Consequences of risk management faced by microfinance institutions (MFIs’) in India

Microfinance institutions (MFIs’) serve two major needs of the rural poor population in India. These twin needs are the financial and social support to fulfill their needs. One of the most critical salient features of the Indian microfinance industry is that most players operate on the lines of the Non-Government Organization (NGO) system (Mimo Finance, 2011). Therefore, they are still struggling with profit making. Also, these institutions do not give much importance to risk management in their operations. Due to this, they face problems such as default and delinquencies in their business.

The previous article talks about the problems of risk management in small scale MFIs’ and to take the research ahead this article focuses on the consequences of those risks. Most importantly, the lack of risk management strategies by small scale MFIs’ leads to a reduction in the confidence of the borrowers, financial donors and investors which automatically raises the issue of sustainability in the long term.

Empirical Investigation on the consequences of problems associated with the risk management

This section will focus on the major problems faced by the MFIs’ with respect to risk management. Previously many researchers have also highlighted the problems and some of the empirical studies has been discussed below.

Increased fraud by client and staff

A lack of credit risk management system leads to frauds, defaults and even delays in payment. A report by Community Development Financial Institutions (CDFI) (2013) sheds light on the lack of transparency in operations and weak controls in the bookkeeping process of MFIs’. The issue of fraudulent activity is very much prominent in small scale MFIs’ as they have a small functioning and operational activity. Also, they lack the resources to conduct a thorough credit assessment of their clients and their employees’ activities. Therefore, sometimes the fraud is not taken seriously and it increases at a greater proportion in the future.

Reduction in profitability

Limited client base to make profits and very few financial donors make MFIs’ more prone to market risks which also include the interest rate risk. The reason is that their returns are almost entirely dependent on the interest rate. However, if there are lower interest rates or stagnation in the interest rate, their profits will start burning up rapidly (Fernando, 2007). This will eventually lead to their inability to sustain operations and eventual demise of the business.

Issues with the credibility of institutions

The operations of MFIs’ in general and small scale MFIs’ in particular are drifting away from traditional grant funds and are increasingly relying on the commercial bank funding. This is increasing the accountability and commitment towards the banks to repay the loan. However, at the micro level, these institutions are still struggling with the events of the defaults and delinquencies. Increased rate of these events in the past has turned down the credibility of various institutions (MicroSave, 2015). This has a twin effect:

1. first on the profitability
2. and second is on the fact that small scale MFIs’ are not able to help the poor who are in actual need of a loan.

Lower rural financial consumption

Majority of the loans taken by people in rural areas are for supporting agricultural activities which makes both the borrower and institution prone to weather risks. Any decrease in the crop output leads to default in the payment of the loans and also a reduction in the consumption of the loans. Small scale MFIs’ have limited clientele and reduced consumption of loans due to any crisis further reduces their business. But sometimes, despite higher need of the loan by rural people, especially women, microfinance institutions are not able to gather sufficient funds from their lending bank, creating a mismatch in the supply and demand (Vetrivel & Kumarmangalam 2010).

Some remote parts of India are still not familiar with the concept of MFIs’ and have to source funds from informal moneylenders, relatives, and friends. The consequence of such an occurrence is that there are increased chances of harassment for loan repayment and high suicide rates in these villages.

Critical insights on overall consequences on the economy

Several consequences have already been highlighted but discussing the case of Andhra Pradesh microfinance crisis is warranted to demonstrate the consequences of risk management problems. A chain of events transpired immediately following the crisis. This includes a reduction in the financial portfolio of the state’s microfinance industry to less than $3 billion. Secondly, the clientele dropping to less than 20 million. And finally, these consequences made matters worse for MFIs’ which failed to get new loans sanctioned from the lending banks (Devi & Shaikh 2017).

The ill effects of failure of risk management in microfinance industry have been well presented in the study by Swain (2008). The author has presented that uncertainty and high volatility in profits due to risks in MFIs’ can lead to the country being caught in the hands of poverty and an increase in the level of vulnerability. The whole scenario of taking and repayment of a loan becomes risky leading to vulnerability of the low-income group of society and decline in the revenue of the small scale MFIs’. This also slows down the rate of financial inclusion of the population.

Apart from that, there are several studies indicating that the rural infrastructure, education, employment and overall level of development gets affected if there is no proper functioning of the channels of financial sources. In other words, small scale MFIs’ are a monetary lifeline for the rural sector.

Infrastructure development

Loans granted by small scale MFIs’ enter the rural economy in a way that people can improve their livelihood through agriculture, construct a house and start small businesses for self -employment. It also leads to improved infrastructure (Swain 2006). However, the issue with the funds sanctioned by small scale MFIs’ is that they are not sufficient to develop infrastructure beyond a certain limit in these rural areas. The credit connection with infrastructure development in rural areas has importance for rural housing. In this case, progressive housing is targeted by small scale-MFIs’. But to accomplish the task of housing, road construction, building construction a long way is yet to be covered (DFID, 2000).

Education

The presence of credit for the education of children in rural areas is essential. MFI play an important role in channelizing the required credit. Microfinance schemes are also designed to target housewives. This includes disbursing indirect benefits such as meeting household expenses which also include child education (Holvoet 2004). Also, studies suggest that with a flow of credit in a household, opening up of small enterprises and education rises.

Employment

Most researchers agree that microfinance leads to self-employment and job creation (Calvo, 2014). Statistics from previous years have shown the exponential rise in employment due to inclusive and innovative frameworks offered by MFIs’. These institutions through funds deployment enable political support towards the community, increase availability of resources, encourage entrepreneurial activities. Similarly, it also fosters cooperation between public and private entities (Assocham, 2016).

MFIs’ should focus on risk management to avoid a crisis

Despite the wide number of advantages that the microfinance industry can have on the rural economic sphere of the country, it will not be enabled without the deployment of a modernized framework for risk management. The techniques of risk management are known but to implement them in accordance with the need is a challenge. For instance, before the Andhra Pradesh crisis, the operations of small scale MFIs’ were plagued with several problems which caused a major upheaval. This case has certainly raised doubts on the sustainability of MFI. Year after year, growth in overall microfinance industry is at a slow pace. This is majorly due to the reasons mentioned in this article and is a cause of concern.  Therefore, government and  National Bank for Agriculture and Rural Development (NABARD) needs to intervene when required.

References

• Assocham (2016) Evolving landscape of microfinance institutions in India. New Delhi. Available at: http://www.ey.com/Publication/vwLUAssets/ey-evolving-landscape-of-microfinance-institutions-in-india/$FILE/ey-evolving-landscape-of-microfinance-institutions-in-india.pdf.
• Calvo, S. G. (2014) Financial Crises , Social Impact , and Risk Management : Lessons and Challenges, World Development Report.
• Cdfi (2013) Nuts and Bolts of Microfinance Risk Management Examples and Tools, 2013.
• DFID (2000) Microfinance for Infrastructure: Recent Experiences.
• Fernando, N. A. (2007) Managing Microfinance Risks: Some Observations and Suggestions, Asian Journal of Agriculture and Development.
• Johnson, S. (2004) ‘Microfinance, Poverty and Education’, in Development and Change.
• MicroSave (2015) Governance Practices Among Microfinance Institutions in India. Available at: http://www.microsave.net/files/pdf/1434520255_Governance_Practices_among_Microfinance_Institutions_in_India.pdf.
• Mimo Finance (2011) Enabling A Formal Risk Management Culture At Micro finance Institutions.
• Nathali Holvoet (2004) ‘Impact of Microfinance Programs on Children â€^TM s Education’, Journal of Microfinance, 6(2).
• Pagadala Suganda Devi & Mohammed Arif Shaikh (2017) ‘Risk management practices of select microfinance institutions in Telangana State, India’, International Journal of Economics and Management Systems, 2.
• Rajula Swain (2006) ‘Microfinance: a Catalyst for Development at Macroeconomic Level?’, Finance & Bien Commun.
• S.C.Vetrivel & S. Chandra Kumarmangalam (2010) ‘ROLE OF MICROFINANCE INSTITUTIONS IN RURAL DEVELOPMENT’, International Journal of Information Technology and Knowledge Management, 2(2), pp. 435–441.
• Swain, R. B. (2008) ‘Department of Economics Working Paper Series Effect of Microfinance on Vulnerability , Poverty and Risk in Low Income Households By : Ranjula Bali Swain and Maria Floro’, Department of Economics Working Paper Series.