Digitization & Demonetization: Has Microfinance Lending in India changed forever?

This is follow up on my previous post on how rural financing and lending in India have changed irrevocably due to Demonetization and Digitization.

Unfortunately in India, loans are expensive for the poor. The Public Sector Banks will not lend to the poorest outside of the agricultural loans and political sops. At the same time all other goods are subsidized for the poor because they are funded by public taxes.

This creates a classic Skin-in-the-Game problem.

Government will not risk unsecured lending through its banks, and those private players who take on the risk – seek higher compensation for the risk in the form of interest rates.

The interest rates on these loans to the poor are above 18%. Lending at such high interest rates remains politically sensitive and a moral grey area.

Let’s examine how Rural Lending and the associated risks are set to change and evolve in the future.

Change 1:  Shift from unorganized to organized sector lending

Demonetization hit village Moneylenders most but Digitization will wipe them out. With big MFIs like Bharat Financial already present in half of India’s districts – the shift from unorganized to organized lending will be further hastened by the lack of liquidity caused by Demonetization as well as the new limits on cash transactions introduced in this year’s budget. The moneylenders cannot compete with the interest rates offered by MFIs (which is capped by the RBI). Digitization and the resulting shift to banking channels and Jan Dhan accounts should wipe out village level moneylenders for all time.

Change 2: Microfinance becomes a Banking Channel

Microcredit is no longer about last mile connectivity. November 2016 marks an inflection point where Microcredit becomes a banking channel itself.

Previously it was:

Micro Units Development and Refinance Agency Bank (MUDRA) -> MFIs -> Rural Borrower

Now it will move to:

MUDRA -> MFIs -> Banking Channel (Jan Dhan / Other Bank Accounts + Aadhar linked payments + ATMs) -> Rural Borrower

Did you see what happened? The Operational Cost went out of the business model. The below illustrates this structural change.

2017-03-17_17-05-41.jpg

The Upside : The Risk Map for Microfinance has Changed

The taking out of operational cost is excellent news for MFIs, as the operational risk is not allowed to be priced into the lending spreads thanks to RBI Regulations.

Processing charges by NBFC-MFIs shall not be more than 1% of gross loan amount. Processing charges need not be included in the margin cap. – RBI Regulations

Type of Risk Current Risk Owner Future Risk Owner
Operational Risk MFIs Banks / Channel Partners
Credit Risk MFIs MFIs

The changes will be EPS accretive. NBFC-MFIs like Satin Credit pay upto 8 Lakh in employee salaries per branch. The operational costs will come down – Branch presence will be lightened and the revenue per employee will also increase.

The end result will be that the business will shift from carrying cash for disbursements to mostly managing collections and performing risk management. Going ahead, the ownership of Credit Risk, which is priced into the interest rates, will become the core business of Microfinance.

The Downside: Eroding Moats

A profitable business will inevitably attract competition. If branch and employee requirements lighten substantially, the entry barriers for offering Microfinance loans will be lowered. A player like Reliance Capital can enter Microfinance lending instead of tying up with Satin Credit Care whose branch network is no longer as huge an “edge” in the business. With the requirements of last-mile connectivity simplified as a part of the digital channel, Banks may be tempted to enter the space themselves.

Whatever the future holds, it will be interesting to see how this trend towards Digitization plays out.

Disclaimer: I am not a SEBI Registered analyst. I am a hobbyist investor writing to organize my thoughts. This post is for educational purposes only. I do not offer Buy or Sell advice and none of my writing should be construed as a recommendation. I am not invested in Satin Creditcare of Reliance Capital. Always seek professional advice for making Buy/Sell/Hold decisions as stock markets are risky and can cause a permanent loss of capital.

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