The Global economic crises has affected all and sundry. Even the heavyweights like Lehmann Bros, who could withstand the Great depression of 1930’s went kaput this time around. On the other hand MFI’s have virtually zero default. How this happened, read on further.

MFI stands for Micro Finance Institutions. Before I get into the lessons part, I will give a brief idea about what MFI’s are and how they work.

Micro Finance is defined as “provision of thrift, credit and other financial services and products of very small amount to the poor in rural, semi-urban and urban areas for enabling them to raise their income levels and improve living standards”. Micro Finance Institutions (MFI) are those which provide these facilities.

The financial services include

• Savings

• Remittances

• Risk mitigation products - Insurance

• Financial counseling

• Lifecycle planning products

Micro Finance has various delivery models. They are listed below

• Grameen Model

• SHG Model

• Community Banking

• Cooperatives

• Credit Unions

• Intermediaries

• Non – Governmental Organizations

• Rotating Savings and Credit Associations (ROSCA’s)

• Village Banking

Grameen Model

This model was the innovation of Dr. Muhammad Younus. He infact went to win Nobel Prize in 2006 for this purpose.

Working of this model:

A bank unit is set up with a Field Manager along with some bank workers, covering an area of about 15 to 20 villages. The manager and workers start by visiting villages to familiarize themselves with the local surroundings in which they will be operating and identify prospective customers, as well as explain the rationale, functions, and mode of operation of the bank to the local population.

Groups of five prospective borrowers are formed; in the first stage, only two of them are eligible to receive a loan. The group is under scrutiny for a month to see if the members are in compliance with the rules of the bank. Now only if the first two borrowers repay the principal plus interest over a period of fifty weeks do other members of the group become eligible themselves for a loan.

These restrictions make sure there is a peer pressure on individuals to repay. In other words, the collective responsibility among the members acts as a collateral on the loan.

The recovery rate for this type of model is around 98% and the number of people availing this service is growing at the rate of 20% annually.

SHG Model

SHG stands for self help groups. They are comprised of twenty or even fewer members, out of which the majority are women from the poorest castesand tribes. Members of the group save small amounts of money, as little as a few rupees a month in a group fund. As and when need arises these members can borrow from this group fund for different type of purposes viz. school fees, household activities, medical bills etc. SHG’s manage their fund well which helps them to borrow from local banks for investment in small business or other farm activities.

These local banks lend up to four rupees for every rupee available in the group fund. The annual rate of interest varies between 11-13%. Nearly 1.5 million SHGs consisting of approximately 30 million women borrow from banks, making the Indian SHG-Bank Linkage model the largest microfinance program in the world.

MFI: These are the institutions which provide micro credit. These institutes can be NGO’s , Credit unions, Cooperatives, Private Banks, Non bank financial Institutions.

MFI’s In India:

• SKS (Swayam Krishi Sangham )

• Sa-Dhan

• Bandhan

• MCFI (Microcredit Foundation of India)

• Grameen Koota

• Asmitha Microfinance Limited

Brief Working of Bandhan :

Source: Bandhanmf.com

Bandhan follows a group structure, individual lending approach. A group of 10-25 members are formed. The clients have to attend the group meetings for 2 consecutive weeks. Only after that, they are entitled to receive loans. The loans are disbursed separately to the individuals and directly to the members. The first loan amount ranges between Rs. 1,000 – Rs. 7,000 for the rural areas and between Rs. 1,000 – Rs. 10,000 for the urban areas. Once the initial loans are repaid, those members are entitled to receive a subsequent loan which is Rs 1,000 - 5,000 more than the preceding loan.

Clients of Bandhan: Landless and asset less women Family of 5 members with monthly income less than Rs. 2,500 in rural and Rs. 3,500 in urban and those who do not own more than 1/2acre of land or capital of its equivalent value.

Interest Rate: Bandhan charges an annualised interest of 23.56% on the loan amount. This rate has been decided based on several factors like cost of borrowing, operating cost, risk gradation etc.

Liability Structure: A Member has to get inducted into a group to avail a loan. The entire group proposes one woman’s name for a loan in the Resolution Book. Two members of the group along with the member’s husband have to sign as guarantors in her loan application form. If she fails to pay her weekly installment, the group inserts peer pressure on her. The sole purpose of the above structure is simply to create peer pressure. Bandhan offers a grace period of 7 weeks i.e. 49 days.

Having understood the model and workings of various MFI, let us now understand what lessons can US banks and other financial institution can learn from these MFI’s.

Lesson 1: Focus on clients/customers rather than collateral

MFI’s lend with almost no collateral at all. Their main clients as explained above are poor women with almost no credit history or credit worthiness They can be christened as sub-subprime clients. MFI’s depend upon the repayment capacity of the individual clients. These institutions have not invested in complex derivative markets to show impressive numbers and neither they are leveraged to crazy heights. They depend upon how well the repayment of loans takes place and as explained about 98% of times it does happen.

On the other hand the US banks lend money to the most creditworthy institutions and yet these secured loans bombed while unsecured loans lend to women without credit history made their repayments on time. MFI’s as explained above initially see whether their clients can repay their loans or not. If they are able to repay they become eligible for another loan.

US banks went on to give loans based on collateral without checking the repayment capacity of their borrowers. Some big institutions, like Lehman Brothers, borrowed extraordinarily to invest in AAA asset backed securities, and went kaput when value of these securities plummeted. NINJA’s were given loans which were secured by the houses. When the value of house plummeted and the rates began to rise, the subprime crises was born and the rest is history.

Therefore assess the cashflows of borrowers and leave enough cushion to make sure repayments are made in a timely and orderly manner.

Lesson 2: Set a certain type of loan limit

US banks were encouraged to give loans so that the managers could earn bonuses for achieving their targets. Also US brokers got commissions from the banks for marketing the loans which in turn increased the greediness of these agents and to earn more commissions they aimlessly went on giving loans to all and sundry without performing the necessary background checks. MFI’s on other hand have a certain cap to the amount they lend. Suppose and MFI lends around Rs. 6000 for the first year, now only if this amount has been repaid then a second loan is given, say of about Rs. 10000. The third loan can be higher depending upon the local economic situation. But MFI’s make sure there is a loan cap to make sure there is no over lending.

The US banks and other lenders should, like MFI should guard against over lending instead of being greedy for some dollars.

Lesson 3: Group Pressure can do wonders

MFI’s lend mostly to poor women with very little or no credit history. Suppose 1 woman defaults and the group is not able to repay the entire group is debarred from further credit. Hence there is enough social pressure for the people who are defaulting, so that they pay on time.

In contrast the defaulting US home owners are given writeoffs and other subsidaires, which is absurd to say the least.

The system of group pressure can be very helpful for global financial system in a way that a financial interdependence could prevent greedy leeches from taking excessive risks like investing in exotic, complex derivatives and taking debt levels to unthinkable levels.

MFI’s are ants compared to what US lenders lend. But the lessons that can be learnt from them can go a long way to make the global financial systems healthy.

The current system has flaws and the time is ripe to make some changes to it. This is the time to redesign the system so that it works well for everyone and not just for some powerful few.

The cues from MFI’s should be seriously looked into, because nobody will want history to repeat itself.