MFIs –

So, what are MFIs? Micro Finance Institutions lend money in small amounts to people who wouldn’t otherwise get credit from regular financial institutions like banks, etc. Their customers could be rural or urban. The amounts they lend could be as little as a few thousand rupees. Naturally, a bank does not see any value in lending such small amounts – their paperwork and red tape will cost more than that!

MFIs borrow from banks in order to lend to their customers. It is a marriage of convenience really – banks don’t have the time and energy to go after small customers, the customers don’t have all the paperwork that banks need and MFIs can make money by being the middlemen. The interest rates at which MFIs borrow from banks is high too, as the customers are classified as high risk. MFIs (ideally) don’t just go lending money to people, they have a lot of ground work to do first. The community is a very important aspect of this lending – as most of the customers have little or no collateral to offer in return for the loan, the community and the social pressure is the biggest motivation to pay back. And, this community does not get built overnight. Also, fiscal discipline is a habit that has to be taught slowly. All this takes time, a lot of people and I doubt if MFIs could stay in business if their loans were cheap.

The customers are better off inspite of these high interest rates, because their only other sources for credit are moneylenders and loan sharks. The usual interest rates they charge start from Rs. 4 per Rs. 100 per day – calculate how much it will be annualized.

If everyone paid back their loans there would not be any problem right? Yes, and that would happen in an ideal world. But in the real world, that’s not how it works. MFI field agents first nurture a community by lending to a few people first. These people are encouraged to become fiscally disciplined and pay back their loans. In time, more people in the community borrow from the MFIs and emulate this seed group of peers. When MFIs are evaluated by banks, they consider the numbers of such reliable customers too. So, the incentive for the MFI is to keep working to increase the number of reliable customers. However, it’s a lot of hard work and some times their field agents take a short cut by repeatedly lending to the same set of reliable customers, and sometimes lending them more than necessary.

Now, if a customer uses the loan for an income generating activity, everything is ok. But what will happen if gets excess credit? Suppose X wants to get married. Since he has easy credit available now, he goes beyond his means and spends that money – but he has no means to pay it back. And there, you have it – a bad loan for the MFI. If the amount lent was small, as it ideally should have been, the loss can still be absorbed as some bad loans are to be expected and factored in anyway. But since the customer was lent repeatedly and maybe even in excess, the field agent is now in a tight spot. And may resort to strong arm tactics.

Also, imagine a situation when the erstwhile loan shark gets into this business and is now legally doing what he already was? Will he really change his ways? Fear and intimidation are the weapons which have always worked for him, why would he abandon them now?

The above is just my understanding (and some insights I got from talking to my sister) and is in no way complete knowledge of the situation. I would be happy to be corrected wherever I am wrong.