micro loan in India is a few hundred dollars or less and while the RBI allows MFIs to use their discretion to set interest rates, they are typically around 26% per year. But Sinha says this sounds much better than it actually is.

The funds cost around 10-11% and operational costs are as high as 7%. With delinquency rates of about 2% across the industry, all that remains for the micro lender is a not particularly exciting 6%.

Capital cure: After the success of the SKS IPO, micro financiers are looking closely at capturing funds through the capital markets route.
Capital cure: After the success of the SKS IPO, micro financiers are looking closely at capturing funds through the capital markets route.

The reasons for the high costs are varied. While the sheer logistics and cost of lending small amounts to poor people who are spread out over vast rural areas can be daunting, the risks involved only make it worse.

In addition India’s MFIs have few options to make money. Unlike banks, most MFIs have limited products to offer their clients.

Some like Saija offer life insurance in collaboration with insurance companies. Although SKS has all along shied away from loans for personal consumption, this year it began offering insurance products and financing mobile phones.

What future for India’s MFIs?

The pushes and pulls of profit and altruism appear to have played themselves out and today India potentially offers the best prospects for lenders of micro loans.

The current buzzword among senior politicians and bankers is “financial inclusion” – despite decades of state decreed drives to open bank branches among the poor and the vulnerable. As a result MFIs with their grassroot presence and understanding of the needs of the financially excluded are increasingly looked on with favour.

The future for India’s MFIs looks promising also because several MFIs, like SKS, are now well beyond being struggling startups. “The market is fairly mature”, says Aarthi Sivanandh a Chennai-based lawyer who focuses on legal issues affecting social causes such as microfinance.

Sivanandh says the industry has spread across the country and its progress has been smoothed by relatively little interference from the RBI. She believes part of the reason behind the RBI’s welcoming attitude to MFIs is that the traditional banks were not really interested in developing micro lending in a booming economy.

For lawyers, microfinance creates unique challenges. Although rules for the creation of a micro lending organization are reasonably straightforward, as the risks are higher drawing up contracts can be tricky.

“The actual beneficiary has no role to play in the contract. You are looking at basic principles of law with a different dynamic,” Sivanandh explains. “MFIs have to sell (themselves) as a commercial product to the investors and a (social service) product to the rural market.”

In a recent interview with the Wall Street Journal, Vikram Akula, SKS’s founder and chairman, explaining his motivation for going public, said, “The only place you can get the amount of money that is needed to help the poor is in the capital markets … That’s why we are doing this IPO.”

This year, SKS’s profits are likely to top Rs1.6 billion. The poor, as it turns out, are not the only ones who are benefiting.