For a long time now, microfinance institutions (MFI) in India have followed the traditional operational model of procurement and distribution of money among rural people. However, during the past 10 years the industry changed radically with a new business model. An increasing number of large commercial companies have entered the fray, making the industry more formal. They have started to include more commercial and semi-commercial banks in the operational process. This has not only increased their clientele but also intensified their commitment towards customers. However, with increased business opportunity, there has emerged a graver need to upgrade their operational process. Apart from customer satisfaction there needs to be more emphasis on risk management, manpower efficiency, funding cycles and debt recovery, among other functions. These focus points need to be addressed especially in case of small scale microfinance institutions (SC-MFI) .
This is because they are still vulnerable in terms of their market position and have poor management strategies for credit risk, operational risk and liquidity risk. The meaning and consequences of the risks mentioned here have already been discussed in the previous article.
This research is focused on the problems faced by small scale microfinance institutions and also the reason behind those problems. To mitigate the number of variegated risks, these small scale microfinance companies invest on customer screening, monitoring, offer various incentives to avoid delinquencies (Dr. Steinwand 2000). Most important risk which is liquidity risk is mitigated through diversification of portfolio of funds (Fernando, 2007). However, the problem with their risk assessment system is that there is poor scrutiny of clients. Furthermore, geographical diversity of these institutions increase in fraud by staff and vulnerability towards repayment of loans. This is because most of the clients take agricultural loans.
Risks faced by small scale microfinance institutions
This section will explain the different types of risks in the small scale microfinance and the impact of such risks on the overall growth of these financial institutions.
A typical small scale MFI in India is exposed to several operational risks. A study by Bharadwaj (2014) points towards the presence of fake agents who “sell” loans in the name of the microfinance institutions. This causes increase in operational risk because of vulnerability to internal shocks and lack of transparency and clarity in operations (Singh, 2014). Secondly, most of the customers of small scale microfinacne companies are people who are dependent on agriculture for their livelihood and this automatically makes the situation risky (MicroSave, 2015). This increases the chances of default as in case of agriculture loans there are chances of moral hazard and adverse selection and natural calamities leading to loss of crop.
Other operational risks include chances of fraud by employees of the company due to poor scrutiny infrastructure. Similarly failure to digitalise their operational processes in order to reduce processing time make their customer service more inefficient. Due to poor addressal of these risks these organizations continued to face issues of credibility, transparency and default.
Small scale MFIs’ are also exposed to several environmental risks (internal and external) due the factors like lack of access to capital market, poor mobilization of funds and ineffective institutional support for poor performance. One of the major external risks posed in this industry is increased competition. During the past decade competition has intensified manifold with many foreign firms investing in small microfinance players. This led to a sales push without due consideration to the borrowers’ repayment capacity (Kono and Takahashi, 2010). Apart from this, other internal risk posed in this industry is lack of skilled manpower to effectively assess the performance of firms and execute remedial strategies. The manpower deployed in such institutions often lacks the educational credibility to carry out their tasks. The industry is also vulnerable to macro-economic changes such as governmental policies and regulatory frameworks.
Liquidity or Credit risk
Liquidity risks are another type of risk faced by the Indian microfinance industry. The industry is heavily dependent on cash as a mode of transaction, especially repayments, as they are of small value. Therefore when the government announced its demonetization move in October 2016, it severely impacted the industry as people’s repayment capacity was hit. Growth rate slowed down from around 89% in 2015-2016 to 26% in 2016-17 (Indo-Asian News Service, 2017). Therefore the industry’s rampant dependence on cash as a mode of exchange is a constant liquidity risk. Other such credit risks are discussed here.
Factors associated with risk management in small scale microfinance
Small scale microfinance institutions in India suffer from a range of risk management problems. Common problems are
- increased competition,
- operational risk and managerial inability (due to wide geographical presence),
- lack of understanding of risk management,
- lack of board member’s engagement,
- poor management response to internal fraud,
( Fernando 2008).
There are numerous factors like government policies, economic and environment aspects and political dynamics that lead to such problems. Explaining the operations of such small scale institutions, Bharat Microfinance (2016) pointed towards the lack the vision of risk management, lack of control on the risk culture and resources to implement risk mitigation techniques. This report also found that they agreed that 40% of their organization board members do not have a risk management committee and 32% do not have risk manager and 23% do not have internal auditor.
The concentration of small scale microfinance institutions in remote rural areas of the country exposes them to operational risks as these institutions are often away from their main branch. The staff of the organization are more likely to indulge in fraudulent activity there is no direct monitoring. In addition to this, there is less incentive to commit to client satisfaction, which thus leads to poor repayment methods and rising debts for the MFI. Also, the presence in such remote locations sometimes invites pressure from local political parties to perform unfavourable actions such as waiving off loans or penalties.
Exponential short-term growth
One of the biggest events to have taken place in India’s microfinance industry is the Andhra Pradesh crisis, which affected the whole system of microfinance in India. Small scale microfinance institutions, under sudden pressure from investors to increase their sales, resorted to poor management practices. This includes failing to assess credit risk of customers, lending aggressively beyond the repayment capacity of the borrowers, charging high interest rates and adopting coercive collection practises. This created a political upheaval in the state and an ordinance called ‘Andhra Pradesh Microfinance Institution Act, 2010’, which restricted the operations of the MFIs’ (Guiyazuddin and Gupta, 2012). The incident of “AP Crisis” affected the lives of several million rural people. At that time around 40% of the market share of microfinance industry was in Andhra Pradesh, mainly run by small players (Legatum Ventures, 2011).
In the past India’s microfinance industry has been reshaped by another main event which came to be known as “Krishna crisis” in 2006. The local politicians and the industry were in deep disagreement due to which the politicians appealed to the local people not to repay the loans taken from small scale microfinance institutions. Interest rates were regularlised by the central bank in 1990 and this was a politically sensitive issue. Some small and local MFIs’ in Tamil Nadu, Karnataka and Andhra Pradesh were accused of charging high interest rate from the people (CRISIL, 2009).
Due to the political interference no MFI was allowed to carry out its operations without registration with the government. This halted the operations of MFIs’ and disturbed the discipline of the borrowers. This inturn delayed the payments and number of default cases increased the crisis. The chaos in the MFI industry was at peak and capital in the form of funds was drying at a faster pace with no possibility of profit making (MicrofinanceFocus, 2011).
Need to develop a effective mechanism for risk management
Microfinance industry in India in general has seen major events, especially in the last decade. Small scale microfinance have been largely affected by this, mainly in the southern states like Andhra Pradesh and Tamil Nadu which are heavily dependent on agriculture. Despite the growing number of threats to its operations, the industry can reap the benefits of certain moves like facilitating micro-insurance and micro-pensions for their clientele to diversify their funding portfolio.
The risk management in these micro finance institutios is of concern as there are several loopholes present in their management. Similarly any event similar to the “AP Crisis” of 2010 will again reduce the pace of growth in this industry. The small scale microfinance institutes will have to bear the brunt of such crisis even more if the lack of managerial skills especially for risk continues to remain. There is definitely a need for developing a mechanism to mitigate the risks and take the advantage of the opportunities that will come ahead of these microfinance institutions.
- Bharadwaj, S. K. & D. G. N. (2014) ‘AN ANALYTICAL STUDY OF MICRO FINANCE INSTITUTION IN INDIA’, Centre for Financial Services.
- Bharat Microfinance (2016) Microfinance in India 2016. New Delhi. Available at: http://indiamicrofinance.com/wp-content/uploads/2016/09/The-Bharat-Microfinance-Report-2016.pdf.
- CRISIL (2009) India top 50 MicroFinance Institutions. Mumbai. Available at: https://www.crisil.com/RatingsSite/CRISIL-ratings_india-top-50-mfis.pdf.
- Dr. Dirk Steinwand (2000) A Risk Management Framework for Microfinance Institutions. Eschborn. Available at: http://www.ruralfinanceandinvestment.org/sites/default/files/1126266387218_A_risk_management_framework_for_MFIs.pdf.
- Fernando, N. A. (2007) Managing Microfinance Risks: Some Observations and Suggestions, Asian Journal of Agriculture and Development.
- Guiyazuddin and Gupta, S. (2012) Andhra Pradesh Mfi Crisis and Its Impact on Clients. Available at: http://www.microsave.net/files/pdf/AP_MFI_Crisis_Report_MicroSave_CMF_Ghiyazuddin_Gupta.pdf .
- Indo-Asian News Service (2017) ‘Indian microfinance loans grew 26% in Q4 of last fiscal’, India.com, 18 May. Available at: http://www.india.com/news/agencies/indian-microfinance-loans-grew-26-in-q4-of-last-fiscal-2145904/.
- Kono, H. and Takahashi, K. (2010) ‘Microfinance revolution: Its effects, innovations, and challenges’, Developing Economies, 48(1), pp. 15–73. doi: 10.1111/j.1746-1049.2010.00098.x.
- Legatum Ventures (2011) Microfinance in India: a Crisis At the Bottom of the Pyramid. Dubai. Available at: http://www.legatum.org/attachments/MicrofinanceCrisis.pdf.
- MicrofinanceFocus (2011) 6 microfinance crises that the sector does not want to remember, MicrofinanceFocus.
- 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.
- Nimal A. Fernando (2008) Managing Microfinance Risks.
- Singh, V. (2014) Indian Microfinance Sector in Capital Markets : Perils and Prospects. Indian Institute of Technology, Bombay.