Microfinance Lending Technologies and their Impact on the Sustainability of Financial Institutions - Coursework Example

? Microfinance lending technologies and their impact on the sustainability of financial s: A comparative review of critical issues Introduction Making finance available or Lending to poor and low income group has been the greatest challenge to the developing and underdeveloped countries throughout the world. “There is a growing tendency among development economists and planners to think that microfinance programs have the potential for equitable and sustainable development with an ultimate goal of eradicating poverty. This received momentum from the award of the Nobel Peace Prize to Dr. Muhammed Yunus and the Grameen Bank, [Bangladesh]”. (Hasan, Hassan & Uddin, 2009, p. 318) Though primarily aims to provide finance to the poorer sections of the society, the people belonging to unorganized sector, especially self-employed or unsalaried without any collateral, the concept of microfinance is not limited to lending, and covers wide range of financial services needed for the development of the communities. The paper discusses about the corporate governance, the objectives microfinance institutions, theoretical background, critical success factors (CSF), future of MFIs per se and with reference to its implications on the development of the society and sustainability. Therefore, it is essential to view microfinance from social angle as well, rather than business angle alone in the interest of a sound and balanced growth of the society for making microfinance as the powerhouse for social development. Objectives of Microfinance Institutions (MFIs) Poverty alleviation is the primary objective of the developmental policy of microfinance through financial inclusion of the people who do not have access to financial institutions. However, sustainability factor is important for the success of the MFIs in the long run. Sustainable MFIs can expand to cover more areas and people. Therefore, sustainability as the secondary objective is to strengthen the primary objective of making financial services available to the poor. The business is not limited to lending to the clients, but includes encouragement of savings in the community, ready access to clients with good track record, support for small business and industries or income generating activities on a cooperative or group lending basis and finance for small housing and farming. The financial services cover money transfers, investments and risk protection though insurance. Governance mechanism In the new development paradigm microfinance play a crucial role with reference to the poverty alleviation in the developing and the underdeveloped countries. The idea of microcredit gain attention in the early 1980s on establishment of Grameen Bank in Bangladesh. It is now identified as a fast-growing field in International Business and Economics and adopted in several countries worldwide as a poverty alleviation strategy in a sustainable manner. Anyanwu (2004, p. 4-5) states that the unwillingness or inability of the formal financial institutions to provide financial services to the urban and rural poor, coupled with the un-sustainability of government sponsored development financial schemes contributed to the growth of private sector-led microfinance in Nigeria. He further states that the MFIs are of the view that women perform better than men in managing meager resources and promoting micro enterprises, and credit to the service sector was very minimal and the MFIs gave no loans for consumption. The concept of microfinance is relatively new to the country, and the demand for funds is met mainly through aid and grants from abroad. Germidis, Kessler & Meghir (1991, p. 40) state “the formal sector would refer to an organized, urban-oriented, institutional system…while the informal sector, itself unorgnised and non-institutional, would deal with the traditional, rural, subsistence (non-monetised) spheres of the economy”. The microfinance industry catering to the needs and welfare of the economically weaker and socially backward sections has been evolving into a key driver of the economy with potential for explosion in growth in future. For example, the credit rating agency CRISIL (a subsidiary of Standard & Poors in India) states “In addition to MFI grading and risk assessment services, we offer ratings on the MFIs' bank facilities and securitisation transactions… involving microfinance loan receivables” (2009). The governance mechanisms adopted in microfinance institutions should be in line with the goals and objectives of financial inclusion of the poor and sustainability. The stakeholders in the industry such as lenders, donor, consultants and other service providers are in many cases international in character. Mersland & Strom (2009) states “financial performance improves when the board has local rather than international directors and when it employs an internal board auditor. Ownership type, however, does not affect financial performance. In the MFI-customer dimension, we find that the MFI is better served with a female CEO”. The policy of the governments influences the growth and development of the industry. For example promulgation of Andhra Pradesh Microfinance Institutions (regulation of money lending) Ordinance, 2010 has been considered by the industry circles as a setback to the growth and development of microfinance industry in India. The ordinance was promulgated to check the unrest in this southern state of India in the backdrop of alleged coercive practices adopted by the MFIs in the state. The ordinance requires the MFIs inter alia to comply with several statutory regulations with reference to the area of operations, rate of interest, display of interest rates in the offices, restrictions on charges other than the interest and identity cards to staff for recovery and stipulates cancellation of registration and punishment of imprisonment for up to three years or a fine up to Rs 1 lakh or both if they resort to any coercive measures, although the bill does not specify a cap on Interest Rates that can be charged. India Microfinance Business News states, “As per the latest information we have received from our sources, all MFI’s are required to suspend collections until they have registered with local authorities in every village where they operate. Nobody is sure about what the procedure is or how long it would take for an MFI to get registered”. Financial inclusion The financial inclusion of the sections of disadvantaged and low income groups who do not have access to other formal financial institutions play a great role in integrating these people into the national economic stream of a country. The well being of the self employed people, both men and women, in the society lends stability to the economy. The microfinance operations cater to the needs of the so-called under-privileged community that includes street vendors, handicrafts manufacturers, small traders, technicians, rural farming community and small scale food processors. The income generated by these people forms the basis for steady demand for various industrial and consumable products generating employment on a larger scale in the society, thereby increasing the level of economic activity. Steady income in the households gives thrust to health and education in the society as a whole as the income would be useful in meeting the medical expenses of the family and the educational needs of the children. There will be an improvement in the lifestyle since microfinance removes the problems associated with the irregular and uncertain nature of incomes. Differentiation among the clients with reference to earning potential and their ability to repay is very important for the success of MFIs, and the role of the government in the other cases, for example destitution e, old age, healthcare should not be confused with the objectives of microfinance. Armendariz, & Morduch, J. (2007, p.86) state that the special feature [in group lending] is that the loans are made individually to group members, but all in the group face consequences if any member runs into serious repayment difficulties. This strategy will be useful in promoting sustainability, though Mersland & Strom (2007) states that group lending do not contribute positively to financial performance, but to outreach. Theoretical background The size of individual loan by MFIs is very small, say around $100, which could vary based on developmental phase of a country. The loans are linked to income generation in respect of the weaker sections of the society, rural or unorganized sector and self-employment, with no collateral. Therefore, savings on the part of the entrepreneurs should form as the basis for financing for effective results. The concept is opposed to the theory of personal failure, because depriving poor of access is believed to be the cause for the underdevelopment in a society and the MFIs seek to rectify this position. Khandakar, Danopoulos & Constantine (2004, p. 4) states: Microfinance theoreticians have advanced two theories regarding their aims - an economic and a psychological. The economic theory treats microfinance institutions (MFIs) as infant industries, while the psychological theory differentiates microfinance entrepreneurs from traditional money lenders by portraying them as "social consciousness driven people."  Lack of microcredit has not caused poverty, but viewing microfinance as the vehicle for social development is important for understanding its impact on the society in proper perspective. Group lending in MFIs is predominant; for example, agriculture loans in rural areas. Ghatak & Guinnane (1999) state “transaction-cost-based theories and joint-liability-based theories…show that the bank can avoid the cost of performing a costly audit every time an individual borrower claims she has low output by inducing her partner to undertake liability for her and audit only when the whole group declares inability to repay”. Enterprise development The fact that banks started downscaling successfully into microfinance indicates the immense potential for enterprise development in this sector. The entry of private companies and banks signifies that the sector has transformed the development based MFIs into profit oriented organizations. This welcome transition, if properly channeled and supported by statutory measures would go a long way in the growth and development of the economy. The credit rating agency CRISIL issued high ratings to a number of microcredit securitizations in India. Microcredit based securitization could ensure steady flow of funds to the industry. The structure of the industry varies from country to country as necessitated by the stages of the development and the support needed for sustainability. Kelly (2011) states that “Root Capital [a nonprofit social investment fund] provides basic loan and financial education to borrowers before approving loans -- a crucial element which is often missed in microfinance… since these lenders are repaid not by the borrower but by the distributor, this approach seems unlikely to fall into some of the traps facing microlending organizations as of late”. Sustainability Lower revenues from the operations, higher administrative overheads in lending and recovery of loans and the financial risks involved are the major challenges to the MFIs. The technological innovations such as smart cards and ATMs are expected to reduce the overheads of the MFIs in the long run. Statutory support for MFIs grounded on equity, justice and fairness is prerequisite for MFIs in achieving the objectives envisaged. Well managed MFIs are comparatively more profitable than the banks. However, the entry of banks with huge financial strength into this space may pose serious threat to the existence of the MFIs operating on a small level in future. MFIs of the government banking institutions with microfinance department are also successful in their operations. The governments also entered into microfinance, for example, Bank Rakyat Indonesia with separate department for microfinance. SBI is the largest bank in India with over 9,000 branches and is also the largest player in the microfinance sector in India with a market share of around 20%. (ICMR, 2005) However, for effective functioning of the MFIs, their institutional participation may be expanded to refinancing to the other MFIs for the healthy growth of this fledgling industry. Marr & Ana (2003) contend that microfinance not only has failed to solve the original problems of information asymmetries between borrowers and lenders, but also, in its pursuit of financial sustainability, is destroying the very foundations of these schemes by disrupting the social fabric of communities, creating more poverty, and excluding the poorest and most valuable from any given group. The arguments appear to be farfetched because pursuing financial sustainability is important for success of the MFIs. Mersland & Strom (2007) states, “Financial performance and outreach are competing objectives. ROA increases with average loan size. We find no "win-win" logic between poverty outreach and financial performance”. Future of MFIs The reach of mobile telephony in societies paved way for expanding user base. The development in technology and telecommunications made it possible for installation of ATMs in the remotest parts of the countries, the use of simple smartcards facilitate and E-finance in a bigger way. The introduction of national identification system in various countries would make the task of account opening by the public easier, though voter identity card, vehicle licenses and family ration cards issued by the government authorities presently serve the purpose. Sundaresan (2008, p. 5) state that technological innovations have also paced the evolution of microfinance: widespread availability of mobile phones, access to community-level kiosks of computer terminals with access to Internet, biometric technology to obtain loan approval and credit history, and correspondent banking have dramatically changed the landscape of microfinance. The government can play a catalyst role for the growth and development of the industry by providing, strategic macroeconomic policy guidance, freedom to fix interest rates to the MFIs for effective credit delivery, and providing refinance facilities to the MFIs through the government institutions. MFIs could improve the culture of savings in the society, especially among the self-employed and rural population by providing good financial services to the clients. Allowing financially strong and stable MFIs to collect deposits from the public would result into increased rate of growth in savings. Hartarska & Nadolnyak (2007) find that regulatory involvement does not directly affect performance either in terms of operational self-sustainability or outreach. However, a case in point contrary to this observation is that the promulgation of Andhra Pradesh Microfinance Institutions (regulation of money lending) Ordinance, 2010 which has severely affected the collection process of the MFIs in the state and resulted into enormous difficulties to the MFIs in their operations. Though there might be valid reasons for regulating the functions of the microfinance industry, the measures initiated must be useful in regulating the industry in the interest of the consumers as well as the industry after taking into account the need for promoting the industry and the underlying social causes related to financial inclusion and economic growth. Generally, the people on account of poor and irregular income have a tendency to avoid repayment of loan, especially in India where the various state governments introduced farm loan waiver schemes or agricultural debt waiver schemes due to failure of crops for many reasons including drought and floods. When the banks, financial institutions and NGOs are planning to promote MFIs, the government controls and regulations should not give negative signals in relation the microfinance industry which would badly affect the sentiments towards the industry and its growth in the long run, especially when it is felt by the economists and planners that financial inclusion of poor could be achieved effectively only through promoting microfinance industry. Critical Issues Breaking the poor from the clutch of usurious local money lenders is an important Critical Success Factor (CSF) in microfinance. Higher initial investment in the introduction of technology in the business operation could be a prohibiting factor for the development. However, savings in cost in the long run justifies investment in technology. Effective exploitation of mobile telephony for interaction with the customers and for providing services is expected to save cost considerably. Higher rate of interest in the case of microfinance is a concern and mainly caused due to increased administrative overheads of the MFIs and the financial risk in lending, bad debts. The pricing of the loan at higher rate is justifiable, considering the other alternative of lending at exorbitant interest rates by the local money lenders, and the governments may not be in a position to make available funds at lower interest to the MFIs. Dunford & Denman (p. 29) state that the temptation of borrowers to avoid repaying the loans is strong unless there are credible incentives to repay and disciplined application of sanctions against non repayment. This aspect underlines the need for combining credit with education to the people covering health and nutrition apart from financial management for a sustained growth. The governments may in coordination with the central banks of the countries take measures to promote microfinance through the commercial banks and developmental financial institutions. Similarly the reforms in the industry are welcome for the healthy growth of the industry. Malpractices or mismanagement of some of the companies in the industry will destroy the whole edifice in the long run. The basic principle of trust and confidence required for the development of the banking industry is applicable in the case of microfinance companies also. Therefore, based on the policy guidelines issued by the federal or central governments, the central banks may formulate uniform rules and regulations for the conduct the business of microfinance for the whole country, instead of allowing each state separately to interfere with the functioning of the MFIs. This is very important because the impact of the regulations which are perceived as favorable to the consumers and encourages non repayment of loans, would affect the performance of the MFIs in the other states also, because they would like to take this as a cue for non repayment of their loans expecting wholesale waivers, which is detrimental to the economy and leads to the extinction of industry. Moreover, in a country like India almost all the banks and financial institutions are operating throughout India in all the states or at least in several states. Therefore, the managements of these companies are expected to follow uniform policies and procedures in conduct of their operations throughout the country in all the states, as they cannot follow different rules or procedures in different states for the same type of customers. Conclusion The Social Performance Task Force defines social performance as: "The effective translation of an institution's social mission into practice in line with accepted social values that relate to serving larger numbers of poor and excluded people; improving the quality and appropriateness of financial services; creating benefits for clients; and improving social responsibility of an MFI." (Microfinance Gateway, 2011) Financial performance alone is not an indicator reflecting the level of service to the clients. The achievement of eradication of poverty, the primary social objective and the sustainability of the MFIs need active support on the part of the government and the NGOs and the involvement of dedicated work force in their service to community. References Anyanwu, C. M. (2004) Microfinance Institutions in Nigeria: Policy, Practice and Potentials, Paper Presented at the G24 Workshop on “Constraints to Growth in Sub Saharan Africa,” Pretoria, South Africa, November 29-30, 2004. http://www.g24.org/anyanwu.pdf Armendariz, B. & Morduch, J. (2007) Aghion The Economics of Microfinance. The MIT Press. CRISIL (2009) India Top 50 Microfinance Institutions, http://www.crisil.com/pdf/ratings/CRISIL-ratings_india-top-50-mfis.pdf Dunford, C. & Denman, V., Food and Nutrition Technical Assistance (FANTA) Project, Academy for Educational Development, Washington, DC. http://www.microfinancegateway.org/gm/document-1.9.28920/33345_file_56.pdf Germidis, D. Kessler, D. & Meghir, R. (1991) Financial systems and development: what role for the formal and informal financial sectors. Development Centre Studies, OECD. GGAP (2011) Microfinance Gateway, http://www.microfinancegateway.org/p/site/m/template.rc/1.11.48260/1.26.9229/ Ghatak, M. & Guinnane, T. W. (1999) The economics of lending with joint liability: theory and practice, Journal of Development Economics Volume 60, Issue 1, October 1999, Pages 195-228, http://www.sciencedirect.com.ezproxy.fiu.edu/science?_ob=ArticleURL&_udi=B6VBV-3Y9TPMS-9&_user=2139759&_coverDate=10%2F31%2F1999&_rdoc=1&_fmt=high&_orig=gateway&_origin=gateway&_sort=d&_docanchor=&view=c&_acct=C000054271&_version=1&_urlVersion=0&_userid=2139759&md5=2e21b1d8af492e38424d92b492e9da72&searchtype=a Hartarska, V. & Nadolnyak, D. (2007) Do regulated microfinance institutions achieve better sustainability and outreach? Cross country evidence, Applied Economics, Volume 39, Issue 10, pp. 1207-1222. Hasan, M. M., Hassan, M. K. & Uddin, M. R. (2009) Local Government Investment Outreach and Sustainability of Microfinance Institutions: A Case Study of BURO, Bangladesh. The Journal of Social, Political, and Economic Studies, Fall 2009, 34, 3. pp. 318-346. ICMR (2005) SBI’s Microfinance Initiatives, Case Study Code: FINC043, 2005. http://www.icmrindia.org/casestudies/catalogue/Finance/FINC043.htm India Microfinance Business News (2010), Andhra Pradesh Microfinance Institutions Ordinance 2010 comes into force, 15 October 2010. http://indiamicrofinance.com/andhra-pradesh-mfi-ordinance-2010.html Khandakar, Q., Danopoulos, & Constantine, P. (2004) Journal of Political and Military Sociology, Microfinance and Third World Development: A Critical Analysis. Summer 2004. ProQuest Information and Learning Company. Kelly, M. (2011) A lending program for the missing middle, Mercycops, 21 January 2011. http://www.globalenvision.org/2011/01/21/lending-program-missing-middle Marr & Ana (2003) A Challenge to the Orthodoxy Concerning Microfinance and Poverty Reduction, ESR Review, Volume 5, Issue 2, pp. 7-42 Winter 2003, Brigham Young University, Marriott School of Management, USA. Mersland, R. & Strom, R. O. (2007), Performance and corporate governance in microfinance institutions, MPRA Paper No. 3887, 07 November 2007. http://mpra.ub.uni-muenchen.de/3887/1/MPRA_paper_3887.pdf Mersland, R. & Strom, R. O. (2009) Performance and governance in microfinance institutions, Journal of Banking & Finance, Volume 33, Issue 4, April 2009, Pages 662-669. Sundaresan, S. (2008) Microfinance: Emerging Trends & Challenges, Edward Elgar Publishing, Read More