Microfinance : Demonetization. Budget. Beyond

The last few months have been testing for NBFCs in general. Demonetization was a black swan event that brought fears of a repeat of the AP Crisis in 2010 that served a near death blow to Microfinance in India.

On paper, Microfinance remains a fragile business model when compared to banks and depository institutions.

Microcredit:

Borrow -> Lend at spread of 10-15%

Banks:

Deposits + Borrowings (RBI, Bonds etc.) -> Lend at net interest margins of 2-5%

Without the cushion of deposits, an MFI must disburse what it borrows, and borrow more to grow its loan book. The cost of customer acquisition for MFIs is also higher than banks.

Imagine what would happen to this fragile business model if the Government, without warning, decides to pull 86% of cash out of circulation. The sudden demonetization of old currency notes in November 2016 disrupted both collections and disbursements by MFIs, which are done primarily in notes of large denomination.

Crisis

Without the cash, many feared quite reasonably – that November 2016 was the beginning of a disaster on the scale of the 2010 AP Crisis or worse;

  • There was a shortage of replacement cash, and with shorter loan cycles MFI collections would be majorly disrupted
  • The Reserve Bank of India refused to allow MFIs to collect payments in old notes
  • Repayment discipline of vulnerable bottom of the pyramid borrowers would break – Political elements were encouraging them to default and rumor mongering about their loans being waived off
  • In Uttar Pradesh, some MFIs temporarily froze disbursements – given the cash situation and impending elections

Such bad news made stock prices crash between 20-50% across listed MFIs. All eyes were on the December quarter results, particularly on their provisions for bad debt and shrinking of loan book.

Bharat Financial, formerly SKS Microfinance had seen its disbursements drop by over 80% during the AP crisis. As expected the panic selling was at its most intense in its counter.

Bharat Finanical is also the bellwether of the industry and has presence across 315 of India’s 640 districts. Bad news for Bharat Financial would be a canary in the mines for Microfinance, like it was in 2010.

All eyes were on its December quarter results and they were (surprise, surprise) not-so-bad.

The collection efficiency in the Nov 11-30, 2016 period improved to 97.5% by Jan 19, 2017. Overall efficiency for Q3-FY17 was 95% – Bharat Financial, earnings release for Q3

All major MFIs have pointed at disbursements and collections returning to normal by end of Q4. The December quarter results indicated an increase in provisions and a flat growth in loan book but nothing that justified the steep fall in their stock prices.

As you would expect, the mood of the market swung after the Q3 results; in some cases stock prices have rallied back to pre-November 2016 levels.

I analyze below how the industry has changed since the AP crisis to make the business model robust:

2017-02-12_17-56-57

The Role of Government

If there was one simple takeaway from the Union Budget for me it was this –

The government is serious about doubling of farmer’s income by 2022

To achieve this Agriculture will have to grow from 2% currently to about 12 or 14% each year. This reform push will positively impact both the asset and liability sides of MFIs:

Disbursements – Disbursements for MFIs should grow as demand for funding for income-generating activities from the unbanked bottom of the pyramid. Presently the bulk of their expenditure is on consumption. Increased incomes will give a spurt to non-discretionary spending, which in turn will spur demand for loans.

Collections – Increasing prosperity of farmers will ensure better credit discipline, lower defaults and lower risk in lending

The RBI has helped institute a regulatory framework for governance of MFIs and also allowed MFIs to self-regulate. One of the reasons for Government buy-in into MFIs is that MFIs are borrowers from public banks, and failure of MFIs will create more bad loans on their severely stressed books.

Competitive Advantage

Banks in India are lenders of last resort (unless you are Vijay Mallya). Unsecured lending to high-risk farmers and rural folk is unthought of.

MFIs lend to these high risk bottom of the pyramid borrowers. They have built risk systems to better profile these customers. They are “asset light” compared to branch banking, enjoy trust of customers and have deeper penetration into the rural regions of India which will be the crucible of expanding economic activity.

With a structural shift towards digital disbursements, better and more sufficient credit bureau data, as well as small bank licenses to NBFCs – MFIs may in fact be the big banks of tomorrow.

Inspite of higher spreads, fragile business model they have endured several crisis without government bailouts and managed to have gross NPAs lower than banks.

My belief is that both the AP crisis and Demonetization were a form of creative destruction for MFIs and the business has emerged stronger as a result. The crisis acted like controlled explosions allowing the industry to shed bad practices and refine risk systems with real-time feedback. This is a rare gift for businesses.

We continue to disburse in centers, only if the collection efficiency of that center is 100% – Bharat Financial, BSE Update on Demonetization Impact 

In 2010 as many as 800 MFIs were in existence, however today only about 600+ are in operation even as the gross loan book has more than trebled.

Competition has reduced, risk data and systems have improved, but spreads have not gone up but have in fact reduced – indicating lowered risk. In line with these changes better credit risk management practices are in place today. Risk data will only improve with the flow of Aadhar / Jan Dhan linked information and the expanding credit bureau network.

Among RBI designated “for-profit” MFIs (termed as NBFCs) there is a maturity and a clearer sense of purpose. The “for-profit” mindset of these NBFC-MFIs has been re-conciled with a conservative, socially conscious lending outlook. This risk culture is important as these NBFC-MFIs corner 90% of the market.

Meanwhile Banks in India continue to be hesitant to take risks in lending to the unbanked. They are in severe distress and in need of a bailout.

The economy needs the steroidal boost of credit expansion to spur investment recovery. For a country on the cusp of growth, money is the most important raw material. The government recognizes this need. So where will this lending come from? NBFCs and MFIs.

Risks

If the present favorable global interest rate environment turns inflationary, the cost of funds will increase and eat into the margins of MFIs. Additionally, if operating costs rise with penetration into untapped districts of UP and other politically sensitive states it could both impact margins and add to existing risks.

Personally, I fear that given the RBI putting caps on the maximum interest rates that can be charged by MFIs – the risk of lending may not be properly priced into the current 10-14% spreads.

Also Banking in India is oligopolistic. If the Government begins to see MFIs as competition to public sector banks, and a hurdle to their re-capitalization – there could be policy changes aimed to put MFIs at a structural disadvantage.

Political Risk has reduced with the RBI acting as the central governing body for MFIs. There is always the odd chance that states may choose to regulate MFIs, and make laws similar to what led to the AP Crisis.

The digital push will incur investment costs and the 300,000 INR cash transaction limit imposed in the budget will affect the MFIs dealing in bigger ticket loans.

There could be a hidden risk from underreporting of bad loans – a trend which was seen in 2010. Though not likely, it is possible that the worst impact of Demonetization will come crashing in a few months.

Disclaimer: I am not a SEBI Registered analyst. I am a hobbyist investor writing to organize my thoughts. I do not offer Buy or Sell advice and none of my writing should be construed as a reccomendation. I am invested in Microfinance but not in any of the companies mentioned above. My views are biased. 

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