Building strong microfinance institutions entails improving governance, professionalising management, strengthening internal controls and accounting practices, and introducing low-cost ways of doing business
Inclusive financial systems in fighting poverty
For most people, finance is an obscure, alien subject. And the immediate assumption about finance is that it cares only about helping the rich get richer. Yet, a growing body of research, some of it by the World Bank, shows that well-developed and inclusive financial systems are associated with more rapid growth and better income distribution. A well-functioning financial system gives households and businesses access to credit and allows them to link-up with the modern, formal economy. It gives people access to savings and insurance, allowing them to protect themselves against future calamities and live a more secured life. And then there is the 'empowerment' dimension of finance, which gives ordinary people access to opportunities that allow them to escape poverty and live a more dignified life. It is perhaps symbolic of this evolutionary thinking that 'building inclusive financial systems that work for the poor' became the mantra of the United Nations International Year of Microcredit 2005.
How inclusive is India's financial system?
In India, since the early national plans, successive governments have emphasised the role of finance in promoting equitable growth. With the majority of India's poor living in rural areas, policies aimed at financial inclusion have understandably had a rural focus. Today, India has a vast network of state-owned banks, regional rural banks and cooperative banks that are mandated to intermediate savings and credit for investment, particularly in the countryside and to weaker segments. And while there has been increased competition and liberalisation in India's financial sector since the early 1990s, which has certainly helped to improve financial sector depth and stability, some of the key features of credit planning, quantitative credit targets and subsidised credit, persist for the rural poor and other disadvantaged segments.
Paradoxically, access to finance on affordable terms remains woefully inadequate for large segments of India's population, particularly for the rural poor. According to a recent study on India by the World Bank and the National Council of Applied Economic Research, some 70 percent of rural poor households do not have a bank account and 87 percent do not have access to credit from a bank or other formal institution.
A key problem is that Government's imperative of deficit financing has driven banks to divert financial resources to safer government bonds. Moreover, there are perhaps not enough incentives for public sector banks to do business, particularly with the poor. Procedures for opening an account or seeking a loan are made cumbersome and costly. It takes an average of 33 weeks for a loan to be approved by a public sector bank in rural India. And banks invariably demand collateral, which the poor lack.
Not surprisingly, moneylenders, who charge exorbitant rates of interest, ranging from 36 percent to 120 percent per annum, remain a strong presence in rural India.
The challenge of improving access to finance
The challenge of ensuring that all Indians have access to the financial services they need to make the best possible use of their human potential is clearly enormous; microfinance programmes can make an important contribution to meeting this challenge, provided outreach can be expanded in a sustainable manner. Estimates suggest that Indian microfinance currently reaches about 12 million customers directly through credit services. This, however, is sorely inadequate in a country where 300 million people live in poverty. And outreach is concentrated in the southern states. In contrast, microfinance in Bangladesh is believed to reach more than 60 percent of the poor across the country.
India is fortunate to have seen some pioneering approaches to microfinance. The Self-Help Group-Bank Linkage programme, for instance, has had worldwide influence on the design of microfinance. But if Indian microfinance has to reach all of India's poor in a sustainable way, some fresh thinking on the subject is necessary.
Building strong microfinance institutions
There is a need to build strong microfinance institutions. This entails improving governance, professionalising management, strengthening internal controls and accounting practices, and introducing low-cost ways of doing business. The biggest hope on cost reduction comes from new technology, for example, transferring funds via mobile phones, as successfully experimented by the Philippines' GXchange, or debit cards for the poor, as introduced by South Africa's Standard Bank.
Cost reduction can also come from approaches that leverage existing infrastructure to deliver financial services to the poor, for example, Banco Postal Brazil's use of the country's vast post office network, and Uganda's Cerudeb and Brazil's Caixa Economica, which have used Point-of-Sale outlets. In all of these, partnerships between microfinance institutions and established commercial financial institutions can play an important role.
These efforts must go hand-in-hand with improvements in transparency. This means better information to both clients and lenders on interest rates, loan problems, and operating practices, as well as enhanced public disclosure of financial accounts of institutions and their dependence on subsidised capital. Pakistan's microfinance institutions, for instance, have made impressive progress in the public sharing of their financial accounts, for example, on the MixMarket website.
Providing financial services to poor
A third priority is for microfinance to expand beyond credit into a wider range of financial services for the poor, including savings, insurance, money transfer, remittances, etc. Today, only a few microfinance institutions in India are seriously offering insurance or remittance services, even though the demand for such services has increased.
Creating financial infrastructure
As microfinance grows, it will need the financial infrastructure to support it. For instance, as microfinance institutions turn to commercial sources for their funding, they require independent assessments from credit-rating agencies. While India has shown the way by establishing the first microfinance rating agency, there is need for greater competition and better rating methodologies.
Appropriate regulation and super-vision
Last but not the least, governments need to ensure that regulatory and supervisory policies genuinely support access to finance for the poor. One common temptation is to impose ceilings on the rate of interest that can be charged on micro-loans.
While such ceilings may appear to ensure cheap credit for poor people, in practice, they reduce the supply of credit, especially to the poor, who are driven instead to borrow from money lenders whose rates are not capped and whose collection methods are notorious. Interest rate ceilings can also reduce the transparency of the cost of credit to borrowers, as lenders evade the caps by adding various service charges and application fees. Evidence shows that a far more effective way for governments to ensure that interest rates are not excessive is to foster healthy competition within the financial sector.
The Reserve Bank of India's recent decision to leave interest rates on microfinance to the discretion of the lending banks is praiseworthy. However, the challenge remains to implement this policy uniformly across all states, as does the challenge of doing away with the interest rate ceiling on small loans (below Rs. 200,000) from commercial banks to rural clients.
While scaling up microfinance is an urgent priority, and it can clearly play an important role in improving access to finance for India's poor, it is not a substitute for an efficient formal financial sector.
After all, over the longer run, microfinance clients will need to graduate to banks where they can access standard loans of larger sizes. So, along with efforts to expand sustainable microfinance, a new wave of reforms is needed to improve the efficiency of India's banks and other formal financial institutions so they can serve underserved sectors in a profitable and sustainable manner. Our estimates suggest that this could raise India's GDP growth by at least 2 percentage points a year, with a significant impact on poverty reduction.