MICROCAPITAL STORY: India’s Stricter Capital Norms may Prompt more Efficient Financial Structures for Microfinance Institutions (MFIs)

India’s present growth rate for its microfinance sector has been recorded at 130 percent, with prospects of continued growth and increased demand in coming years. Microfinance Institutions (MFI) in India have been responsible for Rs 10,000 crore (approx. USD 2.23 billion) in loans to low-income individuals and small businesses. Currently a sector consisting of about 135 MFI’s throughout the country, the government of India has begun introducing tighter norms for the capital adequacy ratios (CAR) of its microfinance lenders, which are expected to be enacted within the coming year.

An MFI’s capital adequacy ratio is a measure of the leverage and, consequently, risk of that institution. In 2005, almost half of all India’s MFIs had a CAR of less than 12 percent, and only those with smaller portfolios (less than USD 1 million) had a “comfortable” rate of 20 percent or more. Many of these were sourced by foundations or other grant mechanisms.

Microfinance institutions use leverage mostly to expand their services and extend loan products to further reach out to clients. However, the high level of leverage that comes from a low CAR places an MFI’s assets at high risk; thus jeopardizing the organization’s existence as a whole.

The Indian government’s plan to tighten capital adequacy norms is expected to have a consolidation effect on the sector. Many MFIs are expected to be acquired by larger institutions. This would unite resources and management, and the consolidated capital could greatly reduce the risk faced by the institutions.

Another plan of action taken by MFIs in the sector is converting into Non-Banking Financial Companies (NBFCs). Fifty of India’s MFIs have already made taken this step, signaling a willingness within the sector to evolve along with their equity requirements, as well as a sophistication within the industry from relatively risky structures to more regulated and institutionalized organizations.

The stricter expectations on the microfinance sector’s capital adequacy will hold MFIs to a higher standard, which will have a progressive effect on the sector as a whole. The current consolidation among institutions within the enormously growing microfinance sector will serve to increase industry information, and perhaps raise transparency among institutions. The regulations will also make MFIs take a closer look at their leverage and may even serve as an efficiency test – forcing institutions to strategize and become more capable players within the Indian financial market.

By Yrenilsa Lopez, Research Assistant

ADDITIONAL INFORMATION

“India Country Profile” Economist Intelligence Unit. Sept. 2008 (subscription only)

Raghuvir Badrinath, “Stringent norms may strengthen microfinance sector.” Business Standard. Sept. 2008

“Technical Note 2: Equity & Leverage In Indian MFIs.” Micro-Credit Ratings International Limited. Sept. 2005

“Indian Rupees (INR) and United States Dollars (USD) Currency Exchange Rate Conversion Calculator”

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