Big financial institutions of all sorts are in dire straits across the globe. But one category remains unaffected—micro-finance. Even as the global financial system freezes and giants like Lehman Brothers collapse, micro-finance institutions (MFIs) are expanding unfazed. Famous financiers face defaults big enough to wipe them out, but MFIs report virtually zero default.
This is extraordinary. Big financiers lend against collateral, a back-up if their borrower defaults. But MFIs lend with no collateral at all. Big financiers lend to the most creditworthy corporations. MFIs lend to poor women whom nobody in history considered creditworthy before. Yet the secured loans to big corporations are bombing, while unsecured loans to poor women are being repaid in full.
How so? What lessons does micro-finance have for Wall Street? I distilled some answers from feedback from promoters of three MFIs that I myself have a stake in: Shubhankar Sengupta of Arohan, Kolkata; Rakesh Dubey of Sonata Finance, Allahabad; and Manab Chakraborty of Mimo Finance, Dehra Dun.
The big lesson for Wall Street is that lending against collateral, supposedly prudent, can blind you to the need for checking the repayment capacity of borrowers. US banks happily gave mortgages of 100% of the value of houses during the housing bubble, and suffered when house prices fell. So did august institutions buying mortgage derivatives. Some, like Lehman Brothers, borrowed massively to invest in AAA mortgage-backed securities, and went bust when value of these securities plummeted. A trillion-dollar house of cards was built on collateral. When the collateral value fell, the house of cards collapsed.
Lesson: don’t just depend on collateral, assess the cash flow of borrowers, and leave a cushion to ensure repayment. The housing bubble induced banks to give NINJA (no verification of income, job or assets) loans, secured just by house value. As house prices rose, their value exceeded the repayment capacity of borrowers. The rest is history.
Microfinance, by contrast, has no collateral at all. MFIs deliberately keep loans small, well within repayment capacity. Some MFIs give first loans of just Rs 5,000 a year. Those who repay qualify for a higher second loan, maybe Rs 7,000, and the third loan can be still higher. But MFIs set an absolute loan limit, ranging from Rs 12,000 to Rs 25,000, depending on local economic opportunities, to guard against over-borrowing. Wall Street needs similar safeguards.
US housing brokers get commissions from banks based on the size and interest rate of loans. This gives them incentives to fiddle documents and data to lend excessive sums at excessive rates of interest, increasing default risk. But MFIs have a fixed interest rate, and fixed ceilings on the first, second and subsequent loans. MFI field agents are trained to ensure that loans do not exceed repayment capacity. Mimo Finance, for instance, gauges the cash flow of borrowers by taking a quick look at the quality of their houses. Wall Street needs similar safeguards.
MFIs lend to groups of poor women. If any borrower defaults, the whole group is barred from credit, so other members put social pressure on the defaulter to repay. This is remarkably effective.
By contrast, defaulting home-owners in the US are treated as victims, offered subsidies and write-offs by politicians. Some home-borrowers may have been duped by brokers, but many others over-borrowed on the assumption of ever-rising house prices. Many bought houses to re-sell at a profit. Some can afford to repay but have decided not to, since default attracts no social opprobrium.
High inflation in India has not caused MFI defaults. MFIs report that worker-borrowers have demanded and got a 20% increase in wage rates, while small-businesses borrowers running tea shops have raised their prices from Rs 2 per cup to Rs 3. By contrast, home borrowers (or even giant corporations) in the US are unable to increase their incomes in line with borrowing costs.
So, the MFI model is small but sound. But don’t lavish excessive praise on it. Western banks lend far too much. But Indian lenders—including MFIs– lend far too little. Rural studies suggest that poor rural households need Rs 25,000 or credit per year. MFIs provide far less. The balance is made up by borrowing from relatives and moneylenders. The system cries out for more formal credit.
The aim must be to enable capable but capital-starved entrepreneurs to move beyond ownership of buffalos and tea-shops. At an MFI meeting in rural Dehra Dun, I saw an enterprising village woman pleading for a loan of Rs 50,000, saying (rightly) that this was the minimum needed for a decent shop. But the MFI regretted that this was beyond its lending limit.
So, don’t get too excited by the fact that we’ve avoided the excessive lending of Wall Street. Bemoan the fact that our stunted financial system fails to reach hundreds of millions. Microfinance has its merits, but is not enough. The big challenge is to move from micro-loans to mini-loans of Rs 50,000 to Rs 2 lakh. These alone can transform poor borrowers from objects of pity to objects of envy.