Report on MicrofinanceReport on Microfinance

Prepared by,

Unnati A. Mehta

Unitedworld School of Business

Mumbai

ACKNOWLEDGEMENT

I would like to express my gratitude to all those who gave me the possibilities to complete this report. I would like to thank Prof. Jayanta Sengupta, Dean, Unitedworld School of Business, Prof. Sangeeta Pandit , Prof. Jaymala S., Prof. Pinaki Ghosh ,Unitedworld School of Business and also college authorities for providing me the opportunity to work on the report.

With a deep sense of gratitude and humble submission I would like to express my heartiest gratefulness to my Faculty Guide Prof Sangeeta Pandit, Unitedworld School of Business , whose help, stimulating suggestions and encouragement helped me in all the times of research for and writing of this report.

Date: 19Augest 2010

Signature: Unnati Mehta

Index

Executive Summary Introduction to Microfinance

History Geographical Spread Book Review

Microfinance Products Microfinance Clients Microfinance Services CRISIL List of Microfinance Institutions in India Business Model Legal forms of MFI’s in India Market Trends Investment Climate Microfinance Bubble Success factors Issues Exits Case study Conclusion References

Executive Summary

The microfinance sector in India has developed a successful and sustainable business model which has been able to overcome challenges traditionally faced by the financial services sector in servicing the low income population by catering to its specific needs, capacities and leveraging preexisting community support networks. As of March 2009, microfinance institutions (“MFIs”) in India reached over 22 million borrowers and had a portfolio outstanding in excess of $2.3 billion.

The microfinance business model in India typically generates a Return on Equity (“ROE”) of between 20% and 30%, driven by financing from commercial banks, strong operating efficiency and high portfolio quality.

Despite achieving rapid growth with a CAGR of 86% in loan portfolio outstanding and 96% in borrowers over the last five years, the microfinance sector still faces a large unmet demand which means that it still has great potential for continued growth.

The microfinance sector is maturing and beginning to diversify its product and service base to address other unmet financial and non-financial needs of the low income population either directly or by acting as a conduit for third-party providers – savings, insurance, remittance and low cost education and healthcare services being some of the key examples.

Given this growth and maturity dynamic, the Indian microfinance sector is increasingly becoming a viable investment sector with commercial investors joining social investors who have been nurturing the industry thus far.

Equity valuations in the Indian microfinance sector are higher than the financial sector due to the high growth expectations and substantial availability of debt to fuel its rapid expansion. This availability of debt to support expansion is expected to grow as more domestic banks take exposure to the industry and alternative debt providers enter the market.

Over the short and medium term, MFI shares are expected to trade at significant premia to book value as they realign their business models to capitalize on unsatisfied demand, and cool down over the longer term as the industry matures and begins to consolidate.

Currently, several exit opportunities exist including secondary and trade sales which are increasing as more mainstream investors enter the market. Another likely exit scenario is M&A, as larger MFIs seek to acquire players with product or geographical niches and banks also seek to enter the sector by forming alliances with existing MFIs. Larger MFIs may also consider IPOs although that may be a less likely exit option for most MFIs in the short to medium term.

Introduction to Micro Finance

Microfinance is defined as any activity that includes the provision of financial services such as credit, savings, and insurance to low income individuals which fall just above the nationally defined poverty line, and poor individuals which fall below that poverty line, with the goal of creating social value. The creation of social value includes poverty alleviation and the broader impact of improving livelihood opportunities.

The concept of micro finance was popularized by Muhammad Yunus tremendously in India. The growing understanding of achieving self sustainability among the rural and urban poor has led to the acceptance and implementation of this idea across India.

Microfinance loans serve the low-income population in multiple ways by:

(1) Providing working capital to build businesses;

(2) Infusing credit to smooth cash flows and mitigate irregularity in accessing food, clothing, shelter, or education;

(3) Cushioning the economic impact of shocks such as illness, theft, or natural disasters.

Moreover, by providing an alternative to the loans offered by the local moneylender priced at 60% to 100% annual interest, microfinance prevents the borrower from remaining trapped in a debt trap which exacerbates poverty.

The range of activities undertaken in microfinance include group lending, individual lending, the provision of savings and insurance, capacity building, and agricultural business development services. Microfinance loans in India range in size from $100 to $500 per loan with interest rates typically between 25% and 35% annually.

History of Micro Finance

The history of microfinance can be traced back as long to the middle of the 1800s when the theorist Lysander Spooner was writing over the benefits from small credits to entrepreneurs and farmers as a way getting the people out of poverty. But it was at the end of World War II with the Marshall plan the concept had an big impact.

The today use of the expression microfinancing has it roots in the 1970s when organizations, such as Grameen Bank of Bangladesh with the microfinance pioneer Mohammad Yunus, where starting and shaping the modern industry of microfinancing. Another pioneer in this sector is Akhtar Hameed Khan. At that time a new wave of microfinance initiatives introduced many new innovations into the sector. Many pioneering enterprises began experimenting with loaning to the underserved people. The main reason why microfinance is dated to the 1970s is that the programs could show that people can be relied on to repay their loans and that it´s possible to provide financial services to poor people through market based enterprises without subsidy. Shore Bank was the first microfinance and community development bank founded in 1974 in Chicago.

From modest origins, the microfinance sector has grown at a steady pace. Now in a strong endorsement of microfinance, the National Bank for Agriculture and Rural Development (NABARD) and Small Industries Development Bank of India (SIDBI) have committed themselves to developing microfinance.

The microfinance sector has been "witnessing a tremendous growth" during the last few years in India in terms of loan portfolio, geographical area and outreach. With India’s GDP growing at the rate of 7.1 % the country’s socio-economic pyramid is turning around the story with millions of poor people becoming entrepreneurs.

Geographical spread of MicroFinance sector in India

Microfinance in India, through the channel of SHG-Bank Linkage Programs (SBLPs) or microfinance institutions, has served over 76 million as of 2009 compared to 59 million a year before.

MFI’s have recorded about 8.5 million clients during the year 2008-09, a growth of 60% over the previous year.

More than 50 percent of low income households are covered by some form of microfinance product.

The total outstanding microfinance loans posted a growth rate of 30% or 359.39 billion over the last year’s level of Rs 229.54 billion.

The overall coverage of the sector is estimated to have reached 76.6 million against 59 Million last year.

The SHG loan outstanding has increased by Rs. 71.5 billion with an addition of 6.9 million clients.

MFIs so far reached 234 of the 331 poorest districts identified by the government.

SBLP registered a decline of number of women SHGs from 82.5% in March 2007 to 80.4% in March 2008.

Despite the rapid expansion of microfinance, large areas of India continue to be underserved it is estimated that the penetration potential of the existing microfinance model is between approximately 43 million and 52 million households, out of which 22.6 million are existing customers.

This implies an unaddressed demand of 20million to 29 million customers currently, as many as 54% of all microfinance clients are concentrated in the Southern States: Andhra Pradesh, Karnataka, Kerala and Tamil Nadu.15 Alternatively, there is an extremely limited microfinance presence in the North and North-east.

MFIs are beginning to realize, however, that the South is becoming overly saturated and there is a commercial need to expand to newer geographies to ensure continued growth and maintain the quality of their portfolio. It has become imperative that MFIs diversify their operational base and limit overexposure to heavily serviced areas and clients.

“Banker to the Poor” Book Review

Muhammad Yunus was born in Chittagong, Bangladesh as the third of fourteen children. He studied at Dhaka University and then Vanderbilt University for his PhD. He did not set out to become a moneylender of any sort, nor did he anticipate starting an organization that would affect the lives of millions. While serving as the department head of Economics at Chittagong University, Yunus began to get involved in the village, Jobra, next to the University.

It was there that the story of a young woman named Sufiya sparked the idea that in the next few years would become Grameen Bank. She was a twenty-one year old mother of three who labored all day to make bamboo stools by hand. Sufiya borrowed the money for each stool, about five taka (twenty-two cents), from middlemen on the condition she would sell the finished stools back to them for five taka, fifty poysha (twenty-four cents). Therefore, her net profit for the entire day’s labor would be only fifty poysha, or two cents for her family. It was a miserably small sum, but as she explained to Yunus, she had no other choice. The middlemen were better than the moneylenders who charged exorbitant rates and only dragged borrowers deeper into the cycle of poverty.

Muhammad Yunus was shocked. In his own words: “In my university courses, I theorized about sums in the millions of dollars, but here before my eyes the problems of life and death were posed in terms of pennies” . The next day he and a student visited the village again, this time making a list of all the people who were dependent on middlemen. In total he found forty-two borrowing a total of 856 taka (roughly twenty-seven dollars). Again he was shocked that such a small amount of money could affect so many people. Aware that if the people were not dependent on the middlemen they could sell their products for the highest possible return, he decided to distribute the money to villagers, interest free, out of his own pocket. The Grameen Bank project was born, which grew and eventually became an independent organization in 1983. Grameen Bank is run off a strict set of principles. Yunus decided to have the loan period last one year, with weekly repayments, after a one week grace period, made to Grameen Bank employees who visit the villagers. Groups are an important component of Grameen’s Banking system. Grameen Bank uses groups of five individuals, having them self-formed rather than assigned to promote

solidarity. By having a prospective borrower, such as a village woman, seek out and convince her friends to join her already starts the process of independence, responsibility and social control the group members have over each other with

the loans. Once a group is formed, loans are only extended to two borrowers. If they repay on time for the first six weeks, then two more members may take out loans; the chairperson is usually the last to take a loan. However, for a group to be recognized by Grameen as eligible for a loan, each member must undergo a week of training on the bank’s policies and pass an oral examination.

One interesting goal Yunus set for Grameen Bank was to have at least half the borrowers be female. This was a struggle given the low social status of women in Bangladesh, but today 97% of Grameen borrowers are women. He cites that women have been shown through studies to use their loaned money to more successfully improve the status of their families (especially their children) than men. When a woman receives a micro-loan her priorities are first improving the life of her children and second improving her household - for example building a stronger roof or buying beds for the family.

Improving the economic status of women also directly affects birth rates, which are an issue in many developing countries. Compared to the general ineffectiveness of government scare-tactics and family planning programs, improving the status of women has been shown by UN studies to significantly lower birth rates. Studies among Grameen clients have shown that the birth rate is significantly lower than the national average. The clients are also much more likely to educate the children they already have. Therefore, the simple loan has not only immediate benefits, but actually improves the future of the next generation.

Muhammad Yunus’ project has grown to serve a total of seven million families in Bangladesh with loans totaling six billion dollars. There are over 250 institutions in 100 countries that operate off Grameen micro-credit principles. For his work, Muhammad Yunus received the Nobel Peace Prize in 2006.

Micro Finance Products

Credit Credit methodology lies at the heart of microfinance and its quality is one of the most determinant factors for the efficiency, impact and profitability of a microfinance institution (MFI). Credit methodology is comprised of a host of activities involved in lending including sales, client selection and screening, the application and approval process, repayment monitoring, and delinquency and portfolio management. It is also linked to the institutional structure and human resource policies such as hiring, training and compensating staff. Getting the credit methodology and product mix right is therefore one of the most demanding as well as rewarding challenges MFIs face.

Savings Products For most of its history, the microfinance industry has focused on delivering microloans to microentrepreneurs, and it is still in the process of seeking greater scale at greater speed for delivering microcredit. The experience of microfinance institutions (MFIs) across the globe that mobilize savings, however, demonstrates that the demand for deposit products is many times that of credit. Although low-income customers save in several forms, not necessarily through formal means, there is a pervasive for safe mechanisms.

Accordingly, savings mobilization is becoming a critical strategic goal for MFIs, especially as microfinance markets become more competitive. MFIs are looking to build their capacity to mobilize savings, either as a funding strategy to support growth while reducing financial costs of funds, or, as a marketing strategy to promote customer loyalty and retention.

One of the challenges that MFIs will face when mobilizing deposits is controlling expenses, as operating costs of managing and delivering savings services are relatively high. Micro savings customers are also more sensitive to charges and fees than wealthier clients, given the smaller average balances and income levels.

Another key challenge is for the MFI to diversify its target segment, as mobilizing savings usually requires attracting a different clientele than the typical micro entrepreneur. Savings mobilization also requires certain standards for quality in customer service, which depends on key resources and capabilities, such as technology, processes and qualified staff.

For institutions transforming into financial intermediaries, the challenges are great as other issues – such as changing a corporate culture, implementing practices required by regulation, developing key functions like treasury and risk management, and building a brand image – require commitment and significant investment. 

Insurance Products

Losses due to natural disasters, fire or death of a family member can be devastating for anyone. For microentrepreneurs and other low-income populations, even common illness can wipe out a lifetime of work, leaving them without any resources to start over. Microinsurance products can help mitigate the effects of losses on clients and their families so that they can retain and build on the gains they have worked so hard to achieve and continue on the path out of poverty.

Micro insurance is a nascent industry, which has made significant strides in the last few years. Products are specially designed to meet the needs of poor clients: premium payments are kept to a minimum, terms and conditions are clear and simple, and exclusions and requirements such as medical examinations are avoided to the greatest extent possible. Micro insurance includes but is not limited to: Life, Health, Accidental Death and Disability, and Property products.  

There are also country-specific challenges faced by MFIs related to the country's regulatory environment and the availability of insurance companies willing and able to underwrite client-appropriate programs that are competitively priced

Remittances These are transfer of funds from people in one place to people in another, usually across borders to family and friends. Compared with other sources of capital that can fluctuate depending on the political or economic climate, remittances are a relatively steady source of funds.

Clients of Micro Finance

The typical micro finance clients are low-income persons that do not have access to formal financial institutions. They are typically self-employed, often household-based entrepreneurs. In rural areas, they are usually small farmers and others who are engaged in small income-generating activities such as food processing and petty trade. In urban areas, microfinance activities are more diverse and include shopkeepers, service providers, artisans, street vendors, etc. Micro finance clients are poor and vulnerable non-poor who have a relatively unstable source of income.

Global India

Total MFIs 1,859 144

Gross loan portfolio USD, 2008

44.2 billion 2.1 billion

Number of borrowers 2008

82.9 million 16.4 million

Deposits USD, 2008 23.7 billion 90.0 million

Average loan balance per borrower USD, 2008

552.0 109.1

The Indian microfinance sector is expected to grow nearly ten times by 2011 to a size of about Rs250 billion from the current market size of Rs27 billion, at a compounded annual growth rate of 76%.

Services Provided by Micro Finance Bank

PROVIDING LOANS:The important service is provided by MFI is given loan. These loans are provided from some productive activities like; starting new business, expansion of business; improving life etc.

CAR FINANCING:MFI also assist those people who cannot pay total amount at once. So, these MFI gave them car on installments like UBL car financing scheme is too popular and too many people taking advantage from this scheme.

HOME FINANCING:Pakistan is a poor country. Purchasing power of Pakistan is very low. So many people are living on rent. They cannot have too many amounts to purchase homes. MFI’s provide loans be considering their job stability and take security for it.

PERSONNEL LOANS:MFI also obtain personnel loans. Those people who have permanent employment and stable jobs. This credit facility depends on the income of an individual.

TALEEMI LOANS:MFI also provide financial aid to the students who cannot bare educational expenses but want to study. MFI assist them in return of some security and it would have to pay after completing the education.

Comparative Analysis of Micro-finance Services offered

CRISIL List of Top 20 Microfinance Institutions in India

1. SKS Microfinance Ltd (SKSMPL)2 Spandana Sphoorty Financial Ltd (SSFL)3 Share Microfin Limited (SML)4 Asmitha Microfin Ltd (AML)5 Shri Kshetra Dharmasthala Rural Development Project(SKDRDP)6 Bhartiya Samruddhi Finance Limited (BSFL)7 Bandhan Society8 Cashpor Micro Credit (CMC)9 Grama Vidiyal Micro Finance Pvt Ltd (GVMFL)10 Grameen FinancialServices Pvt Ltd (GFSPL)11 Madura Micro Finance Ltd (MMFL)12 BSS Microfinance Bangalore Pvt Ltd (BMPL)13 Equitas Micro Finance India P Ltd (Equitas)14 Bandhan Financial Services Pvt Ltd (BFSPL)15 Sarvodaya Nano Finance Ltd (SNFL)16 BWDA Finance Limited (BFL)17 Ujjivan FinancialServices Pvt Ltd (UFSPL)18 Futures Financial Services ChittoorLtd (FFSL)19 ESAF Microfinance & Investments Pvt. Ltd (EMFIL)20 S.M.I.L.E Microfinance Limited.

MICROFINANCE BUSINESS MODEL The microfinance business model is designed to address the challenges faced by the traditional financial services sector in fulfilling the credit requirement of the low income segment at an affordable and sustainable cost. Most MFIs follow the Joint Liability Group (JLG) model.

A JLG consists of five to ten women who act as co-guarantors for the other members of their group. This strategy provides an impetus for prudent self-selection of reliable and fiscally responsible co-members. Moreover, the JLG has an inbuilt mechanism that encourages repayment in at timely fashion as issuance of future loans is contingent upon the prior repayment record of the group.

Metric Amount (in India)

Interest rate charged typically 25-35% p.a.

Interest on debt 12-16%; lower for larger MFIs

Operating expense ratio 6-15% depending on level of efficiency

ROA typically 3-5%

Debt/Equity Typically 5-8x

ROE 20-30%

Micro-loan sizes vary from an initial loan size between $100 and $150 to subsequent loans of $300 to $500 with an annual interest rate between 25% and 35%.The term loans are structured with weekly or monthly repayment schedules and a 6-month to 2 year term. Microfinance institutions typically charge a higher rate of interest to their clients than traditional commercial banks as the administrative costs of servicing smaller loans is far higher in percentage terms than the cost of servicing larger loans.

Additionally, MFIs provide doorstep services to their customers, a strategy that has a high cost associated with it, especially in rural areas where population densities tend to be low. Because of this model, MFIs generally face an operating expense ratio (“OER”) between 6% and 15%, depending on the scale and efficiency level of the particular MFI as well its area of operations.

Additionally, today, MFIs face borrowing costs in the range of 12% to 16% per annum, depending on the size and track-record of the individual MFI. This model allows well-run MFIs to achieve a ROA of about 3% to 5% and a ROE of as much as 20% to 30%. These high ROA and ROE numbers are contingent upon low cost financing from commercial banks and the ability to maintain high portfolio growth along with high portfolio quality.

The portfolio quality for MFIs is typically superior to commercial banks with total Nonperforming Assets 180 days past due of 0.2% to 3% as opposed to 3% to 10% for commercial banks.Metric Amount (in India)

Legal Forms of MFI’s in India

Types of MFIs EstimatedNumber

Legal Acts under which Registered

1. Not for Profit MFIsa.) NGO - MFIs

400 to 500 Societies Registration Act, 1860 orsimilar Provincial ActsIndian Trust Act, 1882

b.) Non-profit Companies

10 Section 25 of the Companies Act, 1956

2. Mutual Benefit MFIsa.) Mutually Aided CooperativeSocieties (MACS) and similarlyset up institutions

200 to 250 Mutually Aided Cooperative SocietiesAct enacted by State Government

3. For Profit MFIsa.) Non-Banking FinancialCompanies (NBFCs)

6 Indian Companies Act, 1956Reserve Bank of India Act, 1934

Total 700 – 800

Market TrendsAs the Indian microfinance sector matures, it is expected the year-on-year growth rate to decline to still high, but more sustainable levels. Over the next four years, it is projected the number of borrowers to grow at 34%, which is 60% less than the historical 5-year CAGR of 86% and the portfolio outstanding to grow at 40%, which is 58% less than the historical 5-year CAGR of 96%.

Even with these cautious assumptions, it is expected MFI borrowers toincrease from 22.6 million to 64 million and portfolio outstanding to increase from $2 billion to $8 billion by 2012. With maturity, MFIs will have to begin reassessing and re-engineering their growth strategies in a couple of years. They will have to take into account market opportunities and risks and adjust their geographical exposure, client base and product offering to remain competitive.

Hints of market conditions that MFIs will have to navigate in the coming yearsare present even today, and MFIs are beginning to recognize these factors as they continue to grow.

Some Encouraging Trends in the Microfinance Sector

Trend 1 – Diversification of MFIs: microfinance providers are beginning to broaden the range of services offered under the microfinance umbrella which started with microcredit, but now includes micro-insurance, micro savings and money transfer facilities as well.

Trend 2 – Specialization of MFIs: microfinance providers are beginning to focus on certain livelihoods such as crop insurance, or handicraft financing, etc. As MFIs study each business model, they can produce services that are aligned with the unique cash flow cycles or the varying demand patters of the client’s business.

Trend 3 – Turnkey Solutions: some MFIs are beginning to provide non-financial services to support their clients’ businesses, such as assisting them with their supply chain, or sharing ‘marketing infrastructure to enhance these micro-businesses’.

Trend 4 – New channels: clients no longer have to visit physical offices of MFIs in order to avail certain services. Franchise-based business models and branchless banking are becoming effective ways of reaching potential clients who often live in disparate rural areas.

Investment ClimateToday, microfinance is gaining prominence as a viable asset class globally,particularly in India. MFIs in India have continued to attract large amounts ofcapital despite the global economic recession. Currently, it is reported that over100 microfinance investment vehicles (“MIVs”) exist globally, and India is a focus for many of them due to its large market size, growth capacity, profitable business models and potential development impact. Moreover, mainstream investors are beginning to participate in this sector, picking up larger stakes than the social investors that have been dominant so far. The entrance of mainstream investors is indicative of an industry that is maturing, but is still expected to grow at a high rate.

Even though the microfinance industry is reaching maturity, the large amounts of untapped geographical territory and client base combined with the MFIs’ wide network create potential for enormous sustainable growth in the future.

MFIs and other service providers are beginning to realize the significant value of the network that has been created by MFIs and efforts are underway to utilize them to deliver both, financial and nonfinancial products and services. These factors will continue to impact the supply of equity for Indian microfinance and hence the equity valuations. Furthermore, since this untapped demand is unlikely to be satisfied in the short or medium term, while valuations will be tempered by cautious investors, premia driven by fundamental growth expectations can be expected to prevail through the short and medium term as MFIs re-engineer their strategies to take advantage of the unsatisfied microloan demand.

Microfinance BubbleMicrofinance has grown at a sharp clip in recent years. Large amounts of capital are flowing to the sector as major banks like Morgan Stanley, Citigroup, and Barclays Bank, among others, prove that investing in microfinance is not a charitable activity anymore. In addition to the involvement of banks and other large companies, microfinance is flooded with funding from a new breed of philanthro-capitalists such as Bill Gates, Warren Buffett, and e-Bay founder Pierre Omidyar. Overall, the microfinance sector can expect to see a sixfold increase in foreign funding over the next several years.. Despite the increasing amount of investment in microfinance, most of these dollars are chasing the same mature and commercially sustainable microfinance institutions that provide a predictable return. An example of this is the wildly successful initial public offering of Mexico's Banco Compartamos, which took place in April 2007. In ten years Compartamos went from a financially self-sufficient NGO to a bank with five successful bond offerings in the market, all rated investment grade by Standard and Poor's and Fitch Ratings. The recent success of Compartamos and Microvest demonstrates that commercial capital now provides an important source of funding for microfinance. As the handful of investment banks and large companies active in the sector establish the business potential of microfinance, others will want their piece of the profit from this emerging asset class. Standard & Poor's2 notes that the USD 15 billion-plus in microloans that are currently on the books pales next to the potential of some USD 150 billion in lending. With a large amount of capital chasing a limited amount of quality assets, microfinance could be the next asset bubble.

Success Factors of Micro-Finance in India

Over the last ten years, successful experiences in providing finance to small entrepreneur and producers demonstrate that poor people, when given access to responsive and timely financial services at market rates, repay their loans and use the proceeds to increase their income and assets.

This is not surprising since the only realistic alternative for them is to borrow from informal market at an interest much higher than market rates. Community banks, NGOs and grass root savings and credit groups around the world have shown that these microenterprise loans can be profitable for borrowers and for the lenders, making microfinance one of the most effective poverty reducing strategies

A. For NGOs

The field of development itself expands and shifts emphasis with the pull of ideas, and NGOs perhaps more readily adopt new ideas, especially if the resources required are small, entry and exit are easy, tasks are (perceived to be) simple and people’s acceptance is high – all characteristics (real or presumed) of microfinance. Canvassing by various actors, including the National Bank for Agriculture and Rural Development (NABARD), Small Industries Development Bank of India (SIDBI). Induced by the worldwide focus on microfinance, donor NGOs too have been funding microfinance projects.

B. For Financial Institutions and banks

Microfinance has been attractive to the lending agencies because of demonstrated sustainability and of low costs of operation. Institutions like SIDBI and NABARD are hardnosed bankers and would not work with the idea if they did not see a long term engagement – which only comes out of sustainability (that is economic attractiveness).

On the supply side, it is also true that it has all the trappings of a business enterprise, its output is tangible and it is easily understood by the mainstream.

This also seems to sound nice to the government, which in the post liberalization era is trying to explain the logic of every rupee spent. That is the reason why microfinance has attracted main stream institutions like no other developmental project.

Real life Examples:

Lakshmi, a 22-year-old school dropout, lived in a remote village of Tamil Nadu. Instead of getting married and starting a family like any other village girl of her age in India, she wanted to set up on her own business. Lakshmi started an Internet kiosk in her village, offering services like e-mail, Internet chat and tips on health and education. The kiosk was partially financed by ICICI Bank and was set up in association with n-Logue Communications.

Latha, a 29-year-old married woman with three children borrowed Rs.18,000 to set up a small provision store in Kothaipalli, a small village, in the north of Andhra Pradesh. Within a year, she started earning Rs.3500 a month from the store. With this money, she was able to provide her children a good education at a local private school. She was a part of a self-help group in Andhra Pradesh which received financial assistance from ICICI Bank. These are real-life examples to illustrate how the micro-lending initiatives of ICICI Bank affected the lives of poor women in India.

Issues in Microfinance

Sustainability

The first challenge relates to sustainability. MFI model is comparatively costlier in terms of delivery of financial services. An analysis of 36 leading MFIs shows that 89% MFIs sample were subsidy dependent and only 9 were able to cover more than 80% of their costs.

This is partly explained by the fact that while the cost of supervision of credit is high, the loan volumes and loan size is low. It has also been commented that MFIs pass on the higher cost of credit to their clients who are ‘interest insensitive’ for small loans but may not be so as loan sizes increase. It is, therefore, necessary for MFIs to develop strategies for increasing the range and volume of their financial services.

Lack of Capital

The second area of concern for MFIs, which are on the growth path, is that they face a paucity of owned funds. This is a critical constraint in their being able to scale up. Many of the MFIs are socially oriented institutions and do not have adequate access to financial capital. As a result they have high debt equity ratios.

Presently, there is no reliable mechanism in the country for meeting the equity requirements of MFIs.The book value multiple is currently the dominant valuation methodology in microfinance investments.

In the case of startup MFIs, using a book value multiple does not do justice to the underlying value of the business. Typically, startups are loss making and hence the book value continually reduces over time until they hit breakeven point. A book value multiplier to value startups would decrease the value as the organization uses up capital to build its business, thus accentuating the negative rather than the positive.

Financial service delivery

Another challenge faced by MFIs is the inability to access supply chain. This challenge can be overcome by exploring synergies between microfinance institutions with expertise in credit delivery and community mobilization and businesses operating with production supply chains such as agriculture.

The latter players who bring with them an understanding of similar client segments, ability to create microenterprise opportunities and willingness to nurture them, would be keen on directing microfinance to such opportunities.

This enables MFIs to increase their client base at no additional costs. Those businesses that procure from rural India such as agriculture and dairy often identify finance as a constraint to value creation. Such businesses may find complementarities between an MFI’s skills in management of credit processes and their own strengths in supply chain management.

HR Issues

Recruitment and retention is the major challenge faced by MFIs as they strive to reach more clients and expand their geographical scope. Attracting the right talent proves difficult because candidates must have, as a prerequisite, a mindset that fits with the organization’s mission.

Many mainstream commercial banks are now entering microfinance, who are poaching staff from MFIs and MFIs are unable to retain them for other job opportunities. 85% of the poorest clients served by microfinance are women. However, women make up less than half of all microfinance staff members, and fill even fewer of the senior management roles.

The challenge in most countries stems from cultural notions of women’s roles, for example, while women are single there might be a greater willingness on the part of women’s families to let them work as front line staff, but as soon as they marry and certainly once they start having children, it becomes unacceptable. Long distances and long hours away from the family are difficult for women to accommodate and for their families to understand.

Microinsurance

First big issue in the microinsurance sector is developing products that really respond to the needs of clients and in a way that is commercially viable. Secondly, there is strong need to enhance delivery channels. These delivery channels have been relatively weak so far. Microinsurance companies offer minimal products and do not want to go forward and offer complex products that may respond better.

Microinsurance needs a delivery channel that has easy access to the low-income market, and preferably one that has been engaged in financial transactions so that they have controls for managing cash and the ability to track different individuals.

Thirdly, there is a need for market education. People either have no information about microinsurance or they have a negative attitude towards it. We have to counter that. We have to somehow get people - without having to sit down at a table - to understand what insurance is, and why it benefits them. That will help to demystify microinsurance so that when agents come, people are willing to engage with them.

Adverse selection and moral hazard

The joint liability mechanism has been relied upon to overcome the twin issues of adverse selection and moral hazard. The group lending models are contingent on the availability of skilled resources for group promotion and entail a gestation period of six months to one year.

However, there is not sufficient understanding of the drivers of default and credit risk at the level of the individual. This has constrained the development of individual models of micro finance. The group model was an innovation to overcome the specific issue of the quality of the portfolio, given the inability of the poor to offer collateral.

However, from the perspective of scaling up micro financial services, it is important to proactively discover models that willenable direct finance to individuals.

EXITS

For early stage investors the most likely source of exit remains secondary or trade sales. In terms of potential M&A exit scenarios, the most likely scenario is the entry of banks as acquirers in the medium term with the RBI’s and the government’s emphasis on using banks to deliver more effective financial inclusion – they could leverage MFIs as the last-mile distribution platform for the existing banking system.

Banks could potentially find it easier to complete acquisitions compared to large MFIs as they are less promoter driven and have better institutional capacity to integrate acquisitions. Acquisitions of regional MFIs by large national MFIs is also possible given certain conditions – the regional MFI would need to have strong penetration in its local market, a similar basic operating model as the acquiring MFI and a certain minimum portfolio size of approximately $50 million to $75 million.

The MFI sector could also see a merger of equals between two mid to large sized MFIs as the industry matures and consolidates over the medium term.Some large MFIs including two to three in portfolio could consider a potential listing in one to two years, but IPOs will be a challenge for the sectoroverall given limited market experience in listing socially-focused firms.

Criteria for a successful IPO will include size; the capacity to absorb large amounts of capital and generate post-issue liquidity of the listed shares; operating experience of the management team; track-record of value creation; and institutional capacity to deal with the listing process, compliance requirements and public scrutiny.

In this regard, the experience of SKS Microfinance in executing its proposed IPO in 2010 will be a useful learning experience for the microfinance sector to determine the extent to which a social business model such as microfinance can be accepted by mainstream and particularly retail investors, and the value these investors are willing to ascribe to its potential.

That exits are still uncommon in microfinance means that for early stage investors like entrepreneurs need to be made aware of their exit obligations, and investors’ relationships with entrepreneurs will be key in realizing exits, especially for minority shareholders.

The ability to work with different mainstream investors, MFI promoters, banks and industry regulators as well as investors’ prior experience and track-record of executing exits in the Indian market will be the key to completing successful exits in Indian microfinance companies.

CASE STUDY

SKS Microfinance Ltd

SKS Microfinance (SKSMF) is the largest microfinance company in India with loan portfolio of ~US$1bn, 2,000+ branches spread across 19 states and 6.8mn members. Its strengths include pan-India presence, scalable operating model, diversified product revenues and access to various sources of capital. Lending primarily to poor women, thebusiness model involves village centered group lending, thereby ensuring a check on asset quality. The huge demand-supply credit gap and inability of banks to penetrate into unbanked areas have driven the growth of microfinance industry. While valuations appear expensive,the scalable business model, market leadership position and high earnings growth provide comfort.

Rural centric business modelThe success of SKS has evolved around five key elements: a)village selection, b) focus towards women, c) member training, d)group lending and e) village level lending and collection. Withlending primarily to poor women, the company has expanded itsreach to 2,029 branches spread across 19 states and over 6.8mnmembers. The pan-India presence has further helped mitigate therisk towards local economic slowdowns and disruption. Throughsystems and solutions in place, it has developed a scalable 3C’smodel – Capital, capacity and cost reduction, which in turn hashelped reach rural masses in large.

Diversified sources of revenue and capitalIn addition to core business towards providing traditional loanproducts, the company has started offering productivity loansdirectly linked to business. This involves strategic alliances withNokia, Airtel, Bajaj Allianz, HDFC, METRO and FAL. Despite being aNBFC-ND, the company has benefited from benign interest rateregime and enhanced sovereign ratings. Historically, it has raisedfunds via alternate channels including – equity and debt issuance,loans with various maturities raised from domestic andinternational banks, and the securitization of components of loanportfolio.

Limited concerns over asset qualityThe village centered, group lending model has ensured SKSMF anadequate check on asset quality. Innovative product structuring,focus on income generating loans and primary focus at womenhave enabled the company to maintain its GNPA and NNPA at low0.33% and 0.16% respectively. In case of default by an existingmember, the group is required to typically make the payment onbehalf of a defaulting member. Any negligence towards paymentbars the group from further borrowing.

Financial highlights(Rs FY07 FY08 FY09 FY10

(I(Rs mn FY07 FY08 FY09 FY10

Revenues 445 1625 5060 8736

yoy growth (%)

- 265.1 211.5 72.6

Operating profit

457 1700 5540 9589

PAT 22 166 797 1748

yoy growth (%)

- 651.3 380.6 119.5

EPS (Rs) 0.8 3.7 14.0 27.1

BV per share (Rs)

26.8 47.8 116.0 146.6

RONW (%) 3.1 7.8 12.2 18.4

Issue detailsIssue opens 28-Jul-10Issue closes* 2-Aug-10Price band (Rs)** 850-985Face value (Rs) 10Lot size 7Total Issue size(mn) 16.79- Offer for sale (mn) 9.34Issue size (Rs m) 16,540Issue type 100% Book buildingIPO rating CARE IPO Grade 4Industry - Finance*Closure date for institutional investors is 31st July, 2010

**Rs50 discount has been offered to retail investors

Shareholding pattern (%)

Shareholding pattern (%) Pre IPO Post IPO

Promoters &promoters group 55.8 37.1Non Promoters 44.2 39.6Public - 23.3Share reservation (%) (%)QIB 60Non institutional 10Retail 30Company managementmanagementDr. Vikram Akula ChairmanMr. Suresh Gurumani Managing DirectorIssue managerLead manager Kotak Investment Banking, Citi,Credit SuisseRegistrar KarvyListing NSE, BSEObjective of issues (Rs m)

Objective of issues To augment capital base tomeet future capital requirementsTo achieve the benefits oflisting on the Stock Exchanges

SKS Microfinance, microfinance firm, listed at Rs. 1,036 a share on the Bombay Stock Exchange, reflecting a gain of five per cent over the issue price.

In line with market expectations, SKS Microfinance opened at Rs. 1,036, up 5.17 per cent over its issue price of Rs. 985 per share. Within minutes of trade, the scrip soared nearly 18 per cent to touch a high of Rs. 1,159.90 per piece.

The company made a smart debut on the National Stock Exchange as well opening with a premium of over five per cent at Rs. 1,040 a share. It was later trading up 16.24 per cent at Rs. 1,145 a share.

On the volume front over 44 lakh shares of the Hyderabad- based firm changed hands on the bourses in early trade. "The brilliant listing of SKS reflects investor confidence. No doubt it is a pleasant listing and clearly shows sign of market recovery. The IPO had generated a huge response and the company's debut on the bourses are in line with market expectations," SMC Capitals Equity Head Jagannadham Thunuguntla said.

The company which entered the capital market on July 28 raised Rs. 1,654 crore through its initial public offer. The public issue of 1.6 crore shares was priced in the range of Rs. 850 to 985 a share.

SKS, founded by Vikram Akula, had fixed the issue price of its IPO at Rs. 985 per share, the upper band of the price range. Retail investors got SKS shares at a discount of Rs. 50 per piece at Rs. 935 per share.

Meanwhile, the broader market was quoting down 21.97 points at 18,144.81 points.

Analysis

SKS Microfinance has a high capital adequacy ratio (of 28.3 per cent which may further improve to excess of 40 per cent post-offer) and strong risk-management systems which address two concerns MFI are facing today — access to capital and maintenance of asset quality.

Most of the portfolio comes under ‘priority lending’ norms of the RBI enabling the sale of this portfolio to other mainstream lending institutions; this also reduces funding costs for SKS to that extent.

While the yields are high, so are operating costs. Operating costs are higher than interest costs and are likely to remain so. However, SKS’ cost-income ratio fell to 52per cent for 2009-10 from 62 per cent.

Over-leveraging by the borrowers is a key risk, as there have been instances where borrowers accessed funds from multiple lenders.

Another concern is the seasonalityof the earnings, which are back-ended to the second half of the year. Given that the MFI loans are to low income groups, during natural calamities, the loan portfolios may result in NPAs due to the inability of the borrower to pay.

Retaining a skilled workforce is a challenge (SKS has attrition rates upwards of 25per cent), which may expand the already high operating costs, given substantial costs involved in training employees. 

CONCLUSION

The strength and sustainability of the Indian microfinance business model lies in the fact that it is serving a large unmet need for financial inclusion. It has thus far successfully tackled challenges that have faced other financial service providers in meeting the demands of this sector through creative product innovation with awareness of the segment’s particular needs and capacities and use of the joint liability group mechanism to manage risk.

The model has been successful in maintaining excellent portfolio quality even with extremely rapid expansion over the last few years. The large size of the currently unbanked population in India and diversity of geography means that the microfinance sector has great potential for continued high growth. Moreover, as the sector approaches maturity, there will be increasing attention focused toward client and geographical diversification and product innovation, financial and non-financial. Besides expanding their own services, MFIs are also being viewed as potential channels for delivery of other products and services to low income and rural populations. Since the scale of the Indian MFI industry has exceeded 20 million clients, other consumer product and service providers are beginning to attach greater value to the microfinance distribution network.

Given this growth and maturity dynamic, the Indian microfinance sector is increasingly seen as a viable investment target with commercial investors joining the social investors who have been nurturing the industry thus far. Equity valuations in the Indian microfinance sector are higher than the financial sector in general and global MFIs in particular due to the high growth expectations and substantial availability of debt to fuel its rapid expansion.

MFI shares are expected to trade at significant premium to book over the short and medium term as MFIs realign their business models to capitalize on unsatisfied demand, and cool down over the longer term as the industry matures and begins to consolidate.

As more investors enter the market, exit opportunities are also increasing in the form of secondary and trade sales. Larger MFIs may also consider IPOs, although that may not be a realistic exit option for most MFIs in the short to medium term. Another likely exit scenario is M&A, as larger MFIs seek to acquire players with product or geographical niches.

The industry is in its initial stage and its development could take many forms, but we expect growth, innovation and financial performance to continue on an encouraging path.

References

www.microfinancegateway.org www.grameenfoundation.org www.sksindia.com www.mixmarket.org www.cgap.org Banker to the poor- Muhammad Yunus