Effects of Demonetisation on Microfinance in India

microfinance

This is a guest post by Arunkumar Krishnakumar, who is deeply involved in the early stage Fintech scene in London but was raised in India. So he is highly qualified to write about this important and controversial topic.  

Muhammad Yunus, who was awarded the Nobel Peace Prize for founding the Grameen Bank and pioneering the concepts of Micro Finance, said:

“I did something that challenged the banking world. Conventional banks look for the rich; we look for the absolute poor”

The Micro Finance industry, despite being hailed as a saviour of the poor, has had a turbulent ride in many parts of the world. There have been various incidents in the emerging markets where farmers have committed suicide when they haven’t been able to pay off their debts. As a result, the industry was regulated in some parts of the world, and institutions offering Microfinance had to adopt different credit strategies. While the focus of many of these institutions have moved away from achieving volumes to offering affordable micro-credit, the global average rate of borrowing is about 30%.  Micro Finance in India has been no different and has had its ups and down. The recent Demonetisation (DEMON) drive in November 2016 looks like a setback to the primarily cash based Microfinance industry.

Microfinance in India:

In India, pioneer Micro Finance Institutions (MFI) operated as non-profit, non-governmental organisations with a strong social focus. They developed new credit techniques; instead of requiring collateral, they reduced risk through group guarantees, appraisals of household cash flow and small initial loans to test clients. In recent times, MFIs have transitioned from non-government organisations to nonbanking finance companies (NBFCs). As a result, once primarily donor-led, MFIs are now increasingly funded by banks and private and shareholder equity.

The Indian Micro Finance industry hit its peak in 2010, when SKS Microfinance, one of the industry leaders had its IPO. Muhammad Yunus, hailed as the father of the industry, criticised the move as the IPO was fundamentally conflicting with the principles of Micro Finance. The IPO offered at $350 million was 13 times over-subscribed. But due to reckless lending and strong-arm collection tactics that followed, strict controls were imposed on the business and loans written off which resulted in a slump. However, over the past few years, regulation of MFIs has been centralised in India and the industry growth stabilised. By 2016 the size of the industry in India was about $8.2 Billion serving over 40 Million customers. About 40% of this industry thrives in the four southern states of India.

In a country traditionally notorious for lack of women empowerment measures, MFI has been a shining light. About 70-80 per cent of the customers are women with a repayment rate of about 95 per cent against repayment rates of about 70 per cent for middle class men who form the primary borrowers for commercial banks.

DEMONetisation

In November 2016, the Indian government launched a huge DEMON drive when they banned 500 and 1000 Rupees notes. In a country where 69% of the population lived in rural areas and 90% of the transactions are cash based, the move was paralysing. For the Micro Finance industry this came as a blow too. Most of the borrowers of the MFIs are based in rural areas; they borrow in cash and repay in cash. Typically, MFIs that have had a repayment rate of 99% have had a fall of upto 12% in repayment rates. For many MFIs the non-performing assets (NPA) have risen by 7-10%.

For a discussion of the impact of DEMON in India please go to this thread on the Fintech Genome.

What does this mean for the MFIs? It might just be a short term blip, rather than a long term trend. However, these MFIs could be affected by the DEMON drive, and the resulting non-payments by their borrowers. While the borrowers will have some negative effect on their credit scores, it might be a bigger issue, if that affected the credit worthiness of the MFIs themselves.

What does this mean for the borrowers? Particularly farmers and SMEs that make up most of the customers are affected in a big way. The drying up of liquidity that the DEMON drive has caused has affected cash dependent rural communities in a big way. Especially in the southern states of India, the drought this year has made matters worse. In Karnataka, about 800 farmers committed suicide in the 12 past twelve months due to the drought and mounting debt, although what percentage of that is due to pressures from MFIs is unknown. In TamilNadu, my home state, farmers-suicide due to debt issues is almost a daily occurrence. There have been several cases where farmers have had to borrow from local lenders at higher rates, to pay off the MFIs, as MFIs tend to be stricter on their debt collection dates.

What can be done about all this? While these are certainly tragic incidents, there are various avenues the government and the MFIs have explored and continue to explore. One positive outcome of it all is that, the top 8 MFIs in India that hold about 40% of the market share, have now been provided the small finance bank licenses. Which would mean they can have their own cash out points and the DEMON drive is very likely to increase usage of their accounts. MFIs have also been lobbying with the Reserve Bank of India (RBI) to extend deadlines for the usage of the banned currency notes and farmers have had some special exemptions to this extent. RBI has also provided MFIs with a further 90 days extension before classifying loans as NPAs, if payments were due in November and December 2016. There have been some signs of recovery in certain parts of the country where repayments had fallen immediately after DEMON. However, most industry experts expect that there would be a further increase in NPAs before the industry recovers.

While the industry shows every sign of recovery, the livelihoods of drought stricken farmers are still up in the air.

PS: I am a big fan of Narendra Modi and his DEMONetisation measures. However, these were some of the unintended effects of such a huge initiative in a land of 1.3 Billion people. The human cost is clearly terrible, yet we have not seen the final chapter in DEMON. If it leads in the end to a more efficient digitized Micro Finance industry, it will have a positive impact on the poor in India and will be studied by other countries facing a similar mission.

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LendUp $150m round shows Underbanked market needs patient capital

patience-is-a-virtue-crop

The Underbanked is one of those inevitable but not imminent markets. It is inevitable that the next billion people entering the global middle class wired to the world through their mobile phone will be a massive market. However it is not imminent. You cannot realistically forecast when this will be big. You need patient capital to fund ventures in the Underbanked market. The recent LendUp $150m raise shows this patient capital in both the debt ($100m) and equity ($50m) portions.

Think like a VC, invest like a Debt Fund

The $100 million in debt came from a fund called Victory Park and will be used to finance LendUp loans.

When you look at Victory Park on Crunchbase you see a fund that is equally comfortable investing in equity or debt. This goes against prevailing wisdom on Wall Street that your fund should be defined by the asset class; you should be either a debt or an equity fund. Victory Park looks more like a thematic fund focused on Altfi (although Victory Park’s own site currently emphasizes the credit/debt part of the story a bit more than the equity part).

No explanation risk or liquidity risk
The $50 million equity portion came from investors like Google Ventures, QED, Kapor Capital, Yuri Milner, SV Angel, Eagle Cliff, Bronze Investments.

What many of these investors have in common is that they are investing their own money (corporate money in the case of Google Ventures).

That means they have neither explanation risk nor liquidity risk compared to traditional funds with LPs putting in most of the capital:

  • Explanation risk. If you invest your own money and it does not work out, you learn from the experience and move on.If you invest other people’s money and it does not work out, it is ok if you invested in what everybody else invested in. However if you invest in something contrarian and it blows up, you have a tough time explaining this to LPs.
  • Liquidity risk. Traditional VC funds need to return money to LPs within some defined time in order to show a track record to raise the next fund. This is OK if you invest in a market that gets quickly to scale. A market such as the Underbanked, which may take a long time to get to scale, needs patient capital. Individuals and family offices often take a multi-generational view. They are “long term greedy”.

Patience is needed to get to Underbanked Version 3

  • Underbanked 1.0: The Gameen Foundationproves that default rates can be low when lending to the very poor. Microfinance is born. This was possibly the most important financial innovation in the last 50 years.
  • Underbanked 2.0: Fast money rushes in to Microfinance and interest rates go to a level that is still better than loan sharks, but not the low rates that billions need in order to escape from poverty. This almost killed Microfinance by giving it a bad reputation.
  • Underbanked 3.0. This is emerging at the moment and is characterized by innovators such as LendUp and others that we have profiled here on Daily Fintech.

The Underbanked is not a suitable market for the VC to IPO high velocity startup model where GPs need to show liquidity to LPs within a defined time. Nor is it a good market to replace subprime mortgages and pay day lending in the debt markets. The Underbanked is a market where scale matters and it takes time to get to scale. Low prices (aka low spreads in financing terms) has been proven to work at scale. There is money at the base of the pyramid, but not if you treat it like a get rich scheme.

Daily Fintech Advisers provide strategic consulting to organizations with business and investment interests in Fintech. Bernard Lunn is a Fintech thought-leader.

 

Microfinance 3.0 to tap the massive Underbanked opportunity

microfinance-pyramid

By Bernard Lunn

  • Microfinance 1.0: The Gameen Foundation proves that default rates can be low when lending to the very poor. Microfinance is born. This was possibly the most important financial innovation in the last 50 years.
  • Microfinance 2.0: Fast money rushes in and interest rates go to a level that is still better than loan sharks, but not the low rates that billions need in order to escape from poverty. Microfinance may not be a suitable market for the VC to IPO high velocity startup model. This almost killed Microfinance by giving it a bad reputation.
  • Microfinance 3.0. This is emerging at the moment and is characterized by three innovations.
  • Free payment wallet with low cost micro payments and simple ways to save money. Look at Ffrees to see how to do this well.
  • Impact investing and philanthropy. Kiva made this accessible and compelling for millions.
  • Poor lending to the poor via a platform. The closest I have found to this is Zidisha. It is peer-to-peer micro lending. Conceptually, the beauty of this model is it “kills two birds with one stone”. The poor get both a saving account (they lend their excess cash) and a lending account (they borrow when they need extra cash).

This is financial inclusion in action and is key to lifting billions out of poverty into a global middle class (and that will be key to global growth). More innovation is needed and is coming in the form of:

  • Digital Identity via mobile devices
  • Asset recording and exchange via Blockchain technology.

Most bankers and most entrepreneurs fight over the Overbanked in the West (spoilt for choice and very rarely switch suppliers) and ignore the massive Underbanked blue ocean market where demand is strong and supply is weak.

Daily Fintech Advisers provide strategic consulting to organizations with business and investment interests in Fintech.