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Micro-Finance- Do we need more competitors or regulators?

Posted in Finance Articles, Total Reads: 2641 , Published on October 15, 2011

“Microfinance” is normally known as financial services for poor and low-income clients. In practice, microfinance is the service that enables low-income house-holds easy access to financial services to fund their income-producing activities, build assets, stabilize consumption, and protect against risks. [1]



Microfinance is one of the very effective ways of providing finance to the relatively low-income clients. It not only helps them sustain their life and operate their businesses but also gives them the opportunity to advance and live a better life. Also, it also helps the government to reach ‘the last mile’ and transfer the benefits of the economic development to each and every remote village in the country.

With this objective in mind, the government started allowing institutions to help the microfinance sector. This gave rise to microfinance institutions or MFI’s as they are generally known and this sector started developing. These institutions have helped a lot of low-income groups business and individuals prosper, especially in the areas of Andhra Pradesh, Maharashtra and Orissa. Of late, a lot of institutions have entered into the sector.

Where do these MFI’s receive their money from? The major source of money for these MFI’s is provided by the banks. Microfinance has been classified as a ‘priority sector’ and hence, with the government regulations on priority sector lending, banks form a major part of the money received by the MFI’s. Other sources of funds include private players, venture capitalists and corporates. Recently, one of the leading microfinance company SKS microfinance came out with an Initial Public Offer or IPO to generate funds through the primary market.

However, as time passed, the sector started facing its own problems. Some of these include a very high rate of interests and inefficient administrative models. What is also seen as a major concern is the shift in the basic purpose of the MFI’s. The purpose of MFI’s is now shifted from providing credit at affordable rates to making this a profit making business. The recent microfinance issue faced by the state of Andhra Pradesh is one of the best examples of the changing environment in this sector.

The ‘Malegam Committee Report’, which was declared in the last week of January, covers in detail, the various problems faced by the state governments as well as the local people while making use of the available microfinance. The reports suggests capping of interest rate, switching to interest-free lending or Islamic finance as alternatives to effective functioning of the microfinance model[2]. However, these measures do not seem to be sustainable steps, in the long run, to solve the problem at hand. Even though lower microcredit interest rates will help increase the horizon of availability of affordable finance for poor households, imposing ceilings on microcredit interest rates is not the answer. Lenders will incur losses if a rate ceiling is set at alevel less than that required for cost recovery, reducing an MFI's willingness and ability to expand operations, and discouraging potential investors from supporting the industry. Capping the interest rates as well as the margin cap will reduce the creditworthiness ofMFIs, reducing their ability to borrow from the market to finance their operations, and prompting a decline in thesupply of credit, contrary to expectations of policy makers who seek such a cap. Also rate ceilings would create an artificially highdemand for microcredit relative to supply and encouragecredit officers and others to adopt rationing devices that,in turn, create rent-seeking opportunities.Thus, Interest rate cap and margin cap are not an appropriate intervention.[3]

Does it then mean that we need more companies or regulators in the sector? More companies or regulators will definitely help in solving the problem to a certain aspect. But saying that this too will be sustainable in the long run is a question which needs to be answered. Increasing the number of competitors will help in reducing the interest rates and hence will increase the usage of microfinance by a large number of people. However, as time will pass, the profitability for such a sector will reduce drastically forcing companies to reconsider their options. Also, the entry of more competitors will mean the entry of private institutions which will again lead to a shift in the main aim of microfinance which is not generating profit but building a successful operation model which will not only address the issue of micro-lending to the poor but also inspire long term sustainability. On the other hand, increasing the number and quality of regulations may seem a good solution in the short run, but will this be sustainable and practically possible. More regulations may bring along with it a whole set of factors which may affect the efficient functioning of the company. Problems may include time lag due to increased bureaucracy, increased cost of documentations and other aspects along with increment in cost for such documentations which will again affect the interest rates.  Instead, what we can look into are other sustainable ways in which the interest rate issue can be resolved and long term sustainable measures be taken.

Microcredit interest rates are high because micro-lending remains a high-cost operation. The key to reducing these rates in a sustainable manner is to reduce costs through improved market competition, innovation, and efficiency.


The numerous strategies which may be employed to ensure the same, a few of which are introduced below

Improving physical, human and financial infrastructure is the key to reach the ‘last mile’ as well as reduce cost and maximize capacity.

Setting up of Credit Information Bureau and use of a technology outsourcing approach will help in regulating the working of MFI’s as well as help in plugging many loopholes in the system.

Leveraging mutual guarantees for gaining financial access is a novel approach which will use collateral substitutes and thereby saving on the cost, time and labour required for the realization of collaterals

Introduction of innovative and flexible products as well as services

‘Value added credit’ approach for overall community development on the lines of the ‘wadi’model for tribal development will help in cost reduction.

Participation of NGO’s for effective capacity buildingwill thereby helping in credit delivery systems

Last but not the least, sustainability of MFI’s and the corresponding model cannot be possible without achieving organizational sustainability (which includes importance of human resources and governance), financial sustainability as well as sustainability in mission.



Microfinance in India, K.G.Karmarkar.
The Malegam Committee Report.
Critical Analysis of the ‘Malegam Committee Report’.

This article has been authored by Kaushal S Sheth of K.J.Somaiya Institute of Management Studies and Research.

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