As defined by the Asian Development Bank (ADB), it is - A provision of a broad range of financial

services such as deposits, loans, payment services, money transfers, and insurance to poor and
low-income households and their micro-enterprises. In the late 90s, numerous agencies involved
in micro-financing operations in India started adding other financial services, including micro-
insurance to its micro-finance operations.

The situation of micro-financing in India has thereby improved with certain steps taken by the
government and now, the private players, banks etc as well.

Need for Micro - Financing

Since independence, various governments in India have experimented with a large number of
grant and subsidy based poverty alleviation programmes. These programmes were based on
grant/subsidy and the credit linkage was through commercial banks only. As a result, these
programmes became unsustainable, perpetuated a dependant status on the beneficiaries and
depended ultimately on the govt. employees for delivery. This not only led to misuse of both credit
and subsidy but banks never looked at it as a profitable and commercial activity as well.

Hence was adopted the concept of micro-credit in India. Success stories in neighboring countries,
like Grameen Bank in Bangladesh, Bank Rakiat in Indonesia, Commercial & Industrial Bank in
Philippines etc, gave further boost to the concept in India in the 1980s. India thus adopted the
similar model of extending credit to the poorest sector and took a no. of steps to promote micro-
financing in the country.

Types of Organizations and Composition of the Sector

Microfinance providers in India can be classified under three broad categories: formal,
semiformal, and informal.

Formal sector

They primarily provide credit for assistance in agriculture and micro-enterprise development and
primarily target the poor. Their deposits at around Rs. 350billion and of that, around Rs. 250billion
has been given as advances. They charge an interest of 12-13.5% but if we include the
transaction costs (number of visits to banks, compulsory savings and costs incurred for payments
to animators/staff/local leaders etc) they come out to be as high as 21-24%.

Semi - formal Sector

The majority of institutional microfinance providers in India are semi-formal organizations broadly
referred to as MFIs. Registered under a variety of legal acts, these organizations greatly differ in
philosophy, size, and capacity. There are over 500 non-government organizations (NGOs)
registered as societies, public trusts, or non-profit companies.

Informal Sector

In addition to friends and family, moneylenders, landlords, and traders constitute the informal
sector. While estimates of their importance vary significantly, it is undeniable that they continue to
play a significant role in the financial lives of the poor.
Steps taken by India to promote micro-financing

It set up development banks, such as SIDBI, NABARD which focused on rural credit and micro-
financing. NGOs and SHGs were encouraged to become the govt�s arm in extending micro-
credit to the poor. They were provided supplementary credit needed to fund the credit, paper
work was reduced between them and the banks. Also, the govt assisted in mobilizing funds from
formal financial institutions to meet the larger credit needs of these organizations.

Focus on Women for micro - credits

A lot of Micro-financing schemes are now increasingly focusing on women primarily as well.
There are compelling reasons for this.

Among the poor, the poor women are the most disadvantaged - they are characterized by lack
of education and access to resources, both of which are required to help them work their way out
of poverty and for upward economic and social mobility.

 The problem is more acute for women in countries like India, despite the fact that women�s
labor makes a critical contribution to the economy.

 Evidence shows that groups of women are better customers than men - they are better
managers of resources - benefits of loans are spread wider among the household if loans are
routed through women - mixed groups are often inappropriate in Indian society - record of all-
male groups is worse than that of all-women groups, everywhere.

Current Scenario of Micro - financing in India

With 75 million poor households potentially requiring financial services, the microfinance market
in India is among the largest in the world. Estimates of household credit demand vary from a
minimum of Rs. 2,000 to Rs. 6,000 in rural areas and Rs. 9,000 in urban settings. Given that 80
percent of poor households are located in rural areas, total credit demand ranges between Rs.
255 billion and Rs. 500 billion. However, only Rs.18 billion of this amount has been generated so
far. The reason for this is that major portion for rural crediting has been from the informal sector
and this is at a very high interest rate, thus reducing the volumes of such credits, and by far has
been for investment purposes (13%) and more for family emergencies (29%) and social
expenditures (19%).

There are a number of factors why rural crediting by the formal sector has not taken pace so far.

 High fiscal deficits have meant that Government is appropriating a large share of financial
savings for itself.

 Persisting interest rate restrictions reduce the attractiveness of lending, particularly to small,
rural clients.

On the other hand, informal credits have been attractive albeit high interest rates due to:

 lexible repayment options

 Convenience and frequency with which such loans can be accessed

 Less reliance on collateral (only 16.5% of households report providing collateral against the
loan)

Meeting the Demands

Inadequacies in rural access to formal finance and the seemingly extortionary terms of informal
finance for the poor provide a strong need and ample space for innovative approaches to serve
the financial needs of India�s rural poor. A gap of as high as 85%-90% in supply and demand
cannot be closed by only the existing MFIs because many, particularly the younger and smaller
organizations, lack the institutional capacity to expand.

Key Concerns

All said and done however, there are certain key issues that need to be tackled before ensuring
the benefits of micro-financing would reach their optimum levels.

Scaling-Up Microfinance: Microfinancing through formal and semi-formal can reach self-
sustainability only when there is substantial volume which they can generate.

Effective policy, legal and regulatory framework - An enabling policy, legal and regulatory
framework is critical to scaling-up. For this the govt. needs to take certain steps as:

 Reducing minimum start-up capital requirements to facilitate the transformation of MFIs into
NBFCs

 Encouraging multiple sources of equity for MFIs

 Developing a set of prudential norms that are more appropriate to institutions serving the
poor, and set up supervision mechanisms around those norms.

Inclusiveness and competition in the microfinance sector can generate high payoff. This will
not only give the borrower a no of options for raising debt, but also drive the costs down to raise
them

Proven Impact of Micro-financing

The effects of micro-financing trickling down to the poorest of Indians can already be observed in
the Indian economy.

Improvement in Asset Position

The average increase in assets was about 72%, from Rs6,843 to Rs11,793 in real terms (in one
to three years) in most of the households where micro-financing has been extended. Before given
the credit, one in three households had no assets; after that, it changed to one in six.

Increase in Savings

While most households given micro-credits were having negligible or no savings, this improved to
Rs. 160-Rs. 460 and in some cases, the average household savings rose to as high as Rs. 1444.

Changes in Borrowing Patterns

With improvement in above two factors, people were more ready to borrow from the semi-formal
and formal sector rather than their traditional creditors i.e. friends and family, moneylenders,
landlords.

Impact on income

The average net income per household increased from Rs 20177 to Rs. 26889.

n late 2009 , CRISIL which is India’s leading ratings, research and risk advisory
company released it’s list of top 50 microfinance institutions in India. The report titled
India’s Top 50 Microfinance Institutions presents an overview of leading players in
India’s microfinance institution (MFI) space.

This is the first inagural issue and includes additional commentary analysing the key
strengths and challenges of different microfinance players in the sector. The publication
is part of CRISIL’s enabling role in the structured evolution of the MFI sector in India.

CRISIL launched MFI grading as early as in 2002 and has since then become the world’s
first mainstream rating agency to develop a separate methodology and scale to assess
MFIs. Currently CRISIL has assessed more than 140 MFIs, and is currently the
most preferred rating agency in the Indian microfinance space.

In light of SKS Microfinance’s proposed IPO in the coming days the CRISIL report is
presented below for the benefit of the readers of this blog. Market sources reveal that
some of these microfinance institutions which figure in the top 50 are in talks with
merchant bankers and investors to tap the primary markets and want to gauge the
response to SKS Microfinance’s IPO before theCRISIL List of Top 50 Microfinance
Institutions in India by Loan Amount Outstanding for 2009

1. SKS Microfinance Ltd (SKSMPL)

2 Spandana Sphoorty Financial Ltd (SSFL)
3 Share Microfin Limited (SML)
4 Asmitha Microfin Ltd (AML)
5 Shri Kshetra Dharmasthala Rural Development Project(SKDRDP)
6 Bhartiya Samruddhi Finance Limited (BSFL)
7 Bandhan Society
8 Cashpor Micro Credit (CMC)
9 Grama Vidiyal Micro Finance Pvt Ltd (GVMFL)
10 Grameen FinancialServices Pvt Ltd (GFSPL)

1. Micro-finance and Poverty Alleviation

Most poor people manage to mobilize resources to develop their enterprises and their
dwellings slowly over time. Financial services could enable the poor to leverage their
initiative, accelarating the process of building incomes, assets and economic security.
However, conventional finance institutions seldom lend down-market to serve the needs
of low-income families and women-headed households. They are very often denied
access to credit for any purpose, making the discussion of the level of interest rate and
other terms of finance irrelevant. Therefore the fundamental problem is not so much of
unaffordable terms of loan as the lack of access to credit itself (Kim 1995).

The lack of access to credit for the poor is attributable 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. For
example, commercial lending institutions require that borrowers have a stable source of
income out of which principal and interest can be paid back according to the agreed
terms. However, the income of many self employed households is not stable, regardless
of its size. A large number of small loans are needed to serve the poor, but lenders prefer
dealing with large loans in small numbers to minimize administration costs. They also
look for collateral with a clear title - which many low-income households do not have. In
addition bankers tend to consider low income households a bad risk imposing
exceedingly high information monitoring costs on operation.

Over the last ten years, however, successful experiences in providing finance to small
entrepreneur and producers demonstrate that poor people, when given access to
responsive and timely financial services at market rates, repay their loans and use the
proceeds to increase their income and assets. This is not surprising since the only realistic
alternative for them is to borrow from informal market at an interest much higher than
market rates. Community banks, NGOs and grassroot savings and credit groups around
the world have shown that these microenterprise loans can be profitable for borrowers
and for the lenders, making microfinance one of the most effective poverty reducing
strategies.

To the extent that microfinance institutions become financially viable, self sustaining,
and integral to the communities in which they operate, they have the potential to attract
more resources and expand services to clients. Despite the success of microfinance
institutions, only about 2% of world's roughly 500 million small entrepreneur is estimated
to have access to financial services (Barry et al. 1996). Although there is demand for
credit by poor and women at market interest rates, the volume of financial transaction of
microfinance institution must reach a certain level before their financial operation
becomes self sustaining. In other words, although microfinance offers a promising
institutional structure to provide access to credit to the poor, the scale problem needs to
be resolved so that it can reach the vast majority of potential customers who demand
access to credit at market rates. The question then is how microenterprise lending geared
to providing short term capital to small businesses in the informal sector can be sustained
as an integral part of the financial sector and how their financial services can be further
expanded using the principles, standards and modalities that have proven to be effective.

To be successful, financial intermediaries that provide services and generate domestic

resources must have the capacity to meet high performance standards. They must achieve
excellent repayments and provide access to clients. And they must build toward operating
and financial self-sufficiency and expanding client reach. In order to do so, microfinance
institutions need to find ways to cut down on their administrative costs and also to
broaden their resource base. Cost reductions can be achieved through simplified and
decentralized loan application, approval and collection processes, for instance, through
group loans which give borrowers responsibilities for much of the loan application
process, allow the loan officers to handle many more clients and hencee reduce costs
(Otero et al. 1994).

Microfinance institutions can broaden their resource base by mobilizing savings,

accessing capital markets, loan funds and effective institutional development support. A
logical way to tap capital market is securitization through a corporation that purchases
loans made by microenterprise institutions with the funds raised through the bonds
issuance on the capital market. There is atleast one pilot attempt to securitize
microfinance portfolio along these lines in Ecuador. As an alternative, BancoSol of
Bolivia issued a certificate of deposit which are traded in Bolivian stock exchange. In
1994, it also issued certificates of deposit in the U.S. (Churchill 1996). The Foundation
for Cooperation and Development of Paraguay issued bonds to raise capital for
microenterprise lending (Grameen Trust 1995).
Savings facilities make large scale lending operations possible. On the other hand, studies
also show that the poor operating in the informal sector do save, although not in financial
assets, and hence value access to client-friendly savings service at least as much access to
credit. Savings mobilization also makes financial instituttions accontable to local
shareholders. Therefore, adequate savings facilities both serve the demand for financial
services by the customers and fulfil an important requirement of financial sustainability
to the lenders. Microfinance institutions can either provide savings services directly
through deposit taking or make arrangements with other financial institutions to provide
savings facilities to tap small savings in a flexible manner (Barry 1995).

Convenience of location, positive real rate of return, liquidity, and security of savings are
essential ingradients of successful savings mobilization (Christen et al. 1994).

Once microfinance institutions are engaged in deposit taking in order to mobilize

household savings, they become financial intermediaries. Consequently, prudential
financial regulations become necessary to ensure the solvency and financial soundness of
the institution and to protect the depositors. However, excessive regulations that do not
consider the nature of microfinance institution and their operation can hamper their
viability. In view of small loan size, microfinance institutions should be subjected to a
minimum capital requirement which is lower than that applicable to commercial banks.
On the other hand, a more stringent capital adequacy rate (the ratio between capital and
risk assets) should be maintained because microfinance institutions provide
uncollateralized loans.

Governments should provide an enabling legal and regulatory framework which

encourages the development of a range of institutions and allows them to operate as
recognized financial intermediaries subject to simple supervisory and reporting
requirements. Usury laws should be repelled or relaxed and microfinance institutions
should be given freedom of setting interest rates and fees in order to cover operating and
finance costs from interest revenues within a reasonable amount of time. Government
could also facilitate the process of transition to a sustainable level of operation by
providing support to the lending institutions in their early stage of development through
credit enhancement mechanisms or subsidies.

One way of expanding the successful operation of microfinance institutions in the

informal sector is through strengthened linkages with their formal sector counterparts. A
mutually beneficial partnership should be based on comparative strengths of each sectors.
Informal sector microfinance institutions have comparative advantage in terms of small
transaction costs achieved through adaptability and flexibility of operations (Ghate et al.
1992). They are better equipped to deal with credit assessment of the urban poor and
hence to absorb the transaction costs associated with loan processing. On the other hand,
formal sector institutions have access to broader resource-base and high leverage through
deposit mobilization (Christen et al. 1994).

Therefore, formal sector finance institutions could form a joint venture with informal
sector institutions in which the former provide funds in the form of equity and the later
extends savings and loan facilities to the urban poor. Another form of partenership can
involve the formal sector institutions refinancing loans made by the informal sector
lenders. Under these settings, the informal sector institutions are able to tap additional
resources as well as having an incentive to exercise greater financial discipline in their
management.

Microfinance institutions could also serve as intermediaries between borrowers and the
formal financial sector and on-lend funds backed by a public sector guarantee (Phelps
1995). Business-like NGOs can offer commercial banks ways of funding
microentrepreneurs at low cost and risk, for example, through leveraged bank-NGO-
client credit lines. Under this arrangement, banks make one bulk loan to NGOs and the
NGOs packages it into large number of small loans at market rates and rcover them
(Women's World Banking 1994). There are many on-going research on this line but
context specific research is needed to identify the most appropriate model. With this in
mind we discuss various possible alternatives of formal-informal sector linkages in India.