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An Interest Bearing Note

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The late C.K. Prahalad, one of the foremost management thinkers, made a virtue out of doing business with the poorest of people, the segment that is referred to as the ‘bottom of the pyramid'. With technology becoming cheaper and all-pervasive, lending ‘tiny amounts of money to people with tinier assets' (as The Economist magazine put it in an article published in 2005) seems to be an obvious way of doing business with what is potentially the largest market for many businesses.

This microfinance business, however, has fallen into disrepute in the past few weeks with stories of borrowers committing suicide in Andhra Pradesh, one of the biggest markets for microfinance services. Compare this to the success of the initial public offering of SKS Microfinance that captured investors' imagination; the admiration for the company was all too brief, as a management struggle ended up putting the company and other firms in the business under the harsh glare of government scrutiny.

Media reports about high interest rates  charged on loans made to people who appear to be ill-equipped to pay such large sums — and thus the suicides, allegedly — have raised eyebrows, even as other stories have reflected on the crores of rupees in stock options that company executives of microfinance companies appear to have benefited from. The seemingly high interest rates charged by microfinance institutions (MFIs) stem from transaction costs, which is why banks have not been very successful in microfinance. Even in the era of priority- sector lending, the banking system had tended to lose a lot of money on loan defaults — apart from the subsidised interest rates prevalent then. In other words, the banks' failure lay in their inability to see microfinance as a sustainable business, and more as a social obligation.

Three types of costs matter: the cost of funds, the cost of associated risk (of default) and administrative costs, all of which are integrated into deriving the final interest rate charged to borrowers. Microfinance depends heavily on personal contact, limiting loan officers' reach to a small number of borrowers, unlike banks that rely on technology for credit scoring (almost all microfinance lending is cash based, and collections take up significant personnel time).

Put another way, administrative costs are not proportional to loan size. The transaction costs of making a single loan of Rs 1 crore by a bank are significantly lower than the costs of making 500 loans of Rs 20,000 each (a typical microfinance loan). Loans by banks are repaid quarterly; microfinance loans are collected with greater periodicity, perhaps even every week.

Dealing with barely literate borrowers with no collateral and credit bureau records, requires time-consuming personal interaction, all of which drive up costs high enough that can only be covered by high interest rates. It is a simple principle of business that if you cannot cover costs, you will not stay in business.

If there is one area that microfinance institutions need to focus their energies on, it is building technology platforms that will reduce their high administrative costs. They also need to build political capital — ask any businessman who has dealt with regulators and government on its importance — that will help blunt the adverse, perhaps even undeserved, publicity that they are getting. Simply put, get with it.

(This story was published in Businessworld Issue Dated 08-11-2010)

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