At at time when large and credible financial institutions valued at multi-billion dollars in assets and turnover who have lent to AAA rated creditworthy companies backed by collateral, have disappeared without a whimper owing to bad mortgages in the US, there is a contrasting story in the Indian hinterland where MFIs (Micro Finance Institutions) have been lending micro loans (not exceeding $500 per family) to ladies in rural families who were not considered creditworthy at any time in past history, have managed to record virtually zero defaults amp; healthy credit growth at healthy interest rates !
What are the reasons for such a stark contrast ? Is there a fundamental flaw in the lending mechanism ?
* The MFI model of lending is solely based on the repaying capacity of an individual or the immediate family. Ladies of the family are considered more reliable borrowers. Hence, they are the target customers, mostly.
The contrasting model of the capital-rich billion dollar investment banks and large lending institutions has been to grow credit-offtake, thereby multiplying the credit in the system in turn increasing the risk of default which can bring an economy down to it’s knees.
* Borrowers from an MFI are divided into SHGs (Self-Help Groups) consisting of groups of borrowers belonging to a village. Any defaulting member of an SHG, automatically causes forfeiture of borrowing rights of all members of the group. Thus, there is a social mechanism of credibility built into the system which forces every individual to repay their loans.
Big lenders on the other hand, focus on creditworthy borrowers who can offer a collateral against the loan. It is this collateral, which can blind the lender against verification of cash-flow and repaying capacity of the borrower. In cases where the collateral for home loans was the home itself, the loans were waiting to be defaulted when the real-estate prices fell in a northward interest-rate regime ! Many such home mortgages were 100% of the home value. This concept is extremely fickle because assets such as real-estate and stock-market exhibit a concept called Negative Equity – wherein, the original purchase price of the asset could be significantly higher than it’s resale value at a later point in time. Collateral is not the only means of judging the viability of a loan. The borrower’s repaying power needs to be assessed thoroughly. There is no social stigma against defaulters of home loans.
* Initial loan amounts of MFIs are extremely paltry called micro loans and are subsequently increased in slabs (not exceeding $500-$600) only after the previous loan has been repaid. The interest rates of all such loans are fixed. MFI agents are trained in assessing the repaying capacity of the individuals so that loans do not exceed repaying power. High inflation in India has not caused MFI defaults.
On the other hand, the excessive exposure of global lending institutions to the real-estate market without an appropriate risk-rating for such a loan portfolio meant that the banks were incentivising home brokers based on the size and interest-rate of loans. This led to excessive lending at excessive interest rates leading to a higher probability of default risk. Instead, there are safeguards to protect such borrowers through the political system. The assumption of most home loan borrowers was the ever-increasing price of real-estate. A high interest-rate regime burst this bubble.
The MFI model is small and sound. It’s model can probably not be emulated fully on a larger scale. But, the most important safeguards of fiscal discipline and cash-flow verification by lenders are basic steps that can not be condoned for a collateral.