As elucidated in the previous piece, we can argue that Indian Microfinance may not have fulfilled all its early promises. However, it can be no one’s case that it hasn’t been impressive in its growth. How do we reconcile this dichotomy? In this piece we will talk about the issues that restrict growth of Indian Microfinance.

Before we delve any deeper it is important that we define how this line of business is different from any other? Microfinance business has following peculiar characteristics

• There are multiple transactions at high frequency with smaller ticket size
• Customer segment is (at least intended) poor and resultantly poorly informed/documented
• Customer isn’t always tech-savvy
• Physical infrastructure is patchy to non-existent as higher density of customers would be found in either rural areas or slum locations.

Now that Indian microfinance has been around for over a period of over 25 years, one would be correct to assume that it would have it all figured out in terms of risks. This holds true for most of the operational risks. MFIs have become well-equipped over the years to deal with those.

But then why do MFIs frequently go bust? The number of failures make it clear that there may be more what meets the eye. In fact, the major reason for even slightly bigger MFIs’ failure has been ALM mismanagement or funds diversion, rather than business failure (at least five of the bigger ones in public knowledge in the last 10 years), We argue that these failures are mainly on account of strategic/environment risks related to governance structure of the MFIs leading to either hubris on part of executives or lack of depth to deal with external challenges.

We can use a simple framework to put these risks into perspective.

Risk Category	Factor	Description	Risk	Impact	Impact Level
Strategic/ Environment	Compete nt board and independ ent board committe es to supervise and guide manage ment	Often, promoter groups find people they personally know, to form independent directors’ block in the “Board of Directors (BoD)”. They may not always be the most competent people around and also may have conflict of interest to voice their independent opinion.	In absence of a competent and independent board, executives are likely to go overboard to grow the business. They take on more than what they can chew or, or their decision, intentionally or unintentionally lead to outright diversion of funds.	Microfinance industry frequently witnesses cases of both kind of failures: MFIs going belly- up (not able to repay loans) and fund diversion. Surprisingly, these issues are always examined post-facto. Despite such regular occurrence, no institutional mechanism seems to be in place to arrest such cases.	Industry

	Insulatio n from local level political interfere nce	Local law enforcement agencies and small-time politicians may find MFIs lucrative targets for rent seeking	MFIs are prone to local level political interference on account of their business being perceived as informal in nature.	Examples of these galore from early 2004 Nizamabad crisis to 2005 AP crisis to 2011-12 AP and Karnataka crisis.
Operational	Level playing field   for all – new/old as well big/small MFIs	To be cost-effective, microfinance institutions rely on unskilled/semi- skilled young graduates. There needs to be a considerable investment in their capacity building. There are some innovations happening using “nudge” mechanisms prompting borrowers and use of “Credit Bureau” to ensure credit discipline. However, it is largely still a human effort driven approach.	With the workforce unequipped to deal with events which don’t follow a pattern, there is ample opportunity for stakeholders with malicious intent to muddle credit discipline.	In the last five years there have been at least three big supply side shocks i.e., demonetization, Covid-1 and Covid-2. Matured MFIs have dealt with these risks much more efficiently than the neo- age ones, which is reflected in their repayment numbers. Multiple MFIs have gone belly-up during these crises.
	Product fit – customer centricity	Most of the MFIs start with plain vanilla product – with ‘one product fits all’ approach, with even the methodology being the same.	In absence of customer centric products, there is low customer loyalty and tendency to switch to new players as soon as one comes around. MFIs are letting go of opportunities to innovate	Customer apathy leads to low customer loyalty as well as gives chance to other financial players to reach out to customers	Organization
	Identifica tion – KYC collection , credit profile data points and loan applicati on filing	For most field staff, it is a physical activity with household to establish identity, collect data and physical application form. Safe-keeping of bulky documents as well as data integrity is questionable	Use of technology hasn’t been thought through. Mostly it is used to replicates physical process	In absence of objectivity, probability of staff manipulating data is high, as their incentives are linked to loans disbursed. The results for the MFIs follow the principle of “Garbage In, Garbage Out”.

Putting these “Critical Factors” in context, to realize its full potential, Indian Microfinance needs to have followed enablers, going for it.

The most important reform that the RBI needs to think about is treating these financial institutions for what they are, important financial service players at par with banks and in some cases larger than the scheduled banks also. We are glad that there has been movement in that direction and a recent consultation paper of RBI is a welcome first step. However, we propose the following

Governance Reforms

• This is the most critical area where regulators need to support the MFI ecosystem. Though most of the commercial MFIs have investor nominated directors as well, still the talent pool at the BoD leaves a lot to desire. It is understandable that when a new company is being set-up, the promoter group would look for those known to them as being part of the Board. However, once a certain scale is achieved, these independent directors may not have much to add to the business. However, the promoter group may not have access to a pool of such competent individuals. This is where the RBI with help of SROs can help create a pool of interested individuals who are keen to add to the industry in lieu of regulated monetary benefits but who are truly independent. Much like how the jury system works in some of the countries, MFI can reach out to this pool and can appoint independent directors to the board depending on their requirement.
• Each MFI could have a minimum number of board committees comprising of mix of independent as well as investor directors to balance interests.

Industry treatment at par with Banks

• Given the growth and role Indian MFIs play, they need to be treated at par with banks beyond a certain scale. That means that the RBI need to be involved in strategic roles. This would at one hand would give much deserved recognition to the industry as well as insulate industry from local level politicking.
• MFIs should seek increasing voice in industry advocacy forums. This will enhance cross-domain flow of views and expertise as well as do much to enhance its image.

De-regulation of interest rates and product norms

• While at one point of time this must have been a requirement especially in wake of multiple crises, however, now it may be proving counter-productive. This puts a kind of artificial ceiling and may make a few small ticket-high frequency products non-competitive for MFIs. Doing away with these non-essential regulations would spur innovation in field of product as well as processes. Given the diversity of business activities and demographical profiles of target segment, this is the need of the hour. This will also give a better level playing field to late entrants who can compete with established players based on their products/processes.

Along with the role RBI needs to play, SROs have equally important role to play to eliminate operational risks for MFIs.

Workforce Empowerment

• SROs need to put in place minimum service standards for their member MFIs in terms of education, compensation as well as training requirements
• Fair representation of underserved social groups in workforce with special focus on women participation
• Grievance redressal mechanism for employees as it can give significant insights about actual ground level operational policies

Client Empowerment

Clients need to be at the center of all that MFIs does. In this regard we suggest the following

• Code of conduct needs to be replaced with a service charter declaring clearly what clients should expect from MFIs? Client charter should be seen as minimum service level and not as the maximum that MFIs need to do.
• SROs need to strengthen their quasi-regulatory role using methods such as mystery shopping or quality assessment of customer grievance redress systems
• Client financial literacy levels need to be assessed before extending them financial products
• Clients’ trainings could also be digitally recorded and available for timely audits by the SROs

We can safely conclude that all players in the Microfinance ecosystem be it the RBI, SROs as well as MFIs have shown exemplary learning abilities to deal with challenges. During these times they have dealt with it all political interference, unfavorable business environment as well as mass defaults. However, it has come out strong with every crisis. Still there are a few factors which lead to both strategic as well as operational risks. Interested stakeholders would do well to address these factors to usher in new era of more inclusive growth in coming times.

In the last part of the series, we are going to talk about how the MFIs need to go about harnessing most of opportunities which are available or in near future, going to be available to them.