Posted by: alok | January 22, 2006

Microfinance

The first in the sequel of ‘Learnings from ISB’…!

Microfinance was introdued to us by Vijay Mulbagal in one of the perspective building sessions at ISB. Instanly i got hooked to the concept, and I had to literally tighten the reins of my random thoughts about opportunities that seem to exist in this arena.

Microfinance – as a concept is very simple – financing simple activities. These activities typically require very small amounts of money of the order of few hundreds, max – a couple of thousands. And the activities could be anything from selling vegetables to buying seeds.

Let me try to weave a story around a hypothetical character – ‘Shyam’. He is a vegetable seller, who buys vegetables in the morning from farmers, puts it on his cart and brings it to city and sells it door to door. If everything gets sold in a day great, otherwise he dumps it.
Shyam is an ideal candidate in need of microfinance. Traditionally, he goes to a moeny lender who lends him Rs. 100 to buy vegetables, which he sells in the cities and returns Rs. 110 to the evening. The remaining is Shyam’s earnings. The cycle repeats everyday, and on the days when Shyam is not able to make 110 bucks, the money lender writes some covenants, which poor Shyam is forced to sign. Shyam is just a representative of millions of Indians in similar situation. Imagine an interest rate of 10% per day.. or more than 4000% a year…!!! Which investment gives such high returns? But still none of the banks or private equity firms are in this business. Why?

The traditional financial institutions are not capable of micro-managing loans of Rs. 100 everyday; these banks operate from 8 am to 8 pm, but Shyam needs money before 6 am and can return only after 9pm; these banks ask for credit ratings or collatoral which Shyam can’t provide; banks can’t open their branches in every village; and they face countless regulations pertaining to Capital Adequecy Ratio, Cash Reserves etc. set by RBI.

So in a nutshell Shyam is helpless and has no choice other than the money lender, who typically happens to be the head of the village, knows Shyam, and knows that Shyam can be made a bonded labor for life time if he defaults on the loan.

Here comes microfinance – a concept which traces his history to Marshall Plan during World War 2, or in recent to 1971 to Al Whitkar. But the notable achievement can be attributed to Muhammad Yunus and his Gramin Bank in Bangladesh. Because of his efforts UNO declared year 2005 as a year of microcredit.

Let’s think Microfinance in a simple way – I can afford to take loans of few lakhs from bank may be with or without collatoral. I take this money and go to the village where Shyam lives. I call on villagers in groups of 4-5 (not all from same family) and give them a collective loan of Rs. 500 to pursuse their business of selling vegetables. They have to return me the money in the evening at say 2% interest. Much less than what Money Lender is giving, but still much higher than what i am giving to the bank.

Why collective loan – I can manage without a collatoral as it creates a peer pressure among the group members to oblige to the loan. I give an incentive to the group, that if all the members of the group repay their loan in time, all of them are eligible for a higher loan of say Rs. 110 each.

How do I manage the logistics of disbursing loans every morning and collecting every evening? I open an institute called ‘MicroFinance Institute’ – (technically I have to register it under non banking act of RBI or one weird act under Andhra Pradesh government, if the number of ‘self-help group’ exceeds a certain value). The MFI appoints one person in each village who can be trusted by the villagers and has some legal papers to authenticate his identity. The MFI operates 2 hours in the morning (7-9am) in the evening 5-7pm, when the guy collects the money for the village, but distrbutes it in a choupal like setting at 6 am in the morning, and collects the interest from previous day, and deposits it in the MFI before going for his normal work.

Now what benefit does Shyam gets – lets say he earns Rs. 40 everyday, of which he used to give 10 to the money lender as interest and 10 as the rent for cart, spends 20. Now with this scheme, he still continues to earn 40 but is able to keep 28, his living standard improves, or he saves more. His savings can be channelled back to the MFI, which can act as a collatoral in case he defaults in future. As he develops a credit line with MFI, we can finance his cart of Rs.1000. He is now in a capcity to save 38, his living std. improves further and so does his savings. Where does he spend his additional earnings – probably on educating his child or buying some goods from other villagers (who would also have financed by MFI), improving their livelihood in turn. So this perpertual cycle continues and creates a win-win situation for all.
What risk is MFI exposed to? – Pilferage in the hands of middleman, money kept in his house overnight, or worst case a combined default by the members of the group – something goes wrong and the entire group says – “nahi de rahey paisa – kar lo jo karna hai”. Some elegant ways of managing these risks can be developed.

What is the size of microfinance market – there are no full proof mechanism as of now to gauge the market size, but the recent estimates stands at $4 trillion worlwide of which $600 Billion is the figure for India…!!!
Still not convinced if this approach will really work – refer to wikipedia – Microfinance or just google – ‘microfinance in india’. A starkling example is the case of a lady (forgot her name), who was able to mobilise around 6 Lakh people under her MFI. It was such a huge market that she could force even HLL for huge discounts on day to day goods in the village, and even influence a leading insurance company for group insurance of the villagers…!! Success of ‘Gramin Bank’ in Bangladesh is another success story.

Now some failure stories – huge amount of microfinance had been disbursed to villagers in Indonesia and one Tsunami wiped everything – entire village was dead or those alive had nothing to pay back. Many MFI’s went bankrupt. Few entered the market after the scene in a hope to improve the condition of the village as well as to make money – but what can you extract from someone who is in wretched condition. But occassions like these are a rarity.
Microfinance is not philanthropy, its not an unfair practice, but still improves lifes of many at the same time earning huge revenue for the MFI, banks and all parties involved.

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Responses

  1. Hey, that was an awesome article. I am so dumb at all this finance and things and even I understood the concept really well.. You know wat u should probably write text books when u r more expereinced.. expecting more informative articles…
    Cheers
    S

  2. Hey Alok,

    I agree with Sowmya…very interesting article! I have zero knowledge of finance and found it really easy to understand the whole microfinance idea. The scale of the industry seems phenomenal.

    Disha

  3. Tat was a superb article.. Simple to understand and easy to digest. Please come up with such simple examples and if possible, even take up one topic in finance/general stuff (like FDI, Mutual Funds etc.) and explain the way you have explained this micro finance. Pretty refreshing after going through all jargonised articles in the past.

  4. Thank You Sowyma, Disha & Pradeep, for your encouraging words. No idea when will I write a book, but articles in blogs.. yes I will continue to do so.

    Thanks Once again
    Alok

  5. I am Ajay and currently working at Tata Motors in the project management division (its been 5 years now). I think your article is simply amazing. The approach used to explain a new concept (Microfinance) helped me understand easily. All the best in your future research. (btw i’m a R2 applicant)

  6. Hey Alok,

    This is an amazing area where social responsibility can be carried by way of profits. C. K. Prahalad’s book “Fortune at the Bottom of Pyramid” talks in great depth about similar things and also discuss few case studies.

    I feel it is definitely a great field for pursuing entrepreneurship, specially in India. It will give access to one of the biggest and competition free market while also providing a good opportunity for shaping up BOP (Bottom of Pyramid) customers into mainstream middle class.

    Abhishek…

  7. hey alok,

    awesome article.. have really understood the concept well… u got me really interested in the subject..

    any idea if you had anyone from ure batch pursue this field?

  8. hi Alok,

    I am a s/w engineer working with Xansa.

    Indeed an interesting article.

    ISB must be a great place to study at.

    Take care and stay in touch.
    sudhir

  9. Hi Alok,

    Remember me?
    Well, as u can see (hope they give the accurate comment time), I have been hooked to ur blog for quite a long time. Fabulous articles. I really liked ur ideas and ur knack of lucidly putting them across to the junta. This one on microfinance gave a good boost to my interest on the subject.
    So…Keep blogging 🙂

    Take care,
    Anu

  10. Ofcourse Anu, how can I dare to forget u?

    Thanks for dropping by my blog, the appreciation and encouraging words. And I am pleased to know your interest in Social work, and microfinance in particular.

    ~Alok


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