Developing products for rural markets Annie Duflo Centre for Micro Finance at IFMR February 14, 2007

Appropriate products for rural markets… Need to be delivered through appropriate channels Need to answer the demand of rural clients Need to be appropriately priced To allow sustainability To be affordable

Outline Products for the rural market: The microfinance innovation in India Microfinance in India: delivery models Product innovations for rural markets: status and challenges Credit products Non credit financial products Non financial services Pricing and transaction costs The role of the Centre for Micro Finance

Constraints to scaling access for the poor Clients’ profile Difficult geographical access Poor require low value transactions Informal activities: need flexible access Illiteracy: difficult to deal with traditional services Lack of financial literacy: need close supervision Information Asymmetry Higher for the poor No credit history Difficulty to evaluate enterprises potential success Inability of the poor to offer collateral High transaction costs Provision of financial services to the poor is constrained by… Against an estimate demand of Rs. 20,000 crore to Rs. 50,000 crore for credit, the supply from financial sources was less than Rs. 2500 crores Traditionally, it has been believed that the poor are not bankable. The main reasons relate to Lack of information on the income flows and expenditure patterns of households (which makes it difficult to assess whether the individual will be able to pay for the services. E.g. in the urban retail client some indicators used are salary slip, income tax return, ownership of assets, number of family members, etc.) The costs of reaching services is very large. E.g. SHARE one of the largest micro finance organisations in the county employs over 3000 people to service a portfolio of Rs. 2000 million. Banks typically handle much larger amounts per individual (ICICI Bank has a 5 person micro-finance team that handles Rs. 4000 million) The absence of facilitative environment such as absence of well functioning commodity markets, non existence of credit bureaus, etc. act as a hindrance. Indian regulations do not permit MFIs to collect savings. However, the FM’s in his budget speech has allowed Banking Correspondents. Low level of Technology Regulatory Issues Staff Incentives within traditional organisations not aligned to maximise access to financial services for poor

…Hence the need for local intermediaries Local organizations have: Local knowledge, therefore can help reduce information asymmetries Have less expensive operations, can therefore help reduce transaction costs. But local organizations don’t have capital Banks have capital, but done have this local knowledge Both should join hands!

Microfinance in India: apparition Until the 90’s despite various efforts and achievements by the government, the banking sector was unable to internalise banking to the poor as a profitable activity Financial sector reforms: motivated policy planners to search for strategies for delivering financial services to the poor in a sustainable manner with high repayment rates. NABARD: empirical observation catalysed by NGOs that poor gather in informal groups  SHG-Bank Linkage Programme (92) Recent emergence of MFIs: professionally run institutions specialized in delivering credit with low cost staff and local knowledge Key innovation in both models was to make use of local knowledge, which traditional banking system does not have.

The microfinance promise New contracts New Management structures Innovations New attitudes

Microfinance: what is it? Often perceived as… …whereas objectives are Micro-credit Group lending Social/charitable activity Suite of financial services Thrift / savings Credit Insurance and Investments Transfer Payments and Remittances Group and individual lending Sustainable activity

Outline Products for the rural market: The microfinance innovation in India Microfinance in India: delivery models Product innovations for rural markets: status and challenges Credit products Non credit financial products Non financial services Pricing and transaction costs The role of the Centre for Micro Finance

Predominant model of microfinance in India: SHG-Bank linkage model Efficient use of capital Y Incentive alignment N Branches assess credibility of SHGs and monitor repayment process 6 months savings Bank Loan to group SHG Repayment commission NGO No liability Grants based Group formation and linkage

Recently emerging model: financial Intermediation by MFIs SHG, JLG or ind. Bank Loan Bank lends to MFIs based on their capital MFI on lends MFI’s capital sets risk absorption capacity hence limits for TL On-lending of same fund at Bank interest rate+MFI trans. costs Efficient use of capital N Incentive alignment Y Double counting of capital by bank and MFI Organization-based lending: Higher pricing than warranted by riskiness of portfolio

These models have limited growth With SHGs, relatively low rates of growth resulting from NGO reliance on grant funds to meet costs Banks wary of large portfolios in the absence of risk sharing structures With MFI intermediation, although underlying portfolio exhibits very low loss rates, sub-optimal lending structures have resulted in Lower flow of resources Capitalization of intermediary is the constraining factor Higher pricing than warranted by riskiness of portfolio Charge on capital reckoned twice Bank/FI take into account riskiness of the intermediary

These models could not resolve the paradox of limited supply A burgeoning segment with very large demand for finance Grass-root agencies capable of providing origination and supervision support in a cost-effective manner Banking system capable of providing large quantum of wholesale finance (owing to priority sector targets) However, there are no ‘natural providers’ of risk capital for microfinance and this has constrained the growth of several MFIs As a result, supply is still a small fraction of the demand for finance

Allowed rapid scale-up Needed a model which: Addresses inability of MFIs to provide risk capital in large quantum, which limited advances from banks Allowed rapid scale-up Separates risk of MFI from risk inherent in the mf portfolio But still provides a mechanism to continuously incentivise partners

Loan at 9%-11% to end customer The Partnership Model Efficient use of capital Y Incentive alignment Y Loan at 9%-11% to end customer Repayment collection Bank MFI (servicer) SHG, JLG or Ind. Service fee Service fee Risk Sharing FLDG Origination, monitoring, collection OD Reduces capital needs Intermediary assumes fraction of the credit risk, leading to reduction in capital required Bank prices on basis of underlying asset rather than rating of intermediary ( ‘asset-based lending’)

…leverages each entity’s advantage which are complementary MFI Bank Strength Social Capital Local knowledge Low cost delivery channel Financial volume / expertise Product innovation Technology Weakness Access to financial markets Financial product expertise Technology Low outreach in remote areas Poor local knowledge Inadequate cost of delivery to serve the low income population

The Partnership Model structure combines debt and mezzanine equity MFI estimates individual and overall loan requirement Bank assesses historical loss rates to Arrive at a pricing for the loan Estimate the quantum of FLDG required from the NGO/MFI Objective Keep the pricing on the loan portfolio close to AAA rates Reflect riskiness in the quantum of the FLDG, assuming the character of mezzanine equity MFI accesses an OD limit - equivalent to the amount of the FLDG – which is drawn in the event of default up to the specified limit General definition It is basically debt capital that gives the lender rights to convert into ownership or equity interest if loan is not paid up on time in full. Such type of financing is quickly available with little or no collateral. However, interest rates for these loans are charged at the rate of 20-30% range. The borrower can treat this type of financing as equity on the company's balance sheet. Mezzanine equity and the partnership model In the ICICI partnership model – the financing structure uniquely combines debt and mezzanine equity. The MFI estimates the loan requirement of client base and makes a fund estimate. Bank assesses a historical loss rate to arrive at pricing for the loan and an estimate of quantum of FLDG to be provided by the NGO/MFI. It keeps the pricing of the loan portfolio close to AAA rates and reflects riskiness in the quantum of FLDG. FLDG assumes the character of mezzanine equity. MFI is provided an OD limit equivalent to the amount of the FLDG, which is drawn in the event of default up to the specified limit.

Portfolio diversification through the partnership model MFIs Single product Single customer segment Knowledge of local area Poor included Banks Multiple products Large customer variety Large risk apetite Poor / Vulnerable excluded Partnership Multiple products Multiple segments Large risk appetite combined with knowledge of local area Poor / Vulnerable included

Limitation of the partnership model for MFIs Advantages Limitations Facilitate growth by reducing MFIs’ challenge to provide risk capital in large quantum Off-balance sheet FLDG as OD (quasi equity) Improves RoE by equity freed up (leverage from 3-4 to 10-12) Separates institution and underlying portfolio risks Continuously incentivise partners on portfolio quality Most banks still using TL, hence reducing MFIs diversification of lenders Level of FLDG dependent on one single lender’s risk evaluation (vs. public market) Level of FLDG based on processes and PAR* No secondary markets for lenders reduces their own liquidity (microfinance not an asset class) No lack of back up servicer cost included in computation of FLDG

Difference between SHG-Bank linkage and MFI model better savings habit stronger group cohesion lower interest rates SHG Grameen MFIs have to cover all intermediation costs Interest rates are higher However interest rates charged by SHGs to clients are similar tighter control and monitoring clients can borrow immediately without savings loans disbursed are higher and individual loan tenure shorter, allowing to increase loan size faster Choosing a model depends on the clientele the organization wants to cater to Grameen model is likely to be suitable to serve tiny enterprise owners and SHG model might be used to serve the wage labourers and farmers or group enterprises

MFIs in India Currently, roughly 66% of the micro finance supply is via the Self Help Group (SHG)-bank linkage route However, MFIs grow faster now, in terms of number of clients and credit flow The share of MFIs is rapidly growing There are about 800 MFIs in India (NABARD) However the top 15 MFIs account for about 70% of the credit through MFIs

Comparison between SHG-Bank Linkage & MFI model 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 2001 2002 2003 2004 2005 MFIs SHG 5 10 15 20 25 30 35 40 45 50 1996 1999 2002 2005 0.2 0.4 0.6 0.8 1 Share in microfinance disbursement by model India annual Microfinance Disbursement Rs billion billion $ % share in Annual Disbursement Year Year Sources : Rough estimate derived from a presentation at a Microfinance Stakeholder Consultation Meeting in Delhi in January organized by the World Bank. Major sources are NABARD Annual Report & Data collected by ICICI Bank. Assumption : MFI disburse 1.5 time of Yr-end O/s loans – Ratio from M-CRIL data

Outline Products for the rural market: The microfinance innovation in India Microfinance in India: delivery models Product innovations for rural markets: supply and challenges Credit products Non credit financial products Non financial services Pricing and transaction costs The role of the Centre for Micro Finance

MFIs Models and products (credit) “Grameen” product 50 weeks tenure Weekly meetings and repayment Joint liability in groups of 5 to 10 members Often given for productive purposes only, often with close monitoring of loan usage Loan size range from Rs. 3000 to Rs. 15,000 – increases with loan cycle Individual lending For new borrowers or “star” borrowers (most of the time) With or without collateral or guarantors/guarantees Generally, not beyond Rs. 1 lakh Different repayment schedules (for ex, daily or monthly) Emergency loans Existing clients 1000 to 2000 Rs For emergency purposes such as health etc. “Grameen” product is the most widespread So far products have been very standardized (which has advantages but also limits customization for clients)

Repayment schedules: vary schedules Weekly schedules may be more or less appropriate depending on nature of businesses CMF-VWS study: Most businesses can be categorized in two types: piece based or independent businesses. For the first type, weekly payments make more sense. Market based clients seem to prefer monthly payments as they sell on credit and can not always recover their payments every week. Need longer term loans with moratorium Existing product implies clients already have a business or an income source, is not suited for financing start-ups

Repayment schedules: allow flexibility Fixed debt contracts have a rationale avoiding operational headaches, cash management problems, risk of loan officer fraud and weakened repayment discipline of borrowers But benefits of flexibility could be huge With fixed schedules, repayment capacity based on incomes of worse weeks/months, limiting loan size The rigidity of contracts may be keeping some borrowers from borrowing or clients with rigid contracts may take actions which reduce the return on their investments. CMF Case study in ASA and Cashpor: some forms of production (sari and carpet weaving) experience significant variance throughout the year low availability of labor in harvest and festival seasons, humidity and moisture from the rainy season etc.

Loan size: often seems too small In some Hyderabad slums, before microfinance introduction, businesses were very prevalent (31% of households) – often low-skilled, very small It seems possible for most household to expand the business, and yet they have not expanded, so there was a clear role for an MFI Average monthly sales proceeds were Rs.13000 while average profit was Rs.3040 per month. A Rs 7,000 loan is probably not sufficient to greatly expand the business. Small loans have a rationale when there is no competition (teach clients financial discipline etc.) However when there is competition, MFIs may want to give larger loans directly.. But too large loans would require evaluating the client, which is too costly to do for everybody.

Therefore.. need for individual lending Group lending is constraining the most entrepreneurial clients After all, not everybody can be a successful entrepreneur. For example, in the OECD only 12% of households run a business Some clients need larger loans, and customized to the business Already exists, but preliminary stages Makes more sense for MFIs to provide it for existing clients

Group Lending vs. Individual Individual lending model bears some additional risks: Difficulty in evaluating individual credit risk in the absence of sound credit-scoring mechanisms Higher risk of default if the borrowers are unwilling to repay Group model, on the other hand, has the risks of Higher default due to problems in group dynamics Increase in drop-out rates due to differences in credit absorption capacity of clients and changing client needs The individual model is suitable to serve the not-so-poor population who can afford to provide some guarantee The group-lending is best suited to serve the poorer segments but does is not optimal for graduated customers

Example of individual lending: SKS Loan given to borrowers which are in business for more then 1 year, and only old SKS clients Guarantee of a govt. employee/of a farmer with land of more than Rs. 1.5 lakh market value/ of a businessman having a business asset of Rs. 2-3 lakhs SKS should have min. of 8 months of operational experience in that area Loan amt: Rs. 20,000-100,000 Term period:1-2years Interest rate: 11% yearly flat Repayment schedule: Monthly Purpose: Income generation and asset development purpose

Individual lending: WWB Methodology Key activities in the lending process: Analysis of Balance Sheet of the business Income Statement of the business Family cash flow Investment Plan Character Assessment Operating Model Staff profile & training Branch location & infrastructure Efficient information system

Outline Products for the rural market: The microfinance innovation in India Microfinance in India: delivery models Product innovations for rural markets: status and challenges Credit products Non credit financial products Non financial services Pricing and transaction costs The role of the Centre for Micro Finance

What low income clients need? The needs of poor people are varied.. Lifecycle needs Protection against Health shocks What low income clients need? Protect against sudden death Protection against loss of assets Need to build or improve homes Protection against weather shocks Send money to their families when migrate

MFIs Models and products (non credit) Insurance Most often as agent of insurance company Most common product is life insurance Bundled with credit Health insurance emerging Savings MFIs not allowed to collect deposits Banking correspondent model (few MFIs have adopted it yet) Remittances Rare product One MFI in Orissa: Adhikar One MFI in Udaipur: Ajewika Bureau Housing loans Rare product Focus on individual loans A few MFIs provide housing loans: IASC, ESAF

Insurance products Protect against loss of assets, damage of property etc. Example of Sewa Bank comprehensive insurance Protect against illness often, failure of business is due to illness that led to low availability of labor Defaults or drop out often due to health shocks The delivery of insurance through MFIs is attractive: Can keep costs relatively low (channels, compulsory product) It protects the MFI as well Health insurance companies products start being sold by MFIs, where MFI is the agent Experience so far suggests that insurance literacy is low and proper awareness campaigns are necessary

Remittances Substantial seasonal migration with large inter-regional financial flows. NSS surveys (’93) indicate 89% of permanent migrants send remittances back home. Likely to be higher among seasonal migrants. But high transfer costs associated with remittances limit propensity, distance and duration of migration. Cheap and reliable channels are rarely available in rural areas Program run by Adhikar, Orissa: 1600 members remitted almost Rs. 6,00,00,000 in 2 years of launching program Apart from being a viable program, MFIs can leverage existing client networks; provide cheap and safe transfer; add on services. Legal Issues in MFIs collecting savings–BC is a possible solution. Scope for MFI to act as money transfer agents also? Stiff competition from informal agents which are quicker and often cheaper Official NSSO statistics quote very low incidence of migration – 17% or less because they focus on only permanent migration but seasonal migration is an important and highly prevalent livelihood strategy - Quoted from Adhikar’s annual reports on “Shramik Sanjog” program – remittance services. This is only from Surat and Gandhidham; in some ways a pilot phase

Housing Finance Challenge worldwide to provide low cost shelter for urban and rural poor – a basic need for poor households. Constraints: for Big Banks/financiers – recovery is a problem and for Small organizations – Lack of capital MFIs are a great solution as they can act as agents for larger financiers and have expertise in dealing with small amounts and their recovery So far, unsophisticated product – usually just a larger loan. Otherwise, mostly NGOs who have implemented government subsidized programs Few MFIs currently providing housing finance but there is a lot of interest in the sector Challenges include: innovative product design for upgradation and ownership; issues of legal title to land; competitive interest rates etc.

Product development: what about the poorest of the poor? So far, MFIs and SHGs do not reach the poorest In AP, the 2 income quintiles above the poorest HH are more likely to receive microfinance through SHG-Bank model, while the poorest and those in the top 2 quintiles are less likely to be in SHGs (Priya Basu, WB) Poorest are not micro entrepreneurs yet – could they become one? Poorest have no ability to repay – at least not with standard product May need more flexible products Or need to be pushed up to a level where they can repay BRAC Target the Ultra Poor (TUP) programme: asset transfer, skill training, handholding, health grant Bandhan in India

Outline Products for the rural market: The microfinance innovation in India Microfinance in India: delivery models Product innovations for rural markets: status and challenges Credit products Non credit financial products Non financial services Pricing and transaction costs The role of the Centre for Micro Finance

Non financial constraints: Skills and Innovation Often, low skilled businesses and little innovation Study in ASA and Cashpor: Of all clients interviewed, only 5 out of 105 demonstrated some entrepreneurial spirit (have begun businesses that are different than traditional activities chosen by most other members). When little specialized skills involved in the businesses, the more businesses start, the more they will crowd each other out. CASHPOR clients weaving saris: returns per sari had often decreased by as much as 60% in the past 5 years. Few businesses grow beyond the size of household business.

Non financial constraints: Skills and Innovation Why is this happening and what should be the role of MFIs in this? Might be dangerous to advise people on what to do but can create information sharing Some businesses fail due to poor management skills  Need for financial training and basic business skills Sewa Bank business and financial literacy training Can partner with other agencies to provide business development training or mentoring services (BYST) Credit is only one side of the story: need to link to a higher value chain, create links between the borrowers and potential buyers

Outline Products for the rural market: The microfinance innovation in India Microfinance in India: delivery models Product innovations for rural markets: status and challenges Credit products Non credit financial products Non financial services Pricing and transaction costs The role of the Centre for Micro Finance

MFIs’ strategies to provide affordable products while being sustainable Serve the poor, including the poorest of the poor Interest rates as percentage of loan higher for small loans Offer affordable products for the poor Need to find strategies to reduce transactions costs and access cheap funds Be sustainable Cover costs Need good repayment rates, therefore requiring expensive operations Serve as many poor as possible Need profits to expand access

How to calculate a sustainable interest rate? The annualized effective interest rate (R) charged on loans will be a function of five elements, each expressed as a percentage of average outstanding loan Portfolio Administrative expenses (AE) Administrative expenses of efficient, mature institutions tend to range between 10%–25% of average loan portfolio (in india can be lower). Loan losses (LL) Many good institutions run at about 1–2%. The cost of funds (CF), India 10% The desired capitalization rate (K) Investment income (II) income expected from the MFI’s financial assets other than the loan portfolio (e.g., cash, checking deposits, legal reserves) Example (India context): 10+2+10+2+2-2=24% Source: CGAP

MFIs’ interest rates in the world Indian MFIs are the most efficient in the world (M-Cril)

Why are transaction costs of MFIs high? Door step services Intense monitoring Repeated interaction If one customer interaction may costs only US $0.25 due to the high number of interactions, this translates into 25 percent of operating costs relative to the average loan portfolio

What are the drivers of costs? Group formation (17-23% of total direct transaction cost) and collection (28-36% of total transaction cost) are the main components of transaction costs The main driver of direct transaction cost is the level of compensation of the field worker This would vary according to geography: An MFI in a difficult geography has to pay a higher compensation level for its employees Location, degree of competition, maturity of branches, seem to have an impact on transaction costs.

Possible strategies to reduce MFI transaction costs Staff costs Increase field worker productivity saturate a place before entering another place Sell more products Experiment with staff Incentives Schemes Focus not only on volume but also on retention as costs higher for first time members Simplify Systems and operations as much as possible ASA, Bangladesh: simplified operations so that they could be performed by less-educated staff Can supervision levels be relaxed/modified for mature customer groups? Operations levels Increase branch activity: sell more products Less “layers” of operations: models without branches (for ex, only area offices and mobile branches)

Possible strategies to reduce MFI transaction costs Products and pricing Repayment schedules: experiment with less frequent schedules! If no more defaults, could lead in less transaction costs Take into account the lifecycle cost also when pricing the loans. Merely looking at first year costs may result in overpricing of loans may drive away some good borrowers Technology Maintenance & centralization of customer's record (bio-metric identification, credit bureau) to avoid many legal documents (eg. KYC) - So that credit worthiness of clients can be access quickly Role of technology: Innovative delivery channel (rural kiosks, mobile telephony, smart cards etc.) - This helps in serving large client base with less resources but one time investment is high

What can banks do? Delivery channels Provide funds to MFIs, either through term loans or partnership model Lend to Self Help Groups Provide grants or long-term loans for infrastructure development Product development Help MFIs with expertise in product development Link MFIs with other companies that have expertise in product development, for ex. Insurance companies Products pricing and costs Help MFIs with back-end technology Through risk sharing with MFI, help reduce costs of funds

Outline Products for the rural market: The microfinance innovation in India Microfinance in India: delivery models Product innovations for rural markets: status and challenges Credit products Non credit financial products Non financial services Pricing and transaction costs The role of the Centre for Micro Finance

CMF’s objectives and mission Established in Feb 2005 at IFMR CMF’s objectives To address knowledge and practice gaps in micro finance sector Experiment on ground solutions CMF’s mission: help the poor by Systematically researching the links between access to financial services and participation of poor in larger economy Participate in maximizing access to financial services Research on micro finance and livelihood financing (RU) Strategy building for MFIs (MSU)

MSU and RU Strategy (MSU) Research (RU) MFIs Strategy for growth Definition and implementation of innovative business models Market research, creation of linkages MFIS best practices sharing Design/test of new financial products Capacity building capital structure, HR, MIS, processes, customer segmentation, governance… Strategy (MSU) Impact of microfinance Impact Evaluation Studies Economics of micro enterprise Insights on HH "financial behavior" Constraints on HH productivity Experimentation on product design Micro finance transaction costs Research (RU)

4 Research areas to maximize micro finance impact 1 2 Impact and product design Micro finance plus Maximize impact On client 4 3 Policy Finance and Organizational issues

The role of research Evaluate impact, and find out what works and what does not Impact evaluation of Spandana’s micro credit programme Impact evaluation of health and weather insurance (SKS, Sewa) Improve existing products In theory flexibility or less frequent repayment schedules could have some benefits, but could also create some complications.. What is better? Repayment schedule research with VWS Flexible repayment schedules with KAS foundation Diversify financial products Remittances product project with Adhikar Sectoral study on Housing finance

The role of research Find out what can maximize the impact of loans Impact evaluation of Sewa Bank’s business training: is it cost effective: how can it be improved? How can organizations be more cost effective while achieving their goals? Study on effect of staff incentives Understand what is going on Find out the risk that small business face that financial services can help with Understand non financial constraints Why are businesses not expanding: what are labor markets constraints?

The role of MFI Strategy Unit Help MFIs with their business and expansion strategies Provide help to MFIs in the following areas: Human Resources Access to capital (securitization etc.) Individual lending Create market linkages for clients Provide them with lower costs and high quality inputs (Godrej Agrovet-Spandana) Provide clients with production/selling opportunities

The role of MSU: encourage vertical growth Vertical growth => deepen share of wallet of existing customers => capture new customer segments New products New customers profiles Customer segment Channel Product Core activity Backward integration Forward integration Geography Capability adjacencies Technology adjacencies Horizontal growth => replicate similar model in new geographies Same products Same customers profiles

IFMR Trust Credit is only one side of the story Example: Wavers may organize themselves in cooperatives but they need to sell the saris, and for a good price Need to link to a higher value chain, create links between the borrowers and potential buyers Sandhi provide market linkages to garments confectioners – one of the entity of the Trust for Networked entities: to fill this missing market Will act like a holding company having a part of equity in each entity formed– to promote outside investment Will mobilize fund from social investors in form of grant or soft loans for the incubation period Will retain a part of profit for itself as revenue Will be based at IFMR - different centers under it will provide specialized services to entities – link to MFIs etc.

Thank you For any question: annie@ifmr.ac.in