Ramesh S Arunachalam
Rural Finance Practitioner
Micro-finance loan assets have several peculiarities that need to be carefully considered while devising regulation and supervisory arrangements – irrespective of whether MFIs (different legal forms) or Business Correspondents (various types of legal entities) are involved in the last mile intermediation. While much of what I am talking about applies to the Indian context very well, the same general principles can easily be used by governments, central banks and donors in other environments as well…Read On…
Unique Characteristics of Micro-Finance and Associated Problems:
First, MF loan assets tend to be predominantly small in amounts but large in number. Second, while the transactions are also small, they are however numerous (repetitive) and most often, predominantly cash oriented – this makes it difficult to trace the source as well as end use. Third, the geographic diversity is huge and these assets tend to be spread over remote rural areas and/or urban slums that make it rather difficult to physically locate them. Therefore, establishing the identity of the micro-finance borrower and hence, the loan asset becomes rather difficult. Fourth, while many of the lenders ask for KYC documentation, it must be noted that what is provided is far from accurate. Therefore, it is very easy for an MFI to show the same assets for different lenders and re-deploy the (surplus) funds in other activities like real estate and the like. I have solid documentary evidence of this happening in India and a lot of this was highlighted as far back as May 2005, in the (now infamous) paper of Thorat and Arunachalam (2005)
Thus, as noted above, these peculiarities can cause serious problems in supervision of micro-finance assets and especially, those who buy these securitized assets must be very careful as there is a good chance that the may be no real persons at all with the associated assets or the assets themselves may have been hypotheticated or pledged to other lenders
Some Practical Strategies For Regulation/Supervision:
Ensure Exclusivity of Micro-Finance Assets: Thus, the only way to safeguard against the above is to ensure the exclusivity of micro-finance assets to specific lenders and that is something that only the regulator can mandate via regulation and ensure through supervision. As per this, each MFI will have to exclusively earmark certain number of whole branches/units across its portfolio and geographies to respective lenders. And this should not be done on a geographic basis as then it may be unfair to some lenders – rather allocation of branches should be done in a fair manner using stratified (by quality of branches) random sampling methodology to ensure that all lenders get a somewhat equal share of excellent, good and ordinary branches. This will ensure equitable distribution of portfolio at risk across the lenders
Mandate A Consortium Approach For Lending To Large MFIs: Further, the lenders will also have to take a consortium approach to lending to the MFIs (at least for those MFIs that have portfolio greater than US $ 100 Million or Rs 500 crores). This will prevent MFIs from setting off one lender against another and also ensure that the micro-finance market is less of a borrower-dominated market. If one were look at the instances in the years 2007 – 2010, there are a number of cases from India where MFIs set off one lender against another and this led to dilution of terms and conditions, including monitoring and supervisory arrangements. In my opinion, a lot of the present problems in India are due to such aspects.
Again, “consortium lending” is something that only the regulator can mandate via regulation and ensure through supervision. And make no mistake, no lenders forum (even those established through the responsible micro-finance project) can ensure consortium lending because by their very nature, the lenders are fierce competitors for the available large and medium sized MFIs. Therefore, only a regulatory diktat can ensure this on the ground.
While lenders typically use rating agencies prior to sanctioning a loan, in this case it is the consortium that must choose a credit rating agency, which among other things must be REALLY independent in terms of not having any other relationship to the larger micro-finance industry and the MFI being rated – especially, the rating agency must not have a sister concern that is involved in capacity building and/or be a part of a larger Corporate group that has such interests in the micro-finance industry. Also, ratings for the same MFI must be rotated among the mainstream rating agencies so that repeat ratings do not become a wrong incentive (or an incentive for providing a higher rating grade). And raw data collected as part of the ratings must be made available for verification by the supervisors auditor and lenders’ internal auditors, as and when required. This may not at all be used but this has to be provided by the rating agency to the consortium of lenders
Make High Quality Randomised Loan Portfolio Audits Mandatory On An Annual Basis: While many of the banks and lenders are going in for loan portfolio audits and the like (I myself participated in the development of loan portfolio audit toolkit that is prominently used in India and other countries), much of the principles used in all these toolkits will have to be changed significantly, especially, in line with lessons from the present Indian crisis. And mainly, client level sensitivities and the prevalence of decentralized models/agents and their practices will have to be factored in specifically. Further, loan portfolio audits are seldom effective in the absence of a transparent MIS that is integrated across geographies, products and clients groups and that again needs to be ensured on the ground (please see following post with regard to MIS at MFIs: http://microfinance-in-india.blogspot.com/2010/11/understanding-state-of-management.html). Also, loan portfolio audits must be conducted by people who are not only independent evaluators but also seen to be independent in terms of having no other relationship with the concerned MFI (or the larger micro-finance industry), at least over the previous 3 years. And finally, there is a critical need for ensuring statistically valid random sampling of an MFIs portfolio while conducting such an audit and that again needs to be implemented on the ground. All of this can be ensured only by regulation and it is hoped that the regulators will do that and also ensure implementation through appropriate supervisory arrangements. While credit rating agencies could also conduct the loan portfolio audits, they must adhere to the transparent terms set out for portfolio audits above and also that mentioned for credit rating agencies earlier.
Make It Mandatory For MFIs to Provide An Annual MIS and Systems Audit Report: Another issue that needs to be made mandatory by regulators is the requirement of an annual MIS and other systems audit – to be certified after due examination by regulator/supervisor empanelled professionals and I will make a separate post on what process should be followed for such certification to be effective. This must form part of the annual filing of returns along with the aforementioned annual loan portfolio audit certificate
Have One Credit Bureau with A Unique ID Linkage: Lastly, while credit bureaus are very useful, the regulatory authority must own the credit bureau. However, the central database should be available for use (on a lease basis) for the different credit bureau service providers. MFIs can link up to different credit bureaus service providers to submit the data but all of this information will have to go into the regulator established central database. Likewise, all concerned industry stakeholders should be able to access this data at a cost of course, subject to various terms and conditions. And it would be great if the credit bureau architecture piggyback rides on unique national IDs for each individual, accessing a micro-finance loan. Only then, can the micro-finance assets become really traceable and accounted for in the complete sense and the real impact of financial inclusion efforts be transparently and objectively determined…
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