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It’s not about interest rates
In the microfinance debate, we need to ask whether credit is the correct first financial product for the poor My driver of four years, to whom I had lent interest free money to buy a house, recently killed himself. He left behind a young wife and two kids. It turned out that having tasted easy credit from me, he resorted to multiple borrowing, indebting himself to the hilt in the process, and ultimately decided to end his life when creditors came knocking. And this is not a story of an unemployed man in rural India, but of a young man who came from Uttar Pradesh to Mumbai to drive a taxi, and was progressing rapidly up the economic ladder.
While I tried to provide emotional and financial support to his family, the incident left a larger question in my mind—is cash credit in the hands of the poor more dangerous than useful?
The various propositions in support of status quo for microfinance institutions (MFIs) and their regulation have the same underlying hypothesis—MFIs are better than loan sharks. The current arguments come in broadly three shapes:
• The better murderer argument— The poor are borrowing heavily anyways from loan sharks, and MFIs are better because they charge lower interest rates and some lend only to women
• The market argument—There are 25 million borrowers from MFIs, which suggests that there is a thriving market for it and borrowers know what they are doing
• The TINA (there is no alternative) argument—with low banking penetration, any form of financial product that reaches the poor should be a good thing
I seek to refute each of these arguments and suggest that, akin to life-threatening consumables such as drugs, tobacco and so on, a financial product that carries an apparent risk to human life should be similarly regulated.
Arguments about microfinance regulation and interest rate ceilings subvert the main issue—the appropriateness of credit as the first financial product for the poor. If micro-loans are not the suitable product for them, then the issue of whether it carries a 28% interest or is interest-free is a moot point. That only a small percentage of borrowers are at risk of default and consequently end their lives is a hollow argument—a death is a death, and one must do everything possible to prevent it. If it is evident that loans to the poor carry such a big risk, then they deserve to be closely regulated.
There have been numerous discussion papers, policy prescriptions and research on what is a reasonable interest rate to be charged for loans to the poor. But the larger question is whether credit is the right first financial product for the poverty-stricken who do not have access to the formal financial system. As is evident in my driver’s case, it is not the interest rate charged on the borrowing alone that pushes the indigent to such extreme steps—in his case, all the borrowings were interest-free. Merely the social stigma of creditors at the door-step can cause such drastic behaviour.
The proponents of leaving MFIs unregulated and letting market mechanisms solve poverty issues would do well to remember the recent global financial crisis, the root of which was sub-prime loans. These loans were simply wrong financial products directed at the wrong consumers. There was indeed a thriving market for them, as was manifest in the amount of sub-prime loans outstanding in the US economy, but they eventually had catastrophic consequences. The financial crisis in the US proved that markets could fail, and wrong financial products could threaten to bring down large economies. Robust individual bankruptcy laws, higher levels of education and stronger social security ensured that there were not as many highly indebted individuals committing suicides, but the system as a whole collapsed.
In India, however, history has shown repeatedly that indebtedness can wreak havoc and cause deaths, leaving families far worse off than they were before they had access to loans. The lesson that financial products can be as dangerous as some other consumer products such as alcohol, drugs and tobacco is an important lesson for developing countries such as ours. This makes it imperative that we warn consumers adequately and regulate the supply of such products. In a country where we still rely on party symbols for elections, owing to the large number of illiterate people, arguing that the solution lies in a free market— where these people will make informed choices about complex financial products—rings hollow.
With banking penetration abysmally low, it is but natural that there would be a thriving market for loan sharks. Our lethargic banking system ensures that the dream of 100% financial inclusion can well be a dream for a long time. MFIs certainly have an important role to play in this wide gap in the product spectrum—between the loan sharks and a fully inclusive formal banking system—but they should also be prepared to submit to rules somewhere in the middle of the regulation spectrum—between the highly regulated banks and the unregulated loan sharks.
It is important to keep in mind that financial inclusion is not the end in itself—it is just a means to achieve inclusive growth. It is indisputable that access to the formal banking system gives the poor the ability to protect, save, grow their money, and plan for emergencies through products such as insurance. Most importantly, it makes the government better able to distribute social welfare to the needy. However, it is fallacious to assume that an unfettered micro-loans market is the panacea to poverty in an illiterate country such as ours.
* Praveen Chakravarty is currently on assignment with the Unique Identity Authority of India, and is a former managing director, BNP Paribas Securities
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