India's Microfinance Sector Facing Collapse

Sources:
WSJ: SKS Chairman Fights Backlash
NYT: India Microcredit Faces Collapse From Defaults
FT: Microfinance: India Considers Rate Cap on Loans to Poor

Microfinance is the practice of extending small loans to individual borrowers who have traditionally lacked access to credit. The goal of this practice is to help the poor start or expand businesses, and it has become a popular antipoverty strategy in the developing world. In India, commercial banks are required to direct a certain percentage of their net credit (40 percent for local banks, and 32 percent for foreign banks) to designated "priority sectors." The Reserve Bank of India designates these sectors, and includes areas such as agriculture, small business, housing, education, and lending to the poor and vulnerable.

In recent years, Indian commercial banks have met this requirement by making loans to microfinance institutions such as SKS Microfinance. Rather than making loans to hard-to-reach borrowers directly, commercial banks turned to these microfinance institutions because it was cheaper and easier for them. Today, Indian banks have $6 billion in outstanding loans to the 44 for-profit Indian microfinance companies. Initially, this relationship was mutually beneficial–– microfinance companies received the liquidity they needed to make the millions of tiny loans to provide poor borrowers with the capital necessary to lift themselves from poverty, and the banks were able to fulfill their required priority lending targets by simply making loans to a couple of large microfinance companies, "rather than trying to establish rural network lending themselves."

Now, it appears that this mutually beneficial relationship is breaking down. Microfinance companies have recently been under scrutiny for their lending tactics, which have been compared to the subprime mortgage crisis in the United States. For example, the microfinance companies borrow from commercial banks at a rate between 11 and 15 percent, and then turn around and lend at a rate of 30 percent. They also have been criticized for their "coercive" debt collection tactics. Further, these microfinance institutions are making huge profits. SKS, India's largest microlender, was valued at $1.5 billion last August. According to India's Minister for Rural Development, "[t]hese institutions are using quite coercive methods to collect . . . . They aren't looking at sustainability or ensuring the money is going to income-generating activities. They are just making money."

All of this came to a head in October, when India's Finance Minister asked India's state-owned banks to stipulate that interest rates be capped at 24 percent in their loan agreements with microfinance institutions, and legislators in Andhra Pradesh passed a strict new law restricting how microfinance companies can lend and collect money. But this new legislation may be too late, as the industry is now facing collapse because it has put the banks' portfolios in serious risk, and many borrowers have no idea how they are going to pay their debts back.

Microfinance systems similar to India's have sprung up in Africa, Latin America, and other parts of Asia. The World Bank has used India as a test for similar social enterprises that make profit will simultaneously filling a social need.

Discussion Question: How should law makers in India, and around the world respond to microfinance companies' tactics?