Transforming MFIs into Local Financial Institutions
By Markos Koemtzopoulos | Markos is an MSU Associate focusing on market linkages in the dairy sector. The microfinance sector in India is growing rapidly with new generation Micro Finance Institutions (MFIs) and commercial banks driving that force. Innovation in terms of product designs, channel configurations, and technology usage is now rife in the Indian microfinance sector. However, to quote Muhammad Yunus, founder of Grameen Bank in Bangladesh and winner of the 2006 Nobel Peace Prize, "India has a long way to go in micro-financing. The microcredit movement is still in its infancy in India" ¹.

Given this stage of transformation in Indian microfinance, the question, then, is how can Indian MFIs grow to achieve universal access to financial services for all people in the most efficient manner? MFIs have two broad strategic options to choose from while aiming to scale up their operations. The first option is to expand geographically while financing the same segment of the population with the same products. This practice is followed by most MFIs in India today. For example, we now see a number of MFIs with a presence in more than two states. The institutions that follow such a strategy do so to leverage their core capabilities, gained from past experience, to replicate the same model across the country.

While such a strategy of "doing what you're good at" ensures rapid expansion without taking too much risk, it is not necessarily the most efficient way to fulfill the overall vision of the sector—that of providing access to financial services for those who do not have access to formal channels. The tradeoff between a pan-India presence and being able to provide a full gamut of financial services that are customized to the needs of each client is high. One of the major challenges with such a horizontal approach is that the MFI risks losing its 'local' character. This local character is significant in client screening, analyzing micro-enterprises that are context-specific, choosing neighbourhoods for expansion, and selecting staff. The other disadvantage is that given the way in which MFIs work, they incur a lot of fixed costs (cost of branch and overheads) in order to serve clients in an area. A strategy of serving a fraction of 'eligible clients' within the MFI's area of operations and a fraction of 'eligible needs' of existing clients might be expensive given that these costs will have to be incurred for every round of expansion.

The second option, therefore, is for MFIs to expand vertically and to offer a comprehensive suite of financial services (credit, savings, insurance, remittances, derivatives, and investments) and serve all credit constrained segments within a limited geography while partnering with specialist agencies to improve local economic activity and productivity. Rather than opt for a large geographic presence across the country, whereby they offer a thin blanket of plain-vanilla credit, MFIs could seek to leverage their local presence to increase their economies of scale and support the growth of the local economy. This means that MFIs would also finance a new class of clients with slightly higher incomes who require higher loan amounts and who likewise do not have access to formal channels to obtain financial services. This would also allow graduated customers to remain with the MFI and continue to benefit from its services rather than leave. Distributing larger loan amounts doesn't necessarily imply mission drift. By distributing larger loan amounts MFIs can leverage significant economies of scale and therefore reduce their overall interest rate which would also benefit poorer customers who borrow smaller amounts. MFIs in Bolivia put this theory into practice, and as they started distributing larger loan amounts through individual lending programmes, the microfinance sector experienced an overall reduction in interest rates from 60% in the early 1990s to around 17% today. We also see that the number of clients with loans smaller than $500 increased by more than 900% as interest rates declined ².

Financing opportunities could also result from creating backward and forward market linkages for the enterprises MFIs' clients invest in. The benefit for the MFIs is to meet its social agenda by ensuring a sustainable livelihood to its client and also to improve its business by cross-selling new products and reducing default risk. There exist several 'missing markets' for livelihood support at a local level that conceptually seem to have strategic significance for MFIs. A microfinance program with a reasonable scale (100,000 members and above) and that has completed 3-4 loan cycles is in a position to contemplate transformation into a Local Financial Institution (LFI). This is because it has a keen sense of the livelihoods (including constraints to growth) that are locally relevant based on observable loan usage data. This is a powerful signaling device to understand where clients think their expertise lies.

Missing markets exist in agricultural productivity, fruit and vegetable storage and processing, infrastructure, and so on. Serving these markets might entail financing not just the primary producer/entrepreneur (who currently is the typical microfinance client), but also other credit-constrained entities in the value chain (for example, the local processing unit, the warehouse owner, or the wholesaler). By intervening in these markets principally as a financier, not only can the MFI stay geographically focused, but it can also start adding value directly to the livelihood of the primary producer/entrepreneur and support the growth of the local economy