Microfinance, India’s little Financial Crisis

In the month of August 2010, India’s largest microfinance company, SKS Microfinance placed itself at the altar of capitalism by listing itself in the Indian stock exchanges. It was a delicate balance between its lofty socialistic goals of helping the poor by extending small loans and the profitability pressures of investors who looked at good returns on their investment. Its traditional backer’s, primarily nongovernmental organizations cried foul and saw it as a deviation from its social ethos. Some went on to equate the IPO as a way for rich people to make money from the very poor. Prof Mohammed Yunus, the much celebrated founder of Grameen Bank derided the move by calling it as a distortion of microfinance. Those sentiments however did not deter celebrity investors including the financial guru, George Soros and the venerable Narayana Murthy, to put in money at good pre-IPO prices. It was not very hard to understand their rationale of harnessing the immense power of capital markets to drive social change at the bottom of the pyramid and make some money at the same time. There was something amiss, though.

Just a few years ago, also around the month of August, one of the most respected investment bankers in the world, Lehmann brothers was rapidly moving towards eventual bankruptcy threatening in its wake, the collapse of the entire financial system. Lehmann’s balance sheet, once its pride was looking weaker by the day, due to the devaluation of assets, primarily related to financial instruments like Credit Debt Obligations (CDO). Companies like Lehmann saw an enormous opportunity in the housing market boom in the United States and bought loans from banks and stripped them into smaller parts and sold individual pieces to investors around the world. The attractiveness of such instruments for investors caused Lehmann to buy more and more of such assets from banks. Insurance companies, like AIG, meanwhile, saw the potential of insuring these assets. As demand for such instruments increased, banks found courage to ease their credit quality norms to give more and more loans. Money was cheap and houses were being bought by people who just could not afford it. It could not last long and finally defaults increased to such a level that investments bankers like Lehmann, who were primarily brokers in the chain, could no longer sustain themselves.

The resemblance of investment bankers in the US in 2008 is not at all striking with microfinance companies like SKS. However, reading between the lines, there are quite a few eerie similarities. Like the housing bubble in the US, India seems to be in a microfinance bubble for some time now. Organizations like SKS and Bandhan have been seeing explosive growth sometimes up to 100% year on year. The mad rush to lend to the poor is not very different from the mad rush to lend for a house in the US. The capacity of the market to fund the poor seems to be as enormous as it was for subprime mortgages in the US. The credit quality (sans the irony) of a large number of the end users in both cases is at best, poor. Companies like SKS charge a very high interest rate, sometimes as much as 30% which severely hampers the ability of the borrowers to pay, much like some of the hapless house owners who took on too much than they could chew. The other similarity between investments banks and microfinance institutions are that both depend on traditional banks for financing, without which they simply cannot exist. While banks have deposits that they can put to work for providing loans, most microfinance institutions just borrow from banks at prevailing interest rates of 8-10% and then add their operational expenses and profits on top to lend at impractical interest rates to poor borrowers. A default of a significant minority of borrowers can derail their very existence as they have very little to fall back upon in terms of assets. The flows of credit from banks for SKS can stop as rapidly as it did for Lehmann, if its loans are found to be unrecoverable. Recent events in Andhra Pradesh have significantly reduced the collection of microfinance institutions and companies like SKS are in a crisis for survival. History will repeat itself if the greed for growth at the cost of financial discipline and plain common sense once again brings down a once fancied industry.