By Mark Straub
To Save the Industry, It’s Time for Policymakers to Embrace Savings
One of the most fascinating subjects of the last quarter century for students of economic development must be the peculiar rise of microfinance as a venture capital-backed asset class, now poised to see multi-hundred million dollar initial public equity offerings in the next 12-18 months on the Indian stock exchange. Well known giants of Indian microfinance who serve millions of clients – SKS, Spandana, SHARE and Bandhan – as well as upstarts Ujjivan and Equitas, have attracted millions in risk capital from top global venture capital firms and sovereign wealth funds, in several cases transforming themselves from non-profit NGOs to corporations in order to raise capital and attract top management talent.
Collectively, the Indian microfinance sector raised over $500M in private equity last year alone. With on-paper valuations of these companies in the hundreds of millions (dollars not Rupees!), and in at least one case over $1 billion, sales of founders’ stock in private secondary sales has created Hyderbadi millionaires seemingly overnight, something unseen in India outside of BPOs, Bollywood and corrupt politicians.
There is a lot of froth in this market. And while it is clear that the sector is receiving a bit of hype, it would be a mistake to overlook the fundamental shift going on in India’s economy, which microfinance both benefits from and is a manifestation of. As India’s GDP continues to chug ahead above 6% despite a global recession and as optimism across the country soars following the first democratic reelection of a prime minister in 40 years, now is the time for the Reserve Bank of India (RBI) and the rest of India’s policy makers to address a key limiting factor that is perverting the development of the microfinance sector and preventing a healthy transition to “microbanking.” The RBI should eliminate the ban on acceptance of savings by microfinance institutions, and expand its federal insurance program (the DICGC, similar to America’s FDIC) to include and protect savings deposits made by microfinance clients in microfinance institutions (MFIs).
Since coming to prominence in Bangladesh in the 1970’s, microfinance has primarily been about giving people loans. However, as important as access to credit is, for both clients of financial institutions and financial institutions themselves, access to savings can be even more important. As a microfinance borrower begins to develop discretionary income he or she needs a safe place to store it. In poor and rural India that often means livestock, which are at risk of death or disease and are not easily liquidated, or gold, which can vary in value over time, carries additional metalworking costs and is not easily divisible. The answer to this problem of savings is federally-insured deposits.
Moreover, as lending organizations grow in size, they must look for additional sources of capital to fuel their lending activities. Borrowing money from banks is one way to source funds. Another is raising private equity. But the best way, the cheapest and most efficient way, is to collect and store savings from that bank’s clients. Unfortunately the RBI and other regulatory bodies that govern microfinance in India today do not allow for-profit MFIs to accept savings from their borrowers. Essentially, they are locked out of transforming into banks. This limitation is the greatest weakness threatening India’s miraculous bottom-of the-pyramid story.
As India continues to grow, demand for savings will grow too, particularly among the poor, who were first overlooked by traditional banks when they asked for loans, and now are likely to be overlooked again when they ask for savings accounts. Banks do not serve these clients well because they do not reach to the village green or the slum’s doorstop, precisely the places where MFIs thrive.
In the absence of accepting savings or “thrift,” these lending organizations (known in Indian regulatory parlance as Non-banking Finance Companies, or NBFCs) inevitably look elsewhere for capital. For the last three years, that has been large banks and international venture capital investors, the latter of whom require equity stakes in return for money. These venture capital firms do bring plenty of value to this market (and in full disclosure, I worked for one in India). They do so by injecting large amounts of capital quickly, by demanding stronger, more transparent corporate governance from management, by introducing technology and global best practices, and by bringing legitimacy and attention to the sector.
But venture capitalists alone cannot build microfinance into the industry it needs to be, an industry that serves all the financial needs of the country’s vast poor population. Venture capital remains a cottage industry and it requires significant returns on capital to satisfy the long-holding cycles and high risk associated with its investments. Client savings on the other hand requires much lower costs.
ICICI, India’s largest bank, pays its depositors 5-7% a year on their savings balances. In contrast, banks that lend to MFIs typically require annual interest rates of 12-14%, and venture capital funds generally target annual IRRs of 25% or more on their investments. Among these options, venture money is the most expensive to MFIs trying to build their businesses, but venture investors have been some of the strongest advocates of this industry in India to date, and the most willing to take risk and put up the necessary cash to fuel growth.
Now is the time for this conversation because as the first crop of private equity-backed MFIs near exit in public markets this year, there are grumblings on blogs and in newspapers from industry observers and regulators suggesting that rates of return on invested capital in these MFIs should be capped. That would be a recipe for disaster. Were regulations introduced stipulating limits on how much could be earned on an MFI investment, panic among investors and the ensuing flight of capital would crush whatever good intentions regulators had, leaving MFIs and their clients stranded with few good options for financing. Moreover, such a move would damage the growing stomach investors seem to be developing for India and confidence in its relatively poor, but promising, consumer base.
A much better alternative is for the Indian government to finally unleash the flood of tiny deposits that many poor borrowers in India are so desperate to protect, by allowing MFIs to leverage their existing relationships with these borrowers and accept savings.
Mark Straub is a guest contributor. He is an investment professional with the DFJ Growth Fund and previously worked at Lok Capital, a micro-finance investment fund in New Delhi.
(11 notes / )