The most important finding in the last two decades

in the world of finance did not come

from the world of the rich or the relatively
well-off. More important than the hedge fund or
the liquid-yield option note was the finding that
the poor can save, can borrow (can indeed decide
on loans to fellow poor), and will certainly repay
loans. This is the world of microfinance.
A good definition of microfinance as provided by
Robinson1 is, ‘Microfinance refers to small-scale financial
services for both credits and deposits —
that are provided to people who farm or fish or herd;
operate small or microenterprises where goods are
produced, recycled, repaired, or traded; provide
services; work for wages or commissions; gain income
from renting out small amounts of land, vehicles,
draft animals, or machinery and tools; and
to other individuals and local groups in developing
countries, in both rural and urban areas’.

Role of NGO Sector5

Over the past 20-25 years, the resultant vacuum in
the financial system has started to be filled, initially
with the pioneering efforts of organisations
such as the SEWA Bank, Ahmedabad and Working
Women’s Forum, Chennai, but more vigorously during
the 1990s, by the entrance of significant numbers
of non-government organisations (NGOs) into
microfinance. Current estimates of the number of
NGOs engaged in mobilising savings and providing
micro-loan services to the poor lie in the range
of 800-1,000 organisations6 .
Initially, many NGO microfinance institutions (MFIs)
were funded by donor support in
the form of revolving funds and
operating grants. In recent years
(roughly since 1994), development
finance institutions such as the
National Bank for Agriculture and
Rural Development (NABARD) and
the Small Industries Development
Bank of India (SIDBI) and micro-finance
promotion organisations
such as the Rashtriya Mahila Kosh
(RMK—the National Women’s
Fund) have also started to provide
bulk loans to MFIs. This has resulted
in the MFIs becoming intermediaries
between the largely public
sector development finance institutions
and retail borrowers consisting
of groups of poor people or
individual borrowers living in rural
areas or urban slums. In another
model, NABARD refinances commercial
bank loans to self-help
groups (SHGs) in order to facilitate relationships
between the banks and poor borrowers.
Though the (mainly) NGO micro-finance sector has
made a start in providing ‘user friendly’ formal financial
services to the poor its outreach is still minuscule
in comparison with the need. Recent compilations
of support provided by major financial
institutions shows that the microfinance
outstandings of domestic financial institutions (including
NGO-MFIs) did not exceed Rs 800 crores
(US$170 million) by March 2002 with an outreach to
less than 5.5 million families – at best less than 10%
of the 60 million poor families in the country. This
includes the NABARD scheme for linking self-help
groups directly with banks. The available data indicates
that progress and outreach in the scheme was
around Rs 650 crores (US$140 million) outstandingand
covering, at most, 4.5 million families at end-
March 20027 .
At the same time, the involvement of commercial
banks in microfinance is negligible both in relation
to the current volume of microfinance and (even
more so) to their broader engagement in rural areas.
The total credit from the scheduled commercial
banks to the ‘weaker sections’8 is estimated at Rs
29,000 crores (US$ 6.7 billion) at the end of March
2001 compared to the total rural deposits of Rs
133,000 crores (US$ 31 billion) . 9

Ways of Delivering Microfinance

MFIs around the world follow a variety

of different methodologies for

the provision of financial services
to low-income families. These methodologies
are overwhelmingly
based on the principle of financial
services being related to the cash
flows of the low-income client
groups and thus aim to facilitate
relatively frequent and very small or
micro-loan and savings transactions.
The focus of such services
is on women, based on the observation
that in financial matters, they
are more responsible than men particularly
since their mobility is restricted
by family responsibilities.
The following is a typology of major
methodologies employed by
MFIs for the delivery of financial
services to low income families:
Self-help Group (SHG)
The SHG is the dominant microfinance methodology
in India. The operations of 15-25 member SHGs
are based on the principle of revolving the members’
own savings. External financial assistance –
by MFIs or banks – augments the resources available
to the group-operated revolving fund. Savings
thus precede borrowing by the members. In
many SHG programmes, the volume of individual
borrowing is determined either by the volume of
member savings or the savings of the group as a
whole. Some NGOs operate microfinance
programmes by organising federations of SHGs to
act as the MFI which obtains external loan funds in
bulk to be channelled to the members via the SHGs.
NABARD has facilitated and extensively supported
a programme which entails commercial banks lending
directly to SHGs rather than via bulk loans to
MFIs. NABARD re-finances the loans of the commercial
banks to SHGs.
Individual Banking Programmes (IBPs)
IBPs entail the provision by MFIs of financial services
to individual clients – though they may sometimes
be organised into joint liability groups, credit
and savings cooperatives or even SHGs. The model
is increasingly popular for microfinance particularly
through cooperatives.
In the case of cooperatives, all borrowers are members
of the organisation either directly, or indirectly
by being members of primary cooperatives or associations
which are members of the
apex society. Creditworthiness and
loan security are a function of cooperative
membership within which
member savings and peer pressure
are assumed to be a key factor.
Though the magnitude and timing
of savings and loans are largely unrelated,
a special effort is made to
mobilise savings from members.
There are now a large number of
‘new generation’ cooperative credit
societies in India devoted specifically
to providing financial services
to the poor. Most of these are in
Andhra Pradesh which was the first
to enact a law permitting mutuallyaided
– as opposed to traditional
government-assisted – cooperative
societies. Elsewhere, a number of
well known programmes such as the
SEWA Bank in Ahmedabad, the Indian
Cooperative Network for
Women, Tamil Nadu and the Annapurna Mahila
Cooperative Credit Society in Mumbai have still
survived under the traditional cooperative laws.
Grameen Model
This model was initially promoted by the well known
Grameen Bank of Bangladesh. These undertake individual
lending but all borrowers are members of
5-member joint liability groups which, in turn, get
together with 7-10 other such groups from the same
village or neighbourhood to form a centre. Within
each group and centre peer pressure is the key factor
in ensuring repayment. Each borrower’s creditworthiness
is determined by the overall creditworthiness
of the group. Savings are a compulsory
component of the loan repayment schedule but do
not determine the magnitude or timing of the loan.
There are some two dozen MFIs in India known tofollow this model.

Mixed Model
Some MFIs started with the Grameen model but converted
to the SHG model at a later stage. However
they did not completely do away with Grameen type
lending and smaller groups. They are an equal mix
of SHG and Grameen model. Others have chosen to
adapt either the Grameen or the SHG model to cater
to their markets while some organisations like
BASIX use a number of delivery channels and methodologies
(including lending to SHGs) to provide
financial services. Such MFIs are still relatively
few but with increasing innovation becoming the
norm in Indian microfinance, their numbers are growing.
Common Characteristics of Microfinance
Models
The common characteristics across the current approaches
to the provision of microfinance services
are summarised in Exhibit 1. In practice, the average
microfinance client’s relationship with an MFI
can be defined by a fairly standard set of obligations.
Attendance of regular weekly (fortnightly or
monthly) meetings of her group
Training in ‘loan utilisation’ or participation
in discussions of developmentally relevant issues
such as social discrimination, gender awareness,
health, sanitation and education
Contribution of fixed amounts, termedby the MFI with direct access of the member limited
or even barred
Repayment of fixed amounts as instalments on
any loan she obtains from the MFI or from her
group.
What she actually receives in return for fulfilling
these obligations are:
Fixed amounts of loan apparently ‘for productive
activities’ – with the size of the loan usually
determined by the longevity of her relationship with
the MFI rather than by her financial needs
Emergency loans for ‘consumption’ – in the
case of some MFIs – but relatively small amounts
and subject to the approval of her group
Insurance – provided by a risk fund or insurance
fund created by a few MFIs, or by an insurance
company in collaboration with the MFI
Other development services, in the case of
multi-service NGO/MFIs.
8 Given by one of the four credit rating institutions specified by RBI in a special Master Circular
[http://www.rbi.org.in/sec14/57835.pdf]
III. Regulatory Framework
Microfinance Act
With the absence of a unified microfinance act uniting MFIs under a single regulating authority with
a standard set of guidelines, regulation of microfinance in India is somewhat disjointed. MFIs are
classified and governed according to the legal act under which they incorporated. An estimated 80
percent or more of the 2,000 MFIs in India are registered as philanthropic societies and essentially
unregulated. Others are categorized as Commercial Banks, Cooperative Banks, Regional Rural
Banks, Non-Banking Financial Companies (NBFCs), Credit Cooperatives, or Mutually Aided
Cooperative Societies, and may be strictly supervised by the Reserve Bank of India, NABARD, or
state authorities, depending on the type of institution. Indian microfinance associations (notably Sa-
Dhan) are working on drafting a microfinance act, which would combine the microfinance activities
of all these institutions under one aegis. Industry actors hope that such an act would reduce confusion
and allow for a better basis for comparison and exchange of information among MFIs. A single
regulating body could require standardized financial disclosure based on international best practices.
Ultimately this should make well-performing MFIs more visible to potential investors or donors.
A microfinance act would be additionally useful for forming consensus about the freedom to set
interest rates. Banks lending less than Rs. 2,000 to individuals may not charge more than their prime
rate, which is currently around 10.5 to 11 percent, while the rate at which they lend to MFIs or at
which MFIs lend to clients is not regulated. Some in the industry support a rate cap in the interest of
consumer protection, but most prefer to allow MFIs the ability to set rates as they see fit, and allow
competition to drive them down.
Savings
MFIs registered under the Societies Act face virtually no financial disclosure requirements. They are
prohibited from legally collecting savings, but it is widely acknowledged that many MFIs mobilize
deposits on behalf of their clients. In some cases this money is deposited in group accounts for clients
in a commercial bank, while in other cases the money is collected into a trust which is invested in the
MFI. This a gray area within the law which highlights the need for the poor to access savings
services to keep their money in a safe, convenient place; and the need for MFIs to lower their cost of
capital. There is a synergy here which seems underutilized in the Indian context. Under Indian
regulations MFIs wishing to collect savings typically transform into NBFCs. NBFCs must be at least
one year old before they can collect deposits, and then only if they have received at least an
investment grade credit rating.8 There is a limit on the terms of deposits that NBFCs can accept: the
interest rate paid on deposits cannot be more than 11 percent and no deposits for less than 12 months
or more than 60 months can be accepted. However, with a minimum capital requirement of Rs. 20
million (approx.
13
US$440,000—considerably higher than found in many other developing countries) and a lengthy
application process, this is not an easy leap to make—and even then the authorization to collect
savings is only granted by special permission from RBI. In fact most requests are denied and RBI is
thought to purposefully drag its feet on the applications so as to limit the number of NBFCs it is
required to oversee. Many in the industry point out that India suffered a number of NBFC failures in
recent years, which explains RBI’s reluctance to grant licenses. But they note that microfinance
institutions were not among those that collapsed, and argue that with adequate supervision steps
could be taken to protect the poor and their deposits. Others feel that savings might be better
approached through alternative models, such as credit unions.
Regulations on Investment
Even without the ability to collect deposits some MFIs are finding it worthwhile to transform into
NBFCs because it allows them to raise equity. Raising equity, too, is subject to stringent regulations
which many find restrictive. Minimum foreign investment in an NBFC is set at US$500,000—and
must be matched by an equal amount of domestic equity as regulations prohibit majority foreign
investment (unless a wholly owned subsidiary is formed, at much greater cost). It is generally agreed
that raising that amount of money in India is sufficiently difficult to effectively prohibit foreign
investment in MFIs. Given this limitation, some are searching for modifications to Indian banking
regulations that could stimulate domestic investment. Some have suggested the implementation of
the concept of the limited liability partnership in India, protecting investors from liability to the
extent of their investment. A further step would be to allow (domestic) venture capital funds and
NGOs to invest in NBFCs. Finally, curiously, RBI in 2002 outlawed even borrowing from abroad—
including from donor agencies. This limits MFIs’ access to capital at preferential rates, a vital source
of funds, and a potential source of quasi-equity, preventing them from leveraging more capital. With
domestic loan rates starting at over 8 percent, borrowing abroad, even at commercial rates, can be of
benefit to MFIs.
MFIs also face restrictions on the receipt of foreign donations. In order to receive overseas grants
they need permission from the Ministry of the Interior in accordance with the Foreign Contribution
Regulation Act. In general, it takes about two to three months to get a temporary permit under this
regulation and the NGO is required to reapply for it every year for three years until it is granted a
permanent permit.
14

9 RBI Master Circular on Micro Credit, August 21, 2004.

10 STRATFOR Global Market Brief, May 23, 2004.
11 By the Centre for Monitoring Indian Economy (CMIE).
VI. Microfinance Sector Risk Factors
Political Risk
Legislative elections in April and May 2004 shifted control of India’s parliament to the left. Because
the winning party, Congress, and its allied parties in the United Progress Alliance, failed to gain a
majority of seats, they must court the support of the Indian Communist Party (CPI-M), which
supports greater government controls over the economy and opposes any relaxing of the limits on
foreign direct investment. This could present a risk of greater government interference in the
microfinance sector, for example by imposing interest rate caps which could hinder the viability of
MFIs facing high transaction costs. However, players in the microfinance industry seem to feel that
the risk of such a cap is quite low. In addition, RBI confirmed in August, 2004 that, “The interest rate
applicable to loans given by…micro-credit organizations to Self Help Groups / member beneficiaries
would be left to their discretion.”9
The positive side of the new government is that as a populist coalition they are believed to be quite
supportive of microfinance as a poverty alleviation and development tool, and therefore may be
willing to support positive legislative changes such as a uniform microfinance act. In general, the
Indian central government seems to pose little risk to the microfinance sector.
However, since the Indian political system is quite decentralized, the laws and governments of the
different states can greatly affect the climate for microfinance. Some state policies have been
extremely supportive of microfinance, while others, primarily due to populist political pressures,
have undermined the sector at times. In addition, states that maintain only a weak rule of law (Uttar
Pradesh, Bihar, and Orissa have been mentioned in this category) may present a riskier operating
environment for both MFIs and micro-enterprises. At least one MFI, however, states that it receives
excellent repayment rates in Uttar Pradesh, a result it attributes to the fact that its clients there have
no other way to access affordable credit.
Economic Risk
Following several years of strong economic growth and technological development, India’s new
government is not expected to make any radical shifts in economic policy. However, the government
is likely to increase social spending, which some analysts believe could “hamper India’s ability to
service its foreign debt and pressure interest rates upward.” 10 Inflation, which remained quite steady
in the range of 3.7 to 4.7 percent per annum from 1999 through 2003, is currently forecast 11 to be 6.5
percent for fiscal year 2004-2005, and peaked at 8.3 percent in August, 2004. This is believed to be
due largely to increases in the price of fuel and manufactured goods.
19
Currency Risk
Although it is important for international investors to consider the costs associated with exchange
rate fluctuations, India’s currency risk should not be especially high. India’s exchange rate can be
characterized as a managed float in relation to the US dollar. That is, RBI intervenes in foreign
exchange markets to keep the exchange rate stable. In addition, as it is possible to purchase a one
year forward contract on Indian currency in liquid markets, it is possible to hedge against currency
risk during this period.
Geographical Concentration
The fact that most Indian microfinance activity (in terms of number of SHGs and MFI size and speed
of growth) is concentrated in the southern states – it is estimated that 85 percent of all Indian
microfinance activity is located in the South, with anywhere between 50 and 70 percent in Andhra
Pradesh alone - means that the risk to investors from Indian MFIs of region-specific shocks such as
natural disasters or political unrest is largely covariant. Indian lenders to MFIs, such as ICICI bank
and Friends of Women’s World Banking, are explicitly trying to increase the number of non-southern
MFIs in their portfolios in order to minimize their exposure to regional concentration risk. In
addition, some MFIs have begun to encourage their clients to engage in diverse livelihood activities
and to provide micro-insurance as a way to minimize the covariant risks that they themselves face
due to geographical concentration.
Saturation and Unhealthy Competition
The only two states in India which could be considered saturated in the microfinance market are
Tamil Nadu and particularly Andhra Pradesh. Many in the industry do feel the level and nature of
MFI competition in Andhra Pradesh is unhealthy and could potentially lead to unsound lending and
reduced portfolio quality due to clients borrowing from more than one institution. Some MFIs
actually use the information that a potential client already has a loan from a reputable MFI as a
reason to make another loan to them. The fact remains that given the absence of credit bureaus MFIs
cannot check on the credit status or history of a potential clients in a market where competition may
be pressuring them to lower their screening standards anyway.
Institutional Risk
Governance
Most successful Indian MFIs are extremely dependent on key energetic and effective leaders, and
many do not have sound governance policies at the board level. This presents a great risk to the
future success and viability of the organization in the absence of those original leaders. However,
some large MFIs have recognized this problem and taken active steps to improve their governance
policies.
20
12 90.4 percent was the average repayment rate among a sample of 42 Sa-Dhan members, although participants in
the Indian microfinance sector have suggested that even higher repayments rates are common.
Managerial Skill
Most Indian MFIs are excellent at doing grassroots work and have a deep understanding of the poor
clients they serve. However, many organizations and most new entrants to the field lack the financial
experience and technical ability to properly manage invested funds. Therefore, one of the key issues
for someone thinking about investing in an Indian MFI should be to look at the financial skill level of
the managerial staff, as well as the quality of the organization’s MIS system. It cannot be assumed
that a high repayment rate indicates that an organization is prepared to make good use of new
investment funds or has a sensible plan for expansion.
Accounting and Financial Reporting
Raters and financial analysts feel that the lack of common and strong accounting and financial
reporting regulation and monitoring for MFIs allows some of them to hide poor financial
performance, exacerbating the risk of the emergence and continued operation of irresponsible MFIs.
This situation heightens the risk of institutional fraud, manipulation of portfolio-at-risk, and
underperforming assets, particularly for unregulated MFIs (i.e., those which are not registered as
financial companies) which have no financial reporting requirements.
Volatility
It is generally agreed that repayment rates in the Indian microfinance sector are quite high (over 90
percent)12 and fairly stable (in part because of family / household risk-sharing over multiple sources
of income which can be used for loan repayment), and that therefore the sector presents a good
opportunity for safe investment. However, opinions differ as to how much the health of the
microfinance sector tracks with movements in the rest of the economy. On one hand, those in the
industry generally believe that since microfinance clients and their micro-enterprises seem to be so
isolated from the mainstream economy, MFIs and micro-enterprises are not likely to be substantially
hurt by downturns in the business cycle. One banker called the demand for the goods and services
offered by micro-enterprises virtually “recession-proof.” It then seems possible, however, that as
microfinance clients and institutions become more linked with mainstream and formal markets,
which appears to be the trend, their financial performance could become more linked with the
performance of the macro-economy in the future.
On the other hand, some argue that the fortunes of the microfinance sector and the macro-economy
are already linked, due to the belief that many microfinance clients repay their loans at least in part
with daily wages. If a significant amount of the money clients use to repay their micro-loans does in
fact come from daily wages, then clients may default
21
more frequently when they face lower demand for their labor during economic downturns, and
movements in the microfinance sector could appear to be pro-cyclical.
22

The Road Ahead – Prospects and Challenges

In this paper we have sought to provide a bird’s-eye view of the microfinance
sector in India. There have definitely been significant advances in recent years and the
concept and practice of SHG-based microfinance has now developed deep roots in many
parts of the country. Impact assessment being rather limited so far, it is hard to measure
and quantify the effect that this Indian microcredit experience so far has had on the
poverty situation in India. Doubtlessly, a lot needs to be accomplished in terms of
outreach to make a serious dent on poverty. However, the logic and rationale of SHGbased
microfinance have been established firmly enough that microcredit has effectively
graduated from an “experiment” to a widely-accepted paradigm of rural and
developmental financing in India. This is no mean achievement. In fact to the extent that
people’s mindsets are the biggest roadblock in the success of an innovation, it may well
be one of the most important steps in the saga of microfinance.
The path ahead is obviously strewn with challenges. Scaling up of projects and
bringing millions of people within the fold of microfinance is no mean task. The most
17
convincing feature of this form of financing, that justifies its admittedly higher costs, is
the near-perfect repayment rates. The expansionary zeal of microcredit practitioners
should be balanced with the quality of loans – indeed a momentous challenge.
Government involvement in SHG-based microfinance is a welcome development but it is
not free from its ills. Government aid almost always brings in its wake political
favoritism and corruption. It is important to ensure that the government microfinance
initiatives do not go the way of their several well-intentioned predecessors.
The biggest challenge in development, however, is the simultaneous development
of investment potential and improvement of skill levels of the borrowers. A glut of lowskilled
services is an unwelcome substitute for scarcity of credit. As microcredit
alleviates the credit availability problem, the need for micro-consulting, business
planning and services like marketing, are being felt with greater acuteness. Microcredit
cannot be expected to be a panacea to rural developmental problems. In some sense, its
role is similar to that of credit in the general economy. It is a string that can hold back
progress, but it is almost impossible to push on a string. There is a very real need of
investments that yield higher returns than the sustainable microcredit interest rates for the
microcredit initiative to be truly successful.
However, so far the evidence – largely anecdotal – points to the several beneficial
side-effects of microcredit. In particular, empowerment of women and the inculcation of
financial training and discipline amongst the poor will undoubtedly have long-term
socioeconomic
benefits. The principles of self-help and microcredit thus hold the key to
economic and socio-cultural freedom for India’s millions of poor, opening the gates of a
hitherto untapped reservoir of human enterprise.