Microfinance needs holistic approach to prevent the debt trap

Microfinance was once applauded as the world’s most powerful tool for eliminating poverty. But it is now on a slippery slope, moving from good to bad. Microfinance is facing trouble because the purity of its mission has been diluted. When it started, microfinance was a financial tool being used for social good. Now it has increasingly become a social tool used as a way to generate money, which is why it has lost a lot of its original sheen. This is one reason why microfinance often runs into heavy weather and hits periodic roadblocks and default crises.

Born out of the simple notion that the poor can save and are bankable, microfinance is an approach to financial inclusion based on providing small denomination loans and other financial services to the working poor and others who lack the collateral, credit history, or other assets and are not served by conventional banking. It has generated considerable enthusiasm, not just in the development community but also at political levels. It has infused an entrepreneurial spirit in tiny business like clay-brick makers, seamstresses, and vegetable sellers.

Microfinance providers made an immediate impact because they were uniquely positioned in reaching out to the poor as they operated in limited and familiar geographies, have a greater understanding of local issues and enjoy greater acceptability amongst the local poor and have simplicity and flexibility in operations, providing a level of comfort to the clientele.

However, in the last decade-and-a-half, microfinance institutions (MFIs) in India have struggled to gain legitimacy as credible institutions even though they have demonstrated the ability to deliver financial services to unbanked low income households sustainably. Serious doubts on their modus operandi, high interest rates, governance, client treatment and transparency continued to bedevil the sector.

The explosion of multiple lending and borrowing was a prime cause, and it was positively encouraged by MFI lenders. Poor households took on multiple loans from different sources, often only for the purpose of repaying one of the lenders, and this was actively fed by the combination of aggressive expansion in the number of clients and strict enforcement of payments. When it came to credit they were continually “bicycling”. This implied that microfinance customers spun the pedals by paying off one loan with the next. This was often because women feared losing this crucial lifeline and falling off the “credit bicycle”.

Poor households, in particular the rural poor, are exposed to unsteady flows of income. The reasons are many, including seasonal unemployment related to the agricultural labour cycle, sickness or death in the family or weather shocks among many others. Given the variability and vulnerability of their income, they value formal microfinance because it is more reliable, even if it is often less flexible than their other tools to manage their cash flow. Banks offer cheaper credit but are mired in thickets of red tape.

Microfinance needs a relook and has to undergo soul searching. When it comes to microfinance it is very important to think outside of the borrowing box. It will have to move beyond its traditional roots. Recent evidence suggests that relatively simple tweaks to microcredit products — including flexible repayment periods, grace periods, individual-liability contracts or the use of technology — may change their impact for both clients and institutions. Microfinance institutions should be consistent in applying best practices in evaluating repayment capacity, offering transparent terms and conditions and using credit bureau information to avoid overstretching clients with debts.

To enable the poor to work their way out of poverty, they need to be enabled to move from one step to another of the financial ladder through graduated credit. Credit should be made available in staggered doses, with every new tranche disbursed after satisfactory repayment behaviour of the clients. This will also ensure that the vulnerable groups do not get into a debt trap; it will also make credit dispensation more efficient and qualitative.

Since low-income communities face multiple risks, their small businesses need to be insured to prevent their slide back into poverty. Micro-insurance softens the impact of economic shocks which are frequent of this segment. Offering micro-credit without micro-insurance is self defeating. It must be an integral component of financial inclusion when offered in conjunction with micro-savings and micro-credit, micro-insurance can keep this segment away from the poverty trap. Offering micro-credit without micro-insurance is fraught with risk. There is, therefore, a need to emphasise linking of micro-credit with micro-insurance. It will also enhance the sustainability of micro-insurance as it is not viable as a standalone product.

Consumer protection in microfinance is not just about fair treatment and safeguarding of clients’ individual rights, but also about proper governance of microfinance institutions. The industry must be in a position to achieve its fundamental social mission of poverty reduction, while ensuring sustainability of operations. Microfinance institutions must deliver demand-driven, quality services to these clients, to low-income people and develop the industry in a healthy way.

Poor households are not well served by simple loans in isolation. Minimalist microfinance provides a bandage where a major operation is needed, and at worst, it deepens the wounds while the bulk of microfinance portfolios may be commercially sustainable and attractive to conventional investors, reaching the still-excluded will continue to require innovation and experimentation. More than micro-loans, what the poor need are investments in health, education, and the development of sustainable farm and non-farm related productive activities. As Marguerite Robinson puts it: “Credit is a powerful tool that is used effectively when it is made available to the creditworthy among the economically active poor participating in at least a partial cash economy — people with the ability to use loans and the willingness to repay them. But other tools are required for the very poor who have prior needs, such as food, shelter, medicine, skills training, and employment.”

The present model of microfinance practices — minimalist microfinance in which finance is the only intervention — unlike in their classical avatar which had enough dollops of social good. Socially embedded microfinance institutions that practice microfinance plus provide clients with training and handholding.

The hard truism is that microfinance has been saddled with misplaced expectations, and we have lost a sense of its more modest, even though critical, potential. It is actually a tool in a broader development toolbox, but in certain conditions, it happens to be the most powerful tool. It will make the poor a little more resilient, but it is not the answer on its own. It has all to do with how we are using it and how we are defining the outcomes.

The writer is member of Niti Aayog’s National Committee of Financial Literacy and Inclusion for Women