THE ROLE OF MICRO FINANCE IN THE MORDERN FINANCIAL

INDUSTRY

Chapter 1

1.1 Abstract: -
NABARD has defined microfinance as the provision of thrift, credit, and many other type
of financial services and products of very small amount basically for the poor people in
rural, semi urban or urban areas and this provision is for enabling these people to raise
their level of income and standard of living.1

Microfinance is a range of financial services which provides assistance to small scale

entrepreneurs as access to banking and other related services for them is quite difficult.
Poverty eradication is the main objective of microfinance as it assists the poor and thus
helps in poverty eradication and by helping the poor it also helps is boosting the economy
and strengthening the financial sector. The main service provided by microfinance is
micro credit but it also provides other wide range of services which includes insurance,
savings, remittance and also non-financial services like training, counseling etc.
Microfinance sector helps in business development and thus it is regarded as one of the
important pillars of the economy in modern times.2

Microfinance existed since the 18th century. Jonathan Swift introduced the Irish Loan
Fund system, which tried to improve the conditions for impoverished Irish citizens, can
be attributed as one of the first micro lending operations. 3 In its modern times, micro
financing became popular on a large scale in the 1970s. Grameen Bank, which was
started by Muhammad Yunus, in 1976, in Bangladesh was the first modern microfinance
institution which gained popularity. The Grameen Bank also suggested to its customers
“16 Decisions”, which was a list comprising of several ways by which the poor people
can improve their lives. This “16 Decisions” comprised of both socio- economic issues
like dowries, drinking water and sanitation. Mohd. Yunus and Grameen Bank were
awarded the the Nobel Peace Prize in 2006 for their incredible efforts.

Microfinance has emerged as a larger movement whose object is "a world in which as
everyone, especially the poor and socially marginalized people and households have
access to a wide range of affordable, high quality financial products and services,
including not just credit but also savings, insurance, payment services, and fund

1
Microfinance in India- Issues, Problems and Prospects: A Critical Review of literature- by S.L. Shetty.
2
Introduction to microfinance by- Todd A. Watkins. Publishers- World scientific. (connecting great minds).
3
Helms, Brigit (2006). Access for All: Building Inclusive Financial Systems. Washington, D.C.: The World
Bank. ISBN 978-0-8213-6360-7.
transfers.4 For instance, in Bangladesh only microfinance has benefitted around 15
million families by providing micro credits to them and also other facilities such as
micro-savings and micro-insurance and all this has also resulted in about 40% reduction
in the rural poverty.

SEWA Cooperative Bank which was initiated by Ela Bhatt in 1974 in Ahmedabad,
Gujarat, is regarded as one of the first modern day microfinance institution of its
kind. The concept of Micro-credit in Bangladesh was introduced by Muhammad Yunus,
who is a Nobel Prize winner. He introduced it in the form of the "Grameen Bank".

NABARD also with the aim to help the poor people who don’t have easy access to banks
and more specifically to help the Self-help Groups (SHGs) which is a model based on
microfinance only. This sector is growing and evolving at a very progressive rate as this
can be seen by analyzing the amount of energy and resources which has been devoted by
the national bodies like Small Industries Development Bank of India (SIDBI) and
National Bank for Agriculture and Rural Development (NABARD).

In the light of this background, this dissertation will majorly focus on microfinance and
its role in modern financial industry, the role of government in strengthening
microfinance and how microfinance is helping the MSMEs in India.

1.2. RESEARCH QUESTION: -

In the light of problem, background leads to the following problem statement, which will
also be the overarching question/statement for this investigation: What is the impact of
Microfinance on the modern financial Industry specifically in India?

1.3. RESEARCH OBJECTIVES: -

The objectives of this research are: -

1. Understanding the meaning of micro finance and the modern financial industry
especially in the context of India.

2. Study the expectations of Microfinance institutions and the challenges faced by them
in obtaining the funds.

3. Understanding the role of Government in boosting Micro finance institutions.

4
Robert Peck Christen, Richard Rosenberg & Veena Jayadeva. Financial institutions with a double-bottom
line: implications for the future of microfinance. CGAP Occasional Paper, July 2004, pp. 2-3.
4. Study the relationship between Commercial banks and microfinance institutions

5. Determine the role of MFIs in the development of MSMEs.

1.4. HYPOTHESIS: -
1. Microfinance institutions help MSMEs in providing finance and thus helps in
eradicating poverty and in turn help in boosting the economy (conclusion)
2. Link between Commercial banks and microfinance institutions and do
microfinance institutions help commercial banks where commercial banks fail?
Commercial banks don’t always help in providing finances to MSMEs
3. Promote economic development, employment and growth through the support of
micro-entrepreneurs and small businesses.

1.5. Methodology
Researcher has applied doctrinal method of research while conducting this research. This
Research is based on the secondary data which includes books, journals, articles, internet
sources, etc.

1.6. Chapterization
This dissertation is divided into seven chapters. The first chapters contains the abstract of
the study which gives a brief understanding about the work, it has also dealt with the
research question, objectives, hypothesis, methodology used in this research work and
the literature review. Chapter two gives a comprehensive understanding about
microfinance and the modern financial institutions. It also deals with the history and
evolution of the Indian financial sector. Chapter three deals with the expectations of the
microfinance institutions, sources from where they raise funds and the challenges faced
by them in doing so. Chapter four talks about role of government in facilitating the micro
finance institutions and the fifth chapter deals with the relationship between the
commercial banks and the microfinance institutions in detail, further the sixth chapter has
dealt with the role of microfinance institutions in developing the small, medium and
micro enterprises as this is one of the main activities in which the microfinance
institutions are involved. Conclusion is there in the seventh chapter which contains the
impact of microfinance institutions on msmes and the financial industry and the
suggestions.
 Chapter 2
Understanding Micro Finance and the Modern Financial
Institution

2.1. An Overview of Microfinance

2.1.1. Definition of microfinance

“Microfinance refers to the provision of small scale financial services including
microcredit, savings, payment services, micro insurance and other services to the rural
and urban poor clients who don't have access to the banking services on sustainable
basis”5.

The definition given by the Asian Development Bank (ADB) states that, “microfinance is
a provision which pertains to a broad range of financial services such as deposit, loans,
payment services, money transfers and insurance to the poor and low-income households
and their micro-enterprises”6.

The World Bank in its definition of microfinance has highlighted a link between
microfinance and development. Microfinance refers to the provision of financial services
to low-income clients, including the self-employed. Microfinance is not simply banking,
it is a development tool. Microfinance involves a wide range of activities such as giving
small loans, providing micro insurance and giving financial and business education to the
poor people and they also indulge in providing vocational training to the poor people who
can learn through these programs so that they can earn their living and can subsequently
become self- sufficient and can further help in the development7.

2.1.2. Historical Development of Microfinance

The history of microfinance can be traced back to the Starr-Bowkett Society. Further in
18th and the 19th century. Jonathan Swift inspired the Irish Loan Funds which was also a
type of microfinance.8 These Irish loans were interest free loans and also sometimes in
the form of charities also. The Individualist anarchist, Lysander Spooner in the mid of the
19th century wrote about the advantages of the microfinance and the benefits derived

5
Parker, 2000.
6
ADB, (Ledgerwood J. , 1998) 2000
7
Ledgerwood J. , 2002
8
Aidan Hollis; Arthur Sweetman (March 1997). "Complementarity, Competition and Institutional
Development: The Irish Loan Funds through Three Centuries" (PDF). Retrieved 30 January 2012.
from small loans by the poor people.9 The first cooperative lending bank was opened in
Germany in the 19th Century to support the poor farmers. It was founded by Friedrich
Wilhelm Raiffeisen 10. In Latin America and Asia microfinance started as an experiment.
In 1950, Commila Model was used by Akhtar Hameed Khan in East of Pakistan,
according to this model loans were given through community based initiatives.11 This
project was not a success because of the over involvement of the Government of Pakistan
and also because of the hierarchies which was made within the group.

Microfinance gained popularity in 1976, when on the outskirts of Chittagong University

campus in the village of Jobra, in Bangladesh, Muhammad Yunus started the Grameen
Bank.12 After seeing the success of the Grameen Bank in Bangladesh many other
microfinance institution have come up and have helped the low income group of the
society and they have also come up with many other strategies which includes providing
collateral free loans to poor people, especially in rural areas, at full-cost interest rates and
these loans are repayable in frequent installments and all the borrowers are arranged into
different groups. In 1983, this institution became a bank. In the year 2006, Nobel Peace
Prize was given to Mohd. Yunus and Grameen Bank for their efforts, loans without
financial security was an idea which was not thought upon and worked before him but he
transformed his dream into reality and helped people throughout the world.13 Mohd.
Yunus once also said that, “Maybe our great-grandchildren will go to museums to see
what poverty was like”14.

2.1.3. Microfinance and its effect on Poverty Elevation

Microfinance is an effective tool for poverty eradication this was underlined by Mohd.
Yunus also, he also once remarked that, “Maybe our great-grandchildren will go to
museums to see what poverty was like”15. This remark shows his confidence in the
technique of microfinance in poverty elevation.

This technique is considered as very effective for poverty alleviation and is also effective
in imparting various information which relates to education, sanitation, health, legal
rights and other information which proves to be helpful in improving the standard of

9
Spooner, Lysander (1846). "Poverty: Its illegal causes and legal cure". Boston. Archived from the
original on 25 October 2012. Retrieved 30 January2012.
10
Deutscher Raiffeisenverband:The Raiffeisen organization: Beginnings, tasks, current
developments Archived 2007-08-10 at the Wayback Machine, March 2011
11
Bateman, Milford (2010). Why Doesn't Microfinance Work?. Zed Books.
12
Armendariz, Beatriz (2005). The Economics of Microfinance. Cambridge, Mass: The MIT Press.
13
www.grameen-info.org/
14
3 Kirkpatrik, Colin H.; Clarke, R.; Charles, P. (2002), “Handbook on Development Policy and
Management” Edward Elgar Publishing, p. 173
15
3 Kirkpatrik, Colin H.; Clarke, R.; Charles, P. (2002), “Handbook on Development Policy and
Management” Edward Elgar Publishing, p. 173
living of the poor people. Many microfinance programs have also targeted the women
who live in house in the society as they are one of the most vulnerable section of the
society. These women are financially weak as they have no assets or any kind of financial
security of their own. Studies have proved that these techniques have improved the
condition of the women by giving them opportunity of self- employment which in turn
provides financial, social security and also helps women in gaining self- confidence and
helps in improving their status in the society.

Microfinance also saves people from the exploitation of the moneylenders who charge
exorbitant rate of interest while providing the loans to the poor people and this
exploitation and makes the poor more poorer and later this turns into a vicious cycle.
Hence majorly low income people of the society are benefitted from microfinance
schemes and these schemes helps them in engaging in micro and small enterprises.16
Effective collateral substitute for short- term and working capital loans to micro-
entrepreneurs17 is provided by micro finance institutions.

2.2. An Overview of Modern Financial Service Sector

2.2.1. Meaning
Capital markets, insurance sector and non- banking financial companies (NBFCs) makes
up the financial sector of a country. Institutions which are involved with money are
included in the financial service sector of financial industry. These institutions includes
business providing money management, insurance sector, issuance of securities, trading
services and lending and investing activities.18 Banks, Credit card issuers, Insurance
companies, Investment bankers, Securities traders, Financial planners, Security
exchanges, pension funds, mutual funds and other smaller financial entities are some of
the institutions which are part of this sector.

In India, commercial banks constitutes the largest part of the financial sector as it covers
sixty- four percent of the total asset in the financial sector. The Government of India has
introduced several reforms to liberalise, regulate and enhance this industry. The
Government and Reserve Bank of India (RBI) have taken various measures to facilitate
easy access to finance for Micro, Small and Medium Enterprises (MSMEs). These
measures include launching Credit Guarantee Fund Scheme for Micro and Small
Enterprises, issuing guideline to banks regarding collateral requirements and setting up a
Micro Units Development and Refinance Agency (MUDRA). With a combined push by
both government and private sector, India is undoubtedly one of the world's most vibrant

16
Schreiner, 2002
17
Hubka, A.; Zaidi, R. (2005), “Impact of Government Regulation on Microfinance”, World Development
Report: Improving the Investment Climate for Growth and Poverty Reduction pg 1.
18
https://www.ibef.org/industry/financial-services-india.aspx
capital markets. In 2017, a new portal named 'Udyami Mitra' has been launched by the
Small Industries Development Bank of India (SIDBI) with the aim of improving credit
availability to Micro, Small and Medium Enterprises' (MSMEs) in the country. India has
scored a perfect 10 in protecting shareholders' rights on the back of reforms implemented
by Securities and Exchange Board of India (SEBI).19

2.2.2. Aims of Finance Industry20

1. The main aim of the finance sector is to provide financial stability both within and
outside the country this also leads to generation of employment and increase in
productivity. All this increases the confidence of people and encourages saving and
investment.

2. Another aim of this industry is to provide an easy access to finance s that people can
manage their needs and expand their opportunities and improve their living standards.
When finance is easily accessible then people can have better self- employment
opportunities, better housing and education facilities.

3. Another important aim is to finance the growing need of the infrastructure of the
country such as roads, power generation, hospitals, schools and other places of public
utilities. The finance sector also aims to help the Government in bearing risks while
undertaking such projects.

4. Sustainable Development is another goal of the modern finance sector. Sustainable

development of the economy requires huge financing and the financial sector through its
various services help in achieving this aim.

2.2.3. Indian Financial Sector

The Reserve Bank of India (RBI) was founded in 1935 under the Reserve Bank of India
Act “…to regulate the issue of Bank Notes and keeping the reserves with a view to
securing monetary stability in India and generally to operate the credit and currency
system of the country to its advantage.” Apart from being the central bank and monetary
policy authority, the RBI is the regulator of all banking activity, including non-banking
financial companies, manager of statutory reserves, debt manager of the government, and
banker to the government. At the time of independence in 1947, India had 97 scheduled21

19
https://www.ibef.org/industry/financial-services-india.aspx
20
https://www.worldbank.org/en/topic/financialsector/overview
21
4 The ‘scheduled’ banks were banks “which were included in the Second Schedule to the RBI Act and
those banks in British India that subsequently became eligible for inclusion in this Schedule by virtue of
private banks, 557 “nonscheduled” (small) private banks organized as joint stock
companies, and 395 cooperative banks. The decade of 1950s and 1960s was characterized
by limited access to finance of the productive sector and a large number of banking
failures.22 Such dissatisfaction led the government of left-leaning Prime Minister (and
then Finance Minister) Mrs. Indira Gandhi to nationalize fourteen private sector banks on
20 July 1969; and later six more commercial banks in 1980. Thus, by the early 1980's the
Indian banking sector was substantially nationalized, and exhibited classical symptoms of
financial repression, viz., high pre-emption of banks' investible resources (with associated
effects of crowding out of credit to the private sector), subject to an intricate cobweb of
administered interest rates, and accompanied by quantitative ceilings on sectoral credit,
as governed by the Reserve Bank of India. Besides the commercial banks, there were four
other types of financial institutions in the Indian financial sector: development finance
institutions (DFIs), co-operative banks, regional rural banks and post-offices.

NABARD, the NHB and SIDBI are continuing largely as refinance institutions with
support from the government.23 As of 2015, there are 1,579 urban co-operative and
94,178 rural cooperative banks. A majority of these banks tend to operate in a single
state, and they are regulated and supervised by state-specific Registrars of Cooperative
Societies (RCS), along with overall oversight by the Reserve Bank of India.24 Asset
management industry in India is one of the fastest growing industry in the world. Total
AUM of the industry increased 40 per cent year-on-year to hit a record Rs 23 lakh crore
(US$ 358.78 billion) at the end of November 2017. Corporate investors accounts for
around 46.26 per cent of total AUM in India. High Net Worth Individuals and retail
investors account for 28.01 per cent and 22.96 per cent, respectively.

Revenues of the brokerage industry in India are estimated to grow by 15-20 per cent to
reach Rs 18,000-19,000 crore in FY2017-18. Insurance industry is another important
constituent of Indian financial services industry. The insurance industry has been
expanding at a fast pace. The total first year premium of life insurance companies grew
18.9 per cent year-on-year to reach US$ 18.44 billion during April-November 2017.25

their paid-up capital and reserves being more than Rs 500,000 in the aggregate…the power to include or
exclude banks in or from the Schedule was vested with the Governor General in Council” (RBI, 2008)
22
As against 566 commercial banks operating in 1951, only 89 survived by 1969, the rest went into
liquidation or amalgamation during 1951–1969; see RBI (2008) for details.
23
IDBI: Industrial Development Bank of India; ICICI: Industrial Credit and Investment Corporation of India;
IFCI: Industrial Finance Corporation if India; NABARD: National Bank fir Agriculture and Rural
Development; NHB: National Housing Bank; SIDBI: Small Industries Development Bank of India.
24
Indian Financial Sector: Structure, Trends and Turns by Rakesh Mohan and Partha Ray September 2016
Working paper No. 580. Stanford Centre for Development.
25
http://blog.ficci.com/financial-sector-india/2776/
2.2.4. Non-Banking Finance Companies (NBFCs)
India has a number of non-banking financial companies (NBFCs). The NBFCs is far from
being a homogenous entity and include many diverse types of financial institutions from
a housing finance company to an equipment leasing company.26 The diversity among the
entities of the NBFC sector is also reflected in attributes like sizes and the extent of
regulatory oversight. In the popular discourse the role of NBFCs are seen from two
distinct angles: (a) they have been very useful for sectors / activities that are generally
excluded from formal banking activities; and (b) at some regularity some of the deposit
raking NBFCs have been source of financial irregularity in some localized pockets and
raised the issue of consumer protection. Although NBFCs have existed for a long time in
India, these entities experienced sudden spurt in their activities between the late 1980s
and the mid-1990s. This sharp jump in NBFC deposits was mostly, “on account of the
high rates of interest offered on such deposits” (RBI, 2003). At the current juncture,
while a large chunk of deposit and non-deposit taking financial companies are regulated
by the RBI, housing finance companies are regulated by National Housing Bank, Chit
Funds are regulated by the State Governments, and Mutual Benefit companies are
regulated by Ministry of Corporate Affairs, Government of India. This multiplicity of
regulators has always become an issue in their functioning.27

26
5 These include: (i) Asset Finance Companies (AFCs); (ii) Loan Companies (LCs); (iii) Investment
Companies (ICs); (iv) Infrastructure Finance Companies (IFCs); (v) Core Investment Companies (CICs); (vi)
Infrastructure Debt Funds (IDF-NBFCs); (vii) NBFC-Microfinance Institutions (NBFC-MFIs); (viii) Factoring
companies (FCs); (ix) Mortgage Guarantee Companies (MGCs); (x) Residuary Non-Banking Companies
(RNBCs); (xi) Housing Finance Companies; (xii) Mutual Benefit Companies; and (xiii) Chit Fund companies.
27
Indian Financial Sector: Structure, Trends and Turns by Rakesh Mohan and Partha Ray September 2016
Working paper No. 580. Stanford Centre for Development.
 Chapter 3

Expectations of Microfinance Institutions and the Challenges Faced By

Them in Raising Funds In India
The eradication of poverty can be said to be the main idea behind microfinance.
Microfinance is majorly involved with the act of providing finance to the marginalized
section of the society who does not have an easy access to the commercial bank. 28 Mohd.
Yunus who founded Grameen Bank and was also a recipient of the Nobel Prize in 2006,
is often considered as a founding father of the microfinance. Being an economist at the
University of Chittagong in Bangladesh, he had an idea of providing loans and financial
support to the marginalized section of the society as the traditional banking system is not
easily accessible to them. His vision was that microfinance would be able to eradicate
poverty by providing finance to the poor people and making them self- sufficient. The
main features of microfinance are helping the lower strata of the society and also
involving women and providing finances and other assistance to them so that they can be
empowered. The vision which was proposed by him was new to many people and it was
accepted by a lot of people all over the world as it proposed one of the remedies to
eradicate poverty in an efficient manner as poverty is one of the major problems in the
development of the country. By providing finances to the marginalized section,
microfinance is also involved in bridging gap between the traditional financial institutes
and the marginalized section.

Credit unions, Non- Governmental Organizations, commercial banks, some government

institutions, cooperative banks and society, etc are some of the institutions which are
involved in microfinancing. In India various Non-Banking Financial Companies (NBFC)
are also involved in the activity of microfinance and thereby providing assistance to the
marginalized section of the society.29

3.1. Goals for Microfinance

The microfinance sector consistently focuses on understanding the needs of the poor and
on devising better ways of delivering services in line with their requirements, developing
the most efficient and effective mechanisms to deliver finance to the poor. Continuous
efforts towards automation of operations is steady improving in efficiency. The

28
Sustainable development with the poor Microfinance Handbook: An Institutional and Financial
Perspective
By Joanna Ledgerwood ; the world bank Washington D.C. (book)
29
https://economictimes.indiatimes.com/money-banking/mfis-at-the-crossroads/articleshow
automated systems have also helped accelerate the growth rate of the microfinance
sector.

The goal for MFIs should be:

• To improve the quality of life of the poor by providing access to financial and support
services;

• To be a viable financial institution developing sustainable communities;

• To mobilize resources in order to provide financial and support services to the poor,
particularly women, for viable productive income generation enterprises enabling them to
reduce their poverty;

• Learn and evaluate what helps people to move out of poverty faster;

• To create opportunities for self- employment for the underprivileged;

• To train rural poor in simple skills and enable them to utilize the available resources and
contribute to employment and income generation in rural areas.

3.2. Purpose of Microfinance Institutions

Traditionally, when a person wants to start a business venture, they go to a bank for a
loan. But what should a budding entrepreneur do if he is too poor to obtain finance to
start a profitable business? The answer lies in a relatively new branch of financial
services called microfinance. Its purpose is to provide basic financial services such as
loans, savings and insurance to underprivileged people. A microfinance institution (MFI)
is simply one that offers such services to the poor; according to the Consultative Group to
Assist the Poor (CGAP), it can be a credit union, commercial bank, financial non-
governmental organization, or a credit cooperative.

Provide Access to Funds: - Typically, the poor acquire financial services like loans
through informal relationships. These loans, however, come at a high cost per dollar
loaned and can be unreliable. Furthermore, banks have not traditionally viewed poor
people as viable clients and often will reject them due to unstable credit or employment
history and lack of collateral. MFIs dismiss such requirements and provide small loans at
high interest rates, thus providing MFIs the funds they need to continue operation.

Encourage Entrepreneurship and Self-Sufficiency:- Underprivileged people may have

potentially profitable business ideas, but they cannot put them into action because they
lack sufficient capital for start-up costs. Microcredit loans give clients just enough money
to get their idea off the ground so they can begin turning a profit. They can then pay off
their micro-loan and continue to gain income from their venture indefinitely.

Empower Women:- Women make up a large proportion of microfinance beneficiaries.

Traditionally, women (especially those in underdeveloped countries) have been unable to
readily participate in economic activity. Microfinance provides women with the financial
backing they need to start business ventures and actively participate in the economy. It
gives them confidence, improves their status and makes them more active in decision-
making, thus encouraging gender equality. According to CGAP, long-standing MFIs
even report a decline in violence towards women since the inception of microfinance.

Community-Wide Benefits: - Generally speaking, microfinance institutions seek to

reduce poverty worldwide. As they obtain funds and services from MFIs, recipients gain
enormous financial benefits which trickle down to others in their families and
communities. New business ventures can provide jobs, thereby increasing income among
community members and improving their overall well-being. Microfinance services gives
hope to people who previously had little or no opportunity to be self-sufficient.

3.3. Financial Resources of MicroFinance Institutions

Savings and deposits

Internationally micro saving products, also known as retail deposits, offered by MFIs
serve as a low cost source of funding and are a common practice in countries like the
Philippines, Uganda, Pakistan, Peru and Kenya. Most governments only allow
microfinance banks to offer micro saving products and prohibit other MFIs from raising
deposits. The potential pitfall of these deposit products is that MFIs may fail to provide
instantaneous liquidity. In India, the SHG model is primarily built up on mobilisation of
savings. SHG members borrow funds from banks against these deposits.30

Individual philanthropic sources and social investors

Non-profit investors, such as individuals interested purely in the social impact of

microfinance, often lend their own money to MFIs through online platforms,
internationally the most famous of which are Kiva and Micro Place. Similarly, high net
worth individuals who are interested in philanthropy often give away great sums of
money to MFIs, in acts known as ‘venture philanthropy’.

Social investors are individuals or institutions (high net worth, foundations, endowments,
and retirement plans) which choose to apply non-financial characteristics to their
investment decision making. These non-financial characteristics are often related to the

30
Srinivasan (2010) Microfinance India: State of the sector report, 2010.
investors’ value system or social mission, and may include concern for environmental
protection, social and economic development of the poor, education and health, as
priorities. For example, in India Rang De, an MFI raises money from social investors.
Commercial institutions also participate in such social investment. For example, Citibank
provides charitable contributions to three local MFIs in Haiti to help restore the country’s
microfinance industry which has suffered severe challenges in the aftermath of the 2010
earthquake.31

Soft loans and grants

Concessionary or soft loans (low cost debt) or grants are another source of funds from
socially responsible investors, which include national and regional development banks,
international NGOs, non-profit corporations, charitable trusts, or funds held by donor and
development agencies, such as the Grameen Trust, Swedish International Development
Agency (SIDA), United States Agency for International Development(USAID), United
Nations Capital Development Fund (UNCDF), the Asian Development Bank (ADB), the
World Bank, the Bill and Melinda Gates Foundation, Ford Foundation, the International
Monetary Fund (IMF), ACCION and CARE. Some development agencies only interact
with governments, but their funds can be accessed either directly or indirectly by MFIs.

Investment funds

Internationally there are many investment funds that specialise in microfinance. These
funds are concentrated in the lending institutions in Latin America and Eastern Europe,
but their pool of available capital is growing fast. Big banks are also entering the field:
Citigroup, Deutsche Bank, TIAA-CREF, Morgan Stanley, ABN AMRO and Societé
Generale are deploying their structuring and fund-management skills to offer investment
products that appeal to a broad range of investor risk profiles and social motivations.32

Microfinance investment vehicles

Microfinance investment vehicles (MIVs) are private entities which act as intermediaries
between investors and microfinance institutions. MIVs may be self-managed, managed
by an investment management firm, or by trustees. They may receive investments
through the issuance of shares, units, bonds or other financial instruments. Depending on
the type of MIV, these investments may then be provided to MFIs as debt, equity, or
guarantees. MIVs make use of different currencies as well, since they are located all over
the world. While some MIVs are primarily profit seeking, others additionally combine
the objective of social impact. This diversity among MIVs makes it possible for many

31
IIMB Management Review Volume 24 Issue 1, March 2012, Pages 28-39.
Volume 24, Issue 1, March 2012, Pages 28-39

32
http://www.forbes.com/2007/12/20/elizabeth-littlefield-microfinance-biz-cz_el_1220littlefield.html.
different types of investors to get involved in the microfinance sector. These have the
capacity to conduct the specialised due diligence and monitoring required for sound
investing in this niche market, and fund investing confers the added benefit of
diversification across many MFIs, countries and currencies. The International
Association of Microfinance Investors (IAMFI) estimates that as of April 2009 there are
104 MIVs with a total of $6.1 billion in assets under management.33

In the Indian context, such potential has not been captured so far. The RBI Report
(2011) suggests that to meet the funding requirements of the sector, a ‘domestic social
capital fund’ may be established. This fund will be targeted towards ‘social investors’
who are willing to accept ‘muted’ returns, say, 10%–12%. This fund could then invest in
MFIs which satisfy social performance norms laid down by the fund and are measured in
accordance with internationally recognised measurement tools.

Quasi-equity

The World Bank in collaboration with the Small Industries Development Bank of India
(SIDBI) has designed a project to offer MFIs a new kind of quasi-equity product aimed at
strengthening MFI balance sheets. Similarly NABARD is also supporting MFIs with the
Microfinance Development and Equity Fund.

Non-convertible debentures

In an attempt to create new avenues to raise funds, non-convertible debentures (NCDs)

were issued by MFIs. The country’s first ever NCD issue that was listed on the stock
exchange was by SKS Microfinance. It had raised Rs. 750 million at a coupon rate of
10% in May 2009, which was soon followed by another issue of SKS and Grameen
Koota. MFIs have increasingly tapped the NCD route to create a diversified lender base.

Bank loans

In the Indian context, commercial banks lend to MFIs and SHGs. Commercial banks in
India have to meet the mandatory requirement of lending 40% of their advances to the
priority sector. Thus banks are a major source of finance to MFIs and their interest rate is
12–14%. Both short-term loans and long-term debt can be acquired from commercial
banks.

The Small Industries Development Bank of India, an apex financial institution for
promotion, financing and development of small scale industries in India, has launched a
major project – the SIDBI Foundation for Micro Credit (SFMC) – to facilitate the
accelerated and orderly growth of the microfinance sector in India. SFMC is emerging as
the apex wholesaler for microfinance in India providing a complete range of financial and

33
(‘Microfinance Investment Vehicles IAMFI, http://www.iamfi.com/investment_vehicles_database.html
non-financial services such as loan funds, grant support, equity and institution building
support to the MFIs. SIDBI also provides equity capital to eligible institutions to meet the
capital adequacy requirements and to raise debt funds. Keeping in tune with the sectoral
requirements, SIDBI has also introduced quasi-equity products viz, optionally convertible
preference share capital, optionally convertible debt and optionally convertible
subordinate debt for new generation MFIs which are generally in the pre break-even
stage requiring special dispensation for capital support by way of a mix of Tier I and Tier
II capital. The Transformation Loan (TL) product is envisaged as a quasi-equity type
support to partner MFIs that are in the process of transforming their existing structure
into a more formal and regulated set-up for exclusively handling microfinance operations
in a focused manner. Being quasi-equity in nature, the TL helps MFIs not only in
enhancing their equity base but also in leveraging loan funds and expanding their
microcredit operations on a sustainable basis. The product has the feature of conversion
into equity after a specified period of time, subject to the MFI attaining certain structural,
operational and financial benchmarks. This non-interest bearing support facilitates the
young but well performing MFIs in making long term institutional investments and acts
as a constant incentive to MFIs to transform themselves into formal and regulated
entities.34

Private equity

The private equity market is an important source of funds for start-ups, private middle-
market companies and firms in financial distress. The huge demand for credit among the
poor has become an attractive investment avenue for private equity and venture capital
investors. These investors normally look for innovative and technology oriented ventures
where a conventional source of funding is difficult. Sequoia Capital India was the first
traditional venture capital (VC) firm to invest in the space with 11.5 million USD in SKS
Microfinance in 2007. The International Finance Corporation (IFC), the investment arm
of the World Bank, has invested 300,000 USD in Utkarsh Microfinance Private Limited,
a microfinance startup providing loans in northern India. The amounts raised through
private equity deals are showing an increasing trend indicating that microfinance is a high
return investment avenue. With India being a very attractive market in this field, many
private equity firms have started investing here.

Equity from capital market sources

MFIs have also started accessing resources through the capital market. Internationally a
few microfinance institutions such as Bank Rakyat at Indonesia (BRI), BRAC Bank in
Bangladesh, Banco Compartamos in Mexico and Equity Bank in Kenya have raised
equity capital through public issue. The four institutions are well known throughout the

34
http://www.sidbi.in/Micro/mfi.htm.
microfinance industry for their exceptional growth, robust financial performance and
ability to expand their outreach to the working poor. They are now listed on national
stock exchanges and, in two cases, have sold internationally35. The initial public offerings
(IPOs) and listings have allowed the four institutions to tap into the mainstream investor
community and take advantage of myriad new opportunities. This has also signalled to
capital markets that the microfinance sector is a potential source of profitable investment.
Raising capital through public issue has increased liquidity for investors by creating
opportunities for equity investors to exit, especially those who contribute as private
equity and seed capital. This has made microfinance an attractive investment avenue for
private investors.

In the Indian context, the SKS IPO is a milestone event. The Hyderabad based SKS
Microfinance floated its first public offering of equity and mobilised 358 million USD,
priced at 1.6 billion USD. The shares which were oversubscribed 13.7 times (primarily
by institutional investment interest) fixed the price per share at Rs 985 reflecting a
valuation of 98 times the face value of shares. Overall, the valuation accorded a book
value to market value ratio of six times. Microfinance has got the attention of the capital
market and around six other MFIs are aspiring to enter the equity market with their own
share floats.

Assignment and securitisation

The rapid growth in the microfinance sector, especially of NBFC-MFIs has led to the
search for innovative financial sources to meet the financial requirements of the sector.
The need for securitisation is common to all financial intermediaries, but when it comes
to microfinance, the growing asset size (which is the very essence of microfinance
economics) puts pressure on the balance sheet. Hence, off-balance sheet methods of
funding, or any devices other than plain balance sheet borrowing are needed to sustain
the growth rate.36

Three forms of structured financial products have gained significance; these are: bilateral
loan assignments, securitisation and collateralised debt obligations (CDOs).

In the case of assignment, the loan pool receivables are directly assigned to the assignee
or the purchaser, usually a bank. These deals are also rated but no specific instrument like
pass-through certificate (PTC) is issued. Banks often prefer this route as the loans need

35
Lieberman, I. W., Anderson, A., Grafe, Z., Campbell, B & Kopf, D. (May 2008). Microfinance and Capital
Markets: The Initial Listing or Public offering of Four leading Institutions. Council of Microfinance Equity
Funds.
36
M.S. SriramCommercialization of microfinance in India: a discussion of the emperor’s apparel
Economic and Political Weekly, XLV (24) (2010), pp. 65-74
not be marked-to-market (as they are on the banking books), whereas the securities
against those loan pools (as in the case of securitisation), if issued by the same seller will
have to be marked-to-market (as they are securities and hence will be on the bank’s
trading books). Besides this, banks will be able to pick and choose the loans that qualify
for priority sector lending norms, and hence such transactions fit exactly into their
objective. So, banks usually go in for bilateral assignment during the fag-end of the
financial year, based on their requirement for such loan pools. Further, most banks also
offer competitive rates if they are keen to have such loans on their books. Securitisation
typically involves the conversion of assets which have predictable future cash flows (for
example, a pool of microloans) into standardised, tradable securities. The securitisation
process allows MFIs to pool the receivables from loans and sell the same to third parties
like banks, mutual funds and insurance companies. This is an opportunity for MFIs to
increase their funding sources.

The primary objective of securitisation is to obtain financing for a company’s ongoing

business needs. However, a properly structured financial asset securitisation also can
permit a company to obtain a lower cost of financing compared to secured or even
unsecured debt. Securitisation allows the originator to remove the asset and all
corresponding risks associated with it completely from its balance sheet. It also reduces
the need to hold capital against the asset. The broad structure of transactions (as in the
case of securitisation) – including bankruptcy remoteness, limited recourse to originator,
performance of servicing function by the originator, and permissible commingling of
pool collections with servicer’s own funds – are common to both assignment and
securitisation.

3.4. Challenges faced by the Microfinance Institutions in Obtaining the

Funds
One of the main economic issue which exist in every developing country is poverty. One
of the main reasons behind the problem poverty is income distribution. In India also
income distribution is very uneven which leads to increase in poverty with every passing
day. Despite of significant progress made by the service and manufacturing sector, the
agricultural sector still plays a very important role in the Indian economy. 50% of the
Indian population depend on agriculture and allied activities and approximately 69% of
India’s population is in rural areas.37 Microfinance majorly focuses on financial inclusion
of this sector of the Indian society as people falling under this sector are comparatively
more backward and poorer. The initiative of NABARD in linking the traditional banking
system with the Self- Help Groups has helped micro finance institutions in achieving its
goals. But still there are many challenges faced by these institutions. They face
challenges with regard to structural, operational and financial processes.

37
Census Report, 2011.
Major challenges faced by Indian microfinance industry

The people who take help of these institutions generally belong to the marginalized
section of the society hence over-indebtedness, high interest rates, and excessive
dependence on the banking system, illiteracy and lack of awareness about the products.

Over-indebtedness due to multiple borrowings and inefficient risk management

Microfinance institutions (MFI) provide financial services to the poorer section of the
society in order to improve their standard of living. Therefore over-indebtedness is major
issue. Lack of risk management framework and multiple borrowings by most clients led
to micro-finance crisis in India in 2008. In some cases, it has been seen that there is no
apex control over the MFIs’ is also a reason. This sector gives loans without collateral
which increases securiy the risk of bad debts. Moreover the fast paced growth of the
sector has not been met with proper infrastructure planning. This kind of problems has
been reported in states like Andhra Pradesh, Karnataka, and Madhya Pradesh. Over
indebtedness is a cause of concern for MFIs’ as it negatively affects their portfolio. It also
makes them vulnerable to credit risk and increases the cost of monitoring38.

High rates of interest as compared to mainstream banks

MFIs’ when compared to commercial banks do not enjoy the same rate of financial
success. One of the reason is that while banking system is centuries old, micro finance is
only a few decades old in India39. MFIs’ charge a very high rate of interest (12-30%) as
compared to commercial banks (8-12%). Recently, the RBI (India’s regulatory bank)
announced the removal of upper limit of 26% interest on MFI loans (ET, 2014). This has
benefited the industry’s players but left the customers in a worse situation than before.
Due to the issues of over-indebtedness caused by the charging of high interest rate, rate
of suicide of farmers increased in states like Andhra Pradesh and Maharashtra.

Over-dependence on banking system for funding

Majority of the MFIs’ in India are registered as Non- Governmental Organizations

(NGOs). They are dependent on financial institutions such as commercial banks for
stabilised funding for their own lending activities. Around 80% of their funds come from
banks. Most of these are private banks which charge a high rate of interest and also the
term of loans is of shorter period. Most of the times, banks lend to micro lending firms in

38
Microfinance India State of the Sector Report 2010 N. Srinivasan www.sagepublication.com
39

Performance Analysis of Banks and Microfinance Institutions in India

Article 2, Volume 5, Issue 1, Winter 2015, Page 9-18, Authors- K. Pal Narwal; S. Pathneja; M. Kumar
Yadav.
order to meet their so-called priority sector loan targets. The over dependence of Indian
microfinance industry on banks make them incompetent and less reactive towards dealing
with default and delinquencies.

Lack of awareness of financial services

Like all other developing and underdeveloped countries, the literacy rate in India is very
low and the rate is much lower in the rural areas. Nearly 76% of India’s adult population
does not understand basic financial concepts. Lack of awareness of financial services
provided by the Indian microfinance industry is a challenge for both, customer
and MFIs’. This factor not only causes hindrance for villagers to join hands with MFIs’ to
meet their financial needs but also makes them financially excluded. MFIs’ are faced
with the task of educating the people and establish trust before selling their product.
Micro finance institutions struggle to make their business more financially viable due to
this lack of awareness.

Regulatory issues

Presently the Reserve Bank of India (RBI) is the regulatory body for the microfinance
industry in India. However it has traditionally catered to commercial and traditional
banks rather than MFIs’. Moreover the needs and the anatomy of micro finance industry
is supremely different from that of banks. In the past the industry has undergone sporadic
and unprecedented regulatory changes. Some of these have benefited the industry greatly,
but a lot of issues were unaddressed, like creating barriers for entry to restrict unworthy
players. Not only has it led to constant structural and operational changes but also created
ambiguity in norms of conduct. Therefore there is a need for a separate regulatory
authority for this industry. Regulatory issues have led to sub-optimal performance and
failure in the development of new financial products and services through which the
poorer section can be benefitted.

Problem in identification of appropriate model

In India, most of the MFIs’ follow Self-Help Group model (SHG model) or Joint
Liability Group model (JLG model). The problem is that most of the time, selection of
model are not scientific in nature. The models are selected randomly, not according to the
situation and also the decision of selection is irreversible in nature. So, it affects the
sustainability of the organisation in the long-run and also increases the risk of borrowings
for the poorer section beyond they can bear. This is also one of the main reasons of crisis
of microlending in the state of Andhra Pradesh. It has been repeatedly stressed that the
industry needs to undergo business process reengineering to effectively reach out to the
under-financed.40

40
https://www.pwc.co.uk/who-we-are/annual-report/annual-report-2016.html
 Chapter 4

The Role of Government in Boosting Micro Finance Institutions

After 1990, India economy has become an open economy and thereby it has attracted
many foreign investors and global corporations to invest in India. All this have made
India as a hub of investment and have put Indian economy at the forefront of world trade
and industry. But even after such transformation in the economy, many people are still
unaffected because of these changes and are still living in poverty. Thus, the idea behind
Microfinance is to provide financial services to the low-income proletariat who
traditionally lack access to banking and other monetary services.

During the last two decades, substantial work has been done in developing and
experimenting with different concepts and approaches to reach financial services to the
poor, by the Government, Non-Governmental Organisations (NGOs) and banking
institutions in various parts of the country.

Microfinance refers to small scale financial services, both credit & savings, that are
extended to the poor in both rural and urban areas. It refers to economic services which
mitigate vulnerability to economic shocks, promotes savings and supports self-
empowerment. Microfinance encompasses a variety of financial instruments. The only
common factor amongst the available services is the low amount of capital involved.
Most Microfinance programs provide multiple services like lending, savings, life
insurance, crop insurance etc.

Such financial services are important for the uplift of the economically weak sections of
the society who are not able to avail financial services from the traditional sector. The
lack of access to credit for the poor can be attributed to practical difficulties arising from
the discrepancy between the mode of operation followed by financial institutions and the
economic characteristics and financing needs of low-income households. Microfinance
based credit delivery mechanism ensures viable financial services to address issues like
actualizing equitable gains from development activities on a sustained basis, and plays a
vital role in fighting poverty

NABARD has taken the lead in promoting microfinance in India. Its Self Help Group-
External website that opens in a new window (SHG) model has created opportunities for
commercial banks to lend to the poor. It has been encouraging voluntary agencies,
bankers, socially spirited individuals, other formal and informal entities and also
government functionaries to promote and nurture SHGs & Microfinance Institutions
(MFIs)).

Due to the Government's active promotion & special schemes, Commercial banks have
actively started lending capital to SHGs & MFIs, which then further lend to their
members overcoming the information asymmetries that the bank would normally have
faced. Thus engaging a dormant source of financing for the needy, as in lending to the
poor, banks face high risks and transaction costs, while the lack of borrower information
and of collateral make it unattractive for the formal financial sector to lend to the very
poor.

4.1. Dominant Models of Microfinance in India

SHG-Bank Linkage Model: This model involves Self Help Groups (SHGs) which are
financed directly by the Commercial Banks (Public Sector and Private Sector), Regional
Rural Banks (RRBs) or Co-operative Banks.

Microfinance programmes focus on organisation at the grassroots level through a process

of social mobilisation that enables the poor to build Self Help Groups (SHGs) amongst
themselves, consisting of 10-20 persons. They participate fully and directly and take
decisions independently in such organisations.

These groups are formed, developed and strengthened to evolve into self-managed
people's organisations which provide internal loans to its members from the group
corpus. The group corpus is supplemented with Revolving Fund sanctioned as cash credit
limit by the banks.

MFI-Bank Linkage Model: This model covers financing of Microfinance Institutions

(MFIs) by banking agencies for on-lending to SHGs and other small borrowers covered
under microfinance sector.

MFIs combine flexibility, sensitivity and responsiveness of the informal credit system
with technical & administrative capabilities and financial resources of the formal
financial sector which rely heavily on collective strength and closeness of social groups
for effective social mobilisation to enable financial empowerment.

MFIs have adapted themselves to circle around the shortcomings of traditional financial
organisations, by forming a partnership between socially focussed NGOs, which invest in
human and social capital at the grass roots, and economically sensitive banking
institutions, experienced in mobilising funds for graduating and enabling rural
communities.

MFIs enable commercial banks to overcome the formal requirements of paper-work to

support transaction costs, information asymmetries and risk, making lending to the poor a
commercially attractive proposition. The role of the MFIs therefore is to act as the
guarantor to the bank, to support the credit worthiness of the poor.

Grameen Model- Grameen Model was pioneered by DR Mohammed Yunus of Grameen

Bank of Bangladesh. It is perhaps the most well known and widely practiced model in the
world. In Grameen Model the groups are formed voluntarily consisting of five borrowers
each. The lending is made first to two, then to the next two and then to the fifth. These
groups of five meet together weekly, with seven other groups, so that bank staff meets
with forty clients at a time. While the loans are made to the individuals, all in the group
are held responsible for loan repayment. According to the rules, if one member ever
defaults, all in the group are denied subsequent loans.

Co-operative model: A co-operative is an organization owned by the members

who use its services. This model works on the principle that every community
has enough human and financial resources to manage their own financial
institutions. The members who own it are the members who use its services and can
come from different sections of same community like agriculture, retail etc. Example is
Sahavikasa or Co-operative Development Foundation (CDF). It helps in assisting
rural women and men in the areas of operation in forming and developing self-
sustainable co-operatives. It also provides education and training to the co-operators
from its work area

4.2. SUPPORT IN THE FORMAL SECTOR41

Microfinance institutions are a big stake holders in the Indian economy hence they are
need to be encouraged by the Government. Further the microfinance institutions provides
loans on fair terms and without collateral hence it is preferred by the people belonging to
the low income group as it frees them from the vicious cycle of debt in which they get
trapped because of the informal lending (especially moneylenders), microfinance also
need support and encouragement from the Government as it requires less documentation
than the commercial banks and are also easily asseccible.

1. NABARD- NABARD is a development bank which facilitates credit flow for

promotion and development of agriculture, small-scale industries, cottage and
village industries, handicrafts and other rural crafts. Its Financial Inclusion
Department (FID) is the nodal agency which oversees the Financial Inclusion
Fund (FIF) and Financial Inclusion Technology Fund (FITF) which promote
microfinance initiatives.

2. Rashtriya Mahila Kosh- The National Credit Fund for Women or the Rashtriya
Mahila Kosh (RMK) has a large number of grant and subsidy based poverty
alleviation programs comprising micro-credit & micro-savings schemes with a
focus on poor women across the country. RMK takes active initiatives in
channelising funds, market development social advocacy.

41
India.gov.in
 3. Small Industries Development Bank of India (SIDBI)- External website that
opens in a new window- SIDBI's Foundation for Micro Credit is the apex
wholesaler for micro finance in India. It provides a range of financial and non-
financial services such as loan funds, grant support, equity and institution building
support to the retailing Micro Finance Institutions (MFIs) including two-tier MFIs
so as to facilitate their development into financially sustainable entities, besides
developing a network of service providers for the sector.
4. Tamil Nadu Womens' Development Corporation- External website that
opens in a new window- The Tamil Nadu Corporation for Development of
Women, in partnership with Non Governmental Organizations (NGOs) and
Community based organizations, supports 'Mahalir Thittam' or Self Help Groups
(SHGs) which inculcate sound habits of thrift, savings and banking amongst the
volunteer members of the scheme.
5. National Handicapped Finance and Development Corporation NHFDC)42 has
been set up to promote economic and development activities undertaken by
Persons with Disabilities. The Corporation assists them by providing loans for
self-employment and other economic ventures. The majority of disabled
population is constantly in need of small loans for sustaining their existing
employment, for generation of further employment as also for meeting varied
personal and social needs. The poorest among the poor need loans of very small
amount but their requirement is quick delivery of loan at their doorsteps.
Traditionally, private money lenders have been playing this role but their
intention has been to exploit the poor instead of helping them and this rather
worsened plight of the poor. Over a period of time, the significance of provision
of credit as an instrument of socio-economic change and development is being
realised and many international and national organisations including the
nationalised banks have come up to provide soft loans to the poor in order to free
them from the clutches of private money lenders. However, the task is gigantic
and a wide gap persists in meeting the credit needs of the poor. With this in mind,
the NHFDC has decided to implement the Micro Credit Scheme as per details
given in the following paras.

4.3. Role of Reserve Bank India

42
http://nhfdc.nic.in/schemes/micro-financing-scheme
4.3. CHALLENGES FACED

Microfinance was first introduced in India in the 1970s. Forty years on, the phenomenal
growth rate of the microfinance sector in the country has brought in funds from socially
motivated donors and investors, both foreign and domestic.

But cost of capital has been considerable, prompting lenders to charge high interest rates
as the average number of loans with borrowers of very small capital has increased across
the country. Large numbers of very small loans demand high rates, and artificially
lowering rates can de-sensitize MFIs from expanding their reach to the very poor.

The high growth of the industry has meant MFIs have, at times, ignored due diligence
and have not taken measures to limit multiple lending. The rapid growth in the for-profit
MFI industry, which is still at a nascent stage, has raised several questions on both
corporate governance issues as well as the viability of the business model.

The fact that the client base of MFIs is the most vulnerable sections of society makes
them a target of political activism and regulatory intervention as well, especially because
the high profit growth of these firms is often seen to be at the expense of the poor.

Although many of the Indian Non-profit organizations (NGOs) which have extended
themselves and set up their own in-house microfinance units, find themselves flailing,
financially. Some of those can be attributed to lack of expertise in the sector, but the
primary reason is suspected to be NGOs' alignment towards public service commitment
which makes it difficult for them to transition into profit based microfinance sector. The
ability to re-gain borrowed capital is necessary for sustainability of the organisations.

The Government has initiated a number of Innovative Pilot projects to address these new
challenges and improve the outreach and sustainability of the MFIs. It has also been
promoting the need for self-regulation by MFIs & NGOs, as over-regulation at a time
when the entire sector is at a budding stage of growth, could throttle the growth potentials
of the SHGs.
 Chapter 5
Commercial Banks and Microfinance Institutions
NEED FOR COMMERCIAL BANKS IN MICROFINANCE
Commercial banks provides a wide range of service which majorly includes accepting
deposits and giving loans to individuals and businesses. Commercial banks also help
microfinance institutions in in several ways, ranging from indirect involvement
while raising the capital to direct interaction with borrowers. Commercial banks
have realized the growth potential, which can be achieved through
microfinance, apart from the social needs. Commercial banks play vital role in
microfinance through following ways-

Direct Lending: Commercial banks can lend to entrepreneurs directly. This sort
of participation of commercial banks are entirely targeted to serve the
microfinance sector. Group lending includes providing a loan to every borrower
of the group. However, new loans are not approved to borrowers if any borrower
defaults his existing loan. The process of group lending entails an
accountability on borrowers to repay their loan in more discipline way.

Partnership with Microfinance Institution: Commercial banks create partnership

with microfinance institutions. Banks lend to MIs in the form of retail and
wholesale banking. However, MFIs are involved in collection,
monitoring and origination of loan. MFIs enjoy lots of benefits by doing tie
up with banks. As the higher amount of capital can increase the size of the loan,
banks have greater reach through their geographical expansion. Furthermore, the
bank’s personnel can also provide mentoring to MFIs in terms of improving the
operational efficiencies of the organization and making it aware of standardized
international practices in the world of finances if the bank has reached such a
standard. One such example is the case of ICICI Bank in India which is working in
partnership with microfinance institutions.

Microfinance Subsidiary: Banks can also choose their microfinance operations

through the creation of a new subsidiaries. Such kind of branches assist banks in
mitigating the risk levels involved while lending to the poor. From the borrower’s
perspective, specialized microfinance services provided by banks may create
higher trust among borrowers and shows the commitment of bank in poverty
reduction.
 Securitization: Last but not the least, commercial banks play vital
role in microfinance by raising funds in international as well as domestic market
for the several lending operations of MFIs.

5.3. COMPARATIVE ADVANTAGES OF COMMERCIAL BANKS IN

MICROFINANCE

At first glance, banks appear well positioned to offer financial services to ever-
increasing numbers of microfinance clients and to earn a profit. Banks have
several advantages over nonbank, micro lending NGOs:•They are regulated
institutions fulfilling the conditions of ownership, financial disclosure, and capital
adequacy that help ensure prudent management.

•Many have physical infrastructure, including a large network of branches, from

which to expand and reach out to a substantial number of microfinance clients.

•They have well-established internal controls and administrative and accounting

systems to keep track of a large number of transactions.

•Their ownership structures of private capital tend to encourage sound

governance structures, cost-effectiveness, and profitability, all of which lead to
sustainability.

•Because they have their own sources of funds (deposits and equity capital), they do not
have to depend on scarce and volatile donor resources (as do NGOs).

•They offer loans, deposits, and other financial products that are, in principle,
attractive to a microfinance clientele. All of these advantages could give banks a
special edge over micro lending NGOs in providing microfinance services.

d)OBSTACLES FOR COMMERCIAL BANKS IN MICROFINANCE-Banks

lack, however, some key ingredients -most of all, the financial methodologies to reach
a low-income population. They also face thorny internal constraints

Shikha Wadhwa*www.ignited.in5Journal of Advances and Scholarly Researches in

Allied EducationVol. V, Issue No.X, April-2013, ISSN 2230-7540that must be
overcome before they can produce a large, successful microfinance program. Our
study of banks in microfinance identified at least six key related issues banks need
to resolve to enter the microfinance market successfully:

•Commitment: the commitment of commercial banks (particularly the larger

banks) to microenterprise lending is often fragile, and generally dependent on one
or two visionary board members rather than based solidly in its institutional mission.
•Organizational structure: Microfinance programs need to be inserted into the larger
bank structure in such a way that they have relative independence and, at the
same time, have the scale to handle thousands of small transactions efficiently.

•Financial methodology: Banks need to acquire an appropriate financial

methodology to service the microenterprise sector —financial innovations that
permit a cost-effective analysis of creditworthiness, the monitoring of a large
number of relatively poor clients, and the adoption of effective collateral substitutes.

•Human resources: Given that microfinance programs differ so radically from

traditional banking, banks must recruit and retain specialized staff to manage
these programs. Issues of recruitment, training, and performance-related incentives
require special consideration.

•Cost-effectiveness: Microfinance programs are costly because of the small size of

their loans and because banks cannot operate them with their traditional
mechanisms and overhead structures. Strategies must be found to minimize processing
costs, increase staff productivity, and rapidly expand the scale of their
microenterprise portfolios —that is, increase the number of loans. Banks must
cover the costs of microfinance operations and specialized training through scale
economies.

•Regulation and supervision: Banks must communicate with banking authorities

to ensure that reporting and regulatory requirements take into account the specialized
nature of microfinance programs.

Commercialization of Microfinance

The term “transformation,” or commercialization, of a microfinance institution (MFI)

refers to a change in legal status from an unregulated nonprofit or non-governmental
organization (NGO) into a regulated, for-profit institution. Regulated, transformed
organizations differ from nonprofits in that they are held to performance and capital
adequacy standards and are supervised by a financial authority, typically the central bank
of the country where they are registered. A transformed MFI also attracts equity
investors. The equity investors want to ensure that the values of their investments are
maintained or enhanced and elect Board members who share a common vision for the
new for-profit institution.43 Among transformed MFIs, varying classifications of
regulated institutions exist, the strictest being banks — rural banks and thrift banks —

43
https://www.microfinancegateway.org
followed by non-bank financial institutions. Different countries have varied names for
these regulated MFIs.

India is a unique, diverse and immensely special country. It encompasses people

following the ideals of Gandhi who offer themselves to serve the poor selflessly, as well
as people with extraordinary commercial acumen who exploit the poor ruthlessly.
Originally, all the original promoters of MFIs in India entered microfinance for its
development potential. They believed in creating sustainable financial institutions
providing credit to the poor, and were genuinely double bottom line organisations. In
most, but not all cases, the entry of PE investor money changed that very quickly indeed
… realising 30% per annum returns cannot be done without a ruthless commitment to
rapid expansion and profitability. 3 The majority of the larger Indian MFIs with PE
investors became single (financial) bottom line organisations, and their promoters,
apparently dazzled by the colour of money, seemed to lose sight of the ideals on which
they set-up their organisations. With PE investments leveraging the banks’ debt capital
that was so freely available as a result of the priority sector lending requirements, the
larger MFIs grew very rapidly indeed. This meant that the legal and governance
structures of the MFIs struggled to keep up with the pace of change. 4 The rules of the
game were underdefined and almost made up as the market evolved. The transformation
of NGO-MFIs into Non Bank Financial Corporations using the Mutual Benefit Trusts of
members’ shares became a common and often abused route to growth.5 And governance
was, in most cases, not a priority. As a result governance did not evolve fast enough to
match the complex and high finance involved in MFIs that were growing exponentially to
serve millions of customers. Where the PE investors took Board seats they quickly
crowded out any remaining social investors and, unsurprisingly given their exit strategies,
drove growth to the exclusion of almost any other priority.44

44
MicroSave India Focus Note 43 Commercialisation of Microfinance in India: Is it all Bad? Manoj K.
Sharma and Graham A.N. Wright May 2010 (Research paper).
 Chapter 6

Micro Finance Institutions and Micro, Small and Medium Enterprises

a) Role of Micro Finance Institutions in the Development of Micro, Small and
Medium Enterprises in India

Definitions of Micro, Small & Medium Enterprises

In accordance with the provision of Micro, Small & Medium Enterprises Development
(MSMED) Act, 2006 the Micro, Small and Medium Enterprises (MSME) are classified in
two Classes: (a) Manufacturing Enterprises – The enterprises engaged in the manufacture
or production of goods pertaining to any industry specified in the first schedule to the
industries (Development and regulation) Act, 1951) or employing plant and machinery in
the process of value addition to the final product having a distinct name or character or
use. The Manufacturing Enterprise are defined in terms of investment in Plant &
Machinery. (b) Service Enterprises – The enterprises engaged in providing or rendering
of services and are defined in terms of investment in equipment.

Need for Micro Finance in the Development of Small Enterprise

The major barrier to the development of Micro and Small Enterprises is access to credit.
These enterprises differ in the level in which they are and the products and services
offered to them by the MFIs.The micro and small enterprises need to be financed
differently and the financing is determined by whether the firm is in the start-up phase or
existing one and also whether it is stable, unstable, or growing. Stable survivors are those
who benefit in having access to the financial services provided by MFIs to meet up with
their production and consumption needs. Unstable survivors are groups that are
considered not credit worthy for financial services to be provided in a sustainable way
and Growth enterprises are Micro and Small Enterprises with high possibility to grow. In
identifying the market, MFIs consider whether to focus on already existing entrepreneurs
or on potential entrepreneurs seeking for funds to start up a business venture. Working
capital is the main hindrance in the development of already existing SMEs and to meet
up, the borrow finance mostly from informal financial services which have high interest
rates and services offered by the formal sector or not offered by these informal financial
services. The business activity of a microenterprise is equally as important as the level of
business development. There are three main primary sector where an enterprise may be
classified; production, agriculture and services. Each of these sectors has its own risk and
financing needs that are specific to that sector

Small medium enterprises (SME’s) plays a major role in economic development through
creating employment, eradicating poverty and generating income. On the other hand,
Microfinance is an important tool that promotes the business development and acts as a
source of business growth through improving working capital. One of the primary reason
for the expansion of small business into medium and further to large is due to
microfinance.

Microfinance is a financial resource for low-income individuals and small medium

enterprises for supplying loans, savings and other financial services to poor. In India
microfinance operates through two channels: a) Self-help group bank linkage
programme: where a small group of 10-20 women or men make small savings through
contribution periodically and begin lending. They even get linked to banks, banks lend to
self-help group after checking their creditworthiness. b) Microfinance institutions: which
is an organization that provides microfinance services from small non-profit organization
to larger banks.

Access to finance is the major problem faced by micro-enterprises, to whom commercial

banks have traditionally concentrated their lending mainly to large formal enterprises
which have the expertise of doing business and possess collateral. They miss out small
enterprises as they lack expertise and riskier investment. Thus it is observed lack of
proper access to finance as one of the factors hindering the SMEs growth. So to facilitate
financing the policies of microfinance institutions have been framed.

Microfinance institution emerged as a noble substitute for informal credit and an effective
instrument for providing funds, financial help for the growth of SME’s. Easy accessibility
of services offered by microfinance institutions has a direct impact on the sales, profit
and physical assets development of SME’s.

As per the research report „The Role of Microfinance in Rural Micro-Enterprises

Development‟ of Prof. Dr. Hans Dieter Seibel, University of Cologne the key issue in
agriculture and rural development during the 1960s and 1970s was agricultural
production. Later on agricultural credit became an important input alongwith improved
seeds and seedlings, fertiliser, pesticides, tools and machines and with the growing
population increasing numbers of rural people could not live on agriculture alone. To
survive they had to engage in numerous activities: on-farm, off-farm and non-farm. Rural
households and rural economies got increasingly diversified. Access to finance was the
limiting factor. Agricultural credit had been exclusive to farmers only. Therefore many
micro-entrepreneurs, traders and household business units were unsatisfied. This
unsatisfied demand prepared the ground for a revolution on the supply side:
microfinance. As per Prof. Dr. Hans Dieter Seibel this should be called the blue
revolution, blue being the bankers‟ colour. As per the report „Microfinance for Micro-
Enterprises: An Impact Evaluation of Self Help Groups of Department of Economic
Analysis and Research‟ of National Bank for Agriculture and Rural Development,
Microfinance movement in India entered into second phase in 1990s. In the present phase
of microfinance processes, sustainability of Micro-Enterprises has become very
important. There are many problems faced by Micro-Enterprises like low profit margin,
repayment of loan, infrastructure problems etc. This report provides the challenges faced
by Micro-Enterprises. According to NABARD 2003-04 report on SHG bank linkage, in
spite of the optimism generated by the expansion of SHG credit and the high recovery
rate there is a gap between actual per capita credit provided to the poor and the demand.
As per Srinivasan, research report 2009, by 2008 there were 54 million microfinance
customers in India, of these; 39.9 million customers were served by the SHG model while
14.1 million were served by the MFI model. While the SHG model accounted for 77% of
the total outreach, its growth rate of 15% in 20007-08, was lowerthan that of the MFI
model which grew by 40%. By March 2009 it is estimated that the total outreach of the
sector had grown to 86.2 million with total loans outstanding of Rs.351 billion (Sa-dhan,
2009). This amounts to only around 6% of the total credit outstanding of commercial
banks in rural and semi-urban areas in 2008 (RBI, 2009). Some studies such as the
Intellecap study entitled “Inverting the Pyramid” (2007) estimate that the potential
market may be 245 million individuals, suggesting there is still a lot of scope for the
sector to grow.

Lack of access to finance has been identified as one of the major constraints hindering the
development of small businesses not just in India but in other developing countries also.
Commercial banks have traditionally concentrated their lending mainly to large formal
enterprises which have expertise of doing business and possess collateral and not on
small enterprises as they lack expertise and are riskier investment. Despite the potential
of SMEs to facilitate economic growth, many studies have highlighted lack of access to
finance as a major problem which hinders the growth of SMEs (Anyanwu, 2003;
Lawson, 2007). In the Focus Note on Financing Small Enterprises: What Role for
Microfinance Institutions?, the authors examine the experience and role of microfinance
institutions (MFIs) in serving small enterprises. They started with an overview of small
enterprises and their financial needs, suggesting that they require more than just loans.
They then analysed the current and potential role of MFIs in serving this market. (CGAP
2012).

Ways in which Microfinance helps in Achieving the goal of development

Rural economy forms the backbone of most developing countries. That being said, the
problem is that significant developments in infrastructure are a little difficult to come by;
thereby birthing a dearth of economic viability. In such a situation, microfinance
institutes are often the only significant pathway towards alleviation of poverty, thus
bettering economic condition.

Small and medium enterprises (SMEs) have long been one of the more chief sources of
employment and livelihood for the citizens in most developing countries, including India.
On the other hand, microfinance is crucial, when it comes to escalation of business
growth by way of generating steady working capital.

So much so, that microfinance has been solely instrumental in catapulting many small
businesses to the next league of augmented productivity and increased turnover. Listed
below are some ways in which microfinance institutions can help fund SMEs based out
of developing nations:

a) By providing easier access to credit facilities: - Microfinance institutions serve as

primary credit and lending facilities for both low-income individuals and small and
medium enterprises that fall shy of accessing easy loans from the organized financial
sectors.

Moreover, most of these institutions provide micro loans and other financial services that
attach affordable rates of interest and entail simpler procedures and minimal
documentation. Here, the financial performance of SMEs, among other factors, depends
on the ease with which they can avail loans from institutions of microfinance, essentially
indicative of a symbiosis.

b) By implementing inclusive policies: - SMEs often hire unskilled and semi-skilled

labourers - many of whom belong to the economically deprived and marginalized
categories - to carry out their routine operations. Microfinance lenders collectively target
aspirations of these sections of people, thereby developing business models aimed at
allaying poverty and improving their standard of living.

c) By aiding business expansion: - Probably the most significant function of

microfinancers is offering SMEs a blueprint for business expansion and assistance to
expand their operational footprint beyond the traditional strongholds. This primarily
happens by way of aid to SMEs to increase the number of outlets, access more uncharted
business areas and eventually become formidable contenders in the market.

Moreover, a group of people, sharing common aspirations and interests, can avail credit
facilities from microfinancing houses. What happens here is that should one of the
participants default at the time of repayment, there is usually a chance that the share
would be distributed and shouldered by the other members of the group.

This way, microfinancers usually find it relatively easier to recover their loans;
something that leads them to lend further, thereby allowing SMEs to utilize the funds, up
their productivity and increase profits in the process.

Microfinance institutes tend to enjoy better credibility: - You might attribute it to the
cooperative attitude of microfinancers, but SMEs have a tendency to trust microfinance
houses more. Another reason behind this might be customized financial products that are
in tune with the exact demands of SMEs and the nature of their businesses.

Developing nations have, beyond much doubt, embraced the concept of microfinance
loans and microfinance institutions, and it is no surprise that these micro lending houses
have come to be the lifeline of SMEs based out of these countries. It is with the help
of micro loans, that many deprived sections of the society have been able to integrate
with the mainstream.

Chapter 7

Conclusion and The Future of Microfinance in India

IMPACT & FUTURE OF MICROFINANCE IN INDIA

Impact & Future of Microfinance in India

Microfinance has been a major success & is growing fast across the country. It has
proved to be a powerful tool in initiating a cyclical process of growth and development.
The general recovery rates for all services have been very high for all MFIs. Although
interest rates are higher than the formal sector due to the perceived risk involved, MFIs
still undercut the local moneylenders by a large margin.

Although microfinance has helped in providing social and economic empowerment, it

cannot eradicate poverty by itself. Good governance, security, health, education and
financial inclusion all work hand-in-hand at poverty alleviation.

Availability of credit may be a trigger for growth but the credit amount, by design, is too
low to eradicate poverty. The Government thus has adopted a multi-pronged strategy to
provide credit to the economically backward, with microfinance positioned strategically
as a livelihood generator.

With the steady growth in reach of microfinance, the SHGs and their federations provide
the social space and the political power that the poor need to overcome these hurdles. The
scope for expansion in the sector remains the major draw for socially inclined profit-
motive organisations & non-profits, both.
IMPACT OF MICROFINANCE A number of field researches have been conducted by
various agencies to study the impact of microfinance on socio-economic aspects of the
clients. These field studies include study commissioned by NABARD in 2002 with
financial assistance from SDC where GTZ which covered 60 SHGs in eastern India. The
World Bank Policy Paper details in the findings of Rural Finance Access Survey (RFAS)
done by World Bank in association with NCAER. The RFAS covered 736 SHGs in the
state of Andhra Pradesh and Uttar Pradesh. These field studies reveal divergent research
findings. But the common findings are of the opinion that there is some increase in
income levels and household assets in real terms among the clients. These studies also
brought out the fact that major occupation of group members was agriculture along with
other activities like farm labour and poultry. Being rain fed area, lack of irrigation
facility; declining agricultural outputs and fragmentation of land have accentuated their
vulnerabilities over a period of time. The group members lack any sort of specific
handicraft skills and do not International Journal of Marketing, Financial Services &
Management Research Vol.1 Issue 11, November 2012, ISSN 2277 3622 Online
available at www.indianresearchjournals.com 152 receive any skill development training
for undertaking any other non- farm activities. In most of the cases, loans from financial
organizations are used by them for meeting their consumptions and emergency
requirement. It also shows that group members do not have confidence to use credit for
productive purposes in view of lack of opportunities and skills. Irrigation and depressed
commodity prices act as deterrent in farm sector investments, while lack of skills and
invasion of rural market by big consumer goods companies reduce the scope for rural
micro enterprises. In this scenario it seems rather naïve to visualize flourishing of micro
enterprises through provision of microcredit (DEVRAJA, 2011). The growth of
microfinance organizations in India has also to be seen in the light of financial sector
reforms in India. Under the new approach, institutional viability is of prime concern and
instruments of directed credit and interest rate directives have been totally diluted or done
away with. As a consequence, banks are increasingly shying away from rural lending as
well as rationalizing their branch net work in rural area. Burgess and Pandey (2004) have
brought out this fact in their study by stating that while between 1977 and 1990 (Pre
reform period) more bank branches were opened in financially less developed states, but
the pattern was reversed in post reform period. Thus the access of the rural poor to credit
through traditional bank lending has been reduced in post reform era. The policy
recommendation is to fill up this gap through microfinance. As per the new design
NABARD is aggressively lending rural poor through Self Help Groups and Microfinance
Institutions. High recovery rate under the program is used to justify the dictum that poor
need timely and adequate credit rather than cheap credit. Robinson(2001) is probably
right in observing that commercial microfinance is not meant for core poor or destitute
but is rather aimed at economically active poor. He opines that providing credit to people
who are too poor to use it effectively helps neither borrower nor lender and would only
lead to increasing debt burden. He suggests that this segment should not be the target
market for financial sector but of state poverty and welfare programs. 7.0. DISCUSSION
AND CONCLUSION Microfinance is multifaceted and works in an integrated system.
There are many stake holders and each one has a definite role to play. In the core there is
client. There is a second level called micro level where MFIs, NGOs, SHGs and Grameen
work to provide financial support to individual client. Apex institutions like NABARD,
SIDBI and other nationalized Banks operate in Meso-Level to provide infrastructure,
information and technical support to micro level players. Around all these levels, there
are financial environment, Regulations, legislations and regulators called Macro level.
With passage of time new opportunities and new challenges are being felt in the field of
microfinance. In recent years microfinance is in news for bad reasons. There are a
number of suicide cases of micro credit clients all over India for excess interest charges
and high handedness of recovery agents in recovery of loans. So, government of India has
brought out a legislation to check the high interest rate on micro credit and protect the
poor from clutches of greedy MFIs. Government of India introduced Micro Finance
Institutions (Development and Regulation) Bill 2012 on May 22, 2012 to establish a
regulator under RBI to regulate and supervise the activities of NGOs and MFIs. The main
features of the Bill are as follows: the Bill allows the central government to create a
Microfinance Development Council International Journal of Marketing, Financial
Services & Management Research Vol.1 Issue 11, November 2012, ISSN 2277 3622
Online available at www.indianresearchjournals.com 153 with officers from different
ministries and Departments. The Bill requires all MFIs to obtain a certificate of
registration from RBI. The RBI has the authority to set maximum annual percentage rate
charged by MFIs and sets a maximum limit on the margin MFIs can make. Margin is
defined as the difference between the lending rate and the cost of funds. It is also
responsible for redressal of grievances for beneficiaries of microfinance services. These
initiatives may go long way in strengthening the micro finance status in India. Lending to
the poor through microcredit is not the end of the problem but beginning of a new era. If
effectively handled, it can create miracle in the field of poverty alleviation. But it must be
bundled with capacity building programs. Government cannot abdicate its responsibility
of social and economic development of poor and down trodden. In absence of any special
skills with the clients of microcredit, the fund is being used in consumption and
procurement of non-productive assets. Hence it is very important to provide skills
development training program like handicraft, weaving, carpentry, poultry, goat rearing,
masonry, bees farming, vegetable farming and many other agricultural and non
agricultural training. Government has to play proactive role in this case. People with
some special skills have to be given priority in lending microcredit. These clients should
also be provided with post loan technical and professional aid for success of their
microenterprises. If government and MFIs act together then microcredit can play a great
role in poverty alleviation.