Tuesday, October 26, 2010

Microfinance Failure Puts Focus on Credit Ratings, Islamic Banking, & Co-operative Banking

Indian microfinance sector has suddenly entered a turbulent phase, casting a long shadow on not only whether for-profit money can ever be used for poverty alleviation, but having the potential to shake the foundations of even Nobel Laureate Dr. Muhammad Yunus promoted Grameen Bank like models for the simple anomaly of the poorest-of-the-poor being charged double the interest rates charged from the richest-of-the-rich. Financial inclusion is noble, and a few MFIs had contributed much towards this noble ideal, but are the poor being increasingly chased for financial inclusion, and are they being included without their interest? While even the role of the credit rating agencies is likely to come under the scanner due to this, much interest is emerging in alternatives to microfinance like Islamic banking and zero-interest or low-interest co-operative banking.

In March of 2009, during the height of the world financial crisis, Vatican had a piece of advice for Western financial system - turn to Islamic banking. Though Catholic Church and mainstream Islam see eye-to-eye on a few ethical issues, such as abortion, this one was unexpected by any measure. But not really, if you really understand Islamic banking, beyond what the name implies.

Even economists like Dr. Manmohan Singh, Pranab Mukherjee, and P Chidambaram don’t seem to have much love for the system. Not that this was the main reason why a recent international conference on Islamic banking in Kochi was strictly curtailed; it was rather due to the issue of speakers arriving on tourist visa.

Not even Dr. Muhammad Yunus is thrilled with classic Islamic banking. Though he considers his Grameen Bank as a practical Islamic banking model, not many are willing to concede the point, and that includes not only international Islamic scholars on the subject, but a native and pragmatic voice like Sheikh Hasina. But it is a profound irony that it was an Islamic state like Bangladesh that made microfinance famous. Its approvers would take the Nobel Peace Prize as proof for microfinancing’s superiority over Islamic banking. Sure, microfinance has proven to be a bit more practical, but superior? Not by a long shot.

And in India, as usual, we have taken something ok from outside - microfinance - and overdone it to monstrous proportions, much like fast food and indecent dressing. Yesterday, microfinance was touted as the next big thing after outsourcing, for all among us - from the poor to the investors. But today, microfinance champions are facing prosecution for coercive recoveries from the poor. If you too were unduly impressed by the microfinance model, don’t despair; even NR Narayana Murthy was impressed.

But the biggest microfinance irony came from rating agencies like CRISIL (BSE: 500092, NSE: CRISIL), which informed the market that they are re-assessing the generous credit rating they had given to many MFIs. Though CRISIL, a Standard & Poor’s company, deserves some credit for always keeping some reservations about the socio-political risks the MFIs faced, the moot point is what kind of an expertise is involved in re-evaluating the ratings much after even the smallest investors have re-evaluated companies like SKS Microfinance (BSE: 533228, NSE: SKSMICRO ). Now, the real paradox is whether Indian rating agencies themselves will get regulated and re-rated due to the MFI rating fiasco, much like how the US rating biggies like S&P, Moody’s, & Fitch came under scrutiny for indirectly causing the sub-prime housing finance crisis. The Indian agencies were already facing some potential regulatory heat before the MFI house of cards started tumbling.

Anyway, coming back to coercion, it is only a side-effect at best. The issue is ultimately about the ‘time value of money’ - that beautiful phrase economists have coined to denote interest. What can justify the poorest-of-the-poor being charged double the interest rate than the richest-of-the-rich? That they have no collateral? Or that moneylenders charge even more? As many micro-finance institutions found out for themselves recently, they are already running out of such excuses. Especially so, since microfinance institutions (MFIs) are actively marketed setups, unlike passive setups like banks. Nobody forced them to chase the poor and lend to them at exorbitant rates; they chose to do it on their own. Nobody gave them a mandate to financially include all the poor they could find.

Does that mean all MFIs are rogue setups? Not at all. In fact, many MFIs were genuine NGOs working for the up-liftment of the poor, not too long back. But slowly but surely the profit motive crept in. Not that profit motive is a bad thing in itself, but profit motive driven by high interest rates, powered by the justification of no collateral, is next to evil.

This is where the relevance of Islamic banking comes. Created around the basic Islamic tenet that Riba (increase in capital without service) and Usury (interest) are Haraam (forbidden), Islamic or Sharia banking delivers most banking services like loans, leases, hire purchases, bonds, equity funds and even derivatives, on an alternate structure.

For example, for effecting an interest-free vehicle or home loan, a fixed sum is added to the purchase price to arrive at the loan value. Not only is this amount much smaller than the interest that would accumulate over the years, but more importantly this amount is fixed, meaning that you won’t be penalised for occasional defaults, and thus the ‘time value of money’ concept is effectively done away with.

Another example of how Islamic banking is effected comes from purchase of a factory or office. The Islamic bank joins with the entrepreneur to form a partnership that will own this new facility, and this partnership will repay the bank the purchase amount (plus a small profit) from profits made by the new facility, and the moment the loan is repaid, the bank exits the partnership. The model is impressive not only due to its avoidance of interest, but due to the more responsible and proactive role the bank will take in ensuring success of the business.

There is no reason why all countries including India shouldn’t actively encourage Islamic banking as an alternative banking channel. Just like alternative medicine like Ayurveda and Naturopathy, there is room for every philosophy. And let merit decide which comes up. Also to be tried is an even greater model proposed by the Mahatma for Indian industry, and which some of our petty politicians converted into their filthy playground - the co-operative movement. Though the country has some successes in this field like Amul, co-owned by 2.8 million dairy farmers, our banking sector is yet to have a big co-operative success like the Swedish JAK, which is a co-operative interest-free bank.


  1. Very good and balanced report. Keep it up.

    Abdul Salam

  2. MFI has taken poor of poor to big ride in the name of upliftment and poverty eradication . Needs to be stopped by RBI before it creates more poor



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