Maybe it’s too early to seek real explanations for the microfinance tragedy in AP. The dust hasn’t settled yet, but I’m struggling to come to grips with the big “why?”. (For a summary of events until Tuesday, see here.) My usual blog sources of all colours for all things development are silent, so far. But the Indian media are buzzing with coverage and an occasional piece of analysis. From what I can tell from these reports, the crisis was caused by a failure to regulate and a set of ultra-perverse incentives for microfinanciers and their employees.

What happened? In the past 6 weeks or so, some 30 to 60 microcredit borrowers in Andhra Pradesh (according to different sources) committed suicide over their loans. Individual stories had surfaced increasingly throughout early and mid-October about borrowers suffering under heavy debt burdens and massive pressure from agents; with measures apparently even including child abduction as punishment for loan default and agents urging borrowers to take their lives to reap credit life insurance. Protests ensued, and last week, the AP government issued an ordinance imposing rules of conduct and compulsory registration on MFIs (microfinance institutions). A consortium of MFIs (MFIN) claimed this had halted their business completely, and this week the MFIs submitted a petition at the AP High Court asking to quash the government’s ordinance.

This Indian news video concisely tells the horrific story.

The High Court today officially permitted MFIs to continue their business activities, while upholding the terms of the ordinance that MFIs may not engage in coercive practices and must proceed with registration. Meanwhile, employees of SKS Microfinance and Spandana have been arrested for harassing borrowers. SKS shares have dropped by over one fifth, indicating that investors are worried about profitability (rightly so). An Indian apex organisation has proposed for all its members to cut interest rates – more about that below.

According to NDTV’s research (see video above, and Associated Press), 17 out of the suicide victims had borrowed from SKS Microfinance, which went public just this summer at a valuation of 1.5 million US Dollars, paying out multimillions to founder Vikram Akula and investor Sequoia Capital (an American venture capital firm) and other private shareholders and international NGOs.

Whether that money has blood on it may be too early to tell. But I will argue here that the drive for profitability in the microfinance sector has contributed significantly, perhaps even decisively, to this tragedy in Andhra Pradesh.

Milking the cow for as much as it will give

At this week’s meeting of the microfinance sectoral organisation/lobby group Sa-Dhan, which represents 260 MFIs, the organisation’s executive director Mathew Titus admitted MFIs were not forthcoming in following voluntary codes of conduct. He also acknowled that the suicides and the resultant government ordinance had created a crisis of confidence in the microfinance sector. But the far greater, and unintended, admission of Sa-Dhan is that interest payments have been excessively high; the cow will simply not give milk forever at this rate. At its Thursday meeting, Sa-Dhan members agreed collectively to cut interest rates by 0.5 to 2 percent – the Indian broadsheet The Hindu smells an image makeover:

The step to snip rates is seen as part of the industry’s fresh initiatives to clear its image in the wake of the suicides in rural Andhra Pradesh allegedly due to coercive methods employed by some MFIs to collect dues and the subsequent ordinance clamped by the State Government.

The Hindu is probably right. SKS, which increasingly looks to be a central figure in this tragedy, has even offered to cut its lending rate by 2 percent. It looks like microfinanciers in India are worried they will lose public support, and are hurrying to cut back on their profitability until this storm blows over.

The incentive structure facing MFIs thus far has been to maximise profitability, attract investment capital, and then generate returns for shareholders. At least for the moment, that incentive structure has moved back while the cultural capital embodied in microfinance investments (in the Bourdieuan sense) must be restored/recapitalised through visible “socially responsible” behaviour

For years, the received wisdom among supporters of microfinance commercialisation has been that competition among privately-owned profit-maximising MFIs will lead to the lowest possible rates for borrowers (though some have begged to differ). If MFIs India now can suddenly cut back rates in order to attract or retain capital, they must be currently overcharging borrowers. Of course the Indian microfinance market is far from perfectly competitive, and the concerted action by MFIs in lowering interest rates and challenging the AP government’s ordinance shows that microfinanciers can even get together to co-ordinate and set prices.

Given that “a vast majority of MFIs in India are non-profit NGOs, which are legally not “owned” by anyone” (Vijay Mahajan and G. Nagashri’s words), the range of interest rates charged is surprisingly narrow. Sa-Dhan members (mostly NGOs) charge 19 to 27 percent, while MFIN MFIs – “31 non-banking finance companies (NBFC) MFIs including the top 10 MFIs” – “normally” charge 24 percent. In this comparison, the non-profit microfinance sector appears to act as if it were a profit maximiser, guided by the ideal that microfinance companies must be “sustainable”, i.e. able to hold their own on the capital market against other investment opportunities. In the case of the for-profit sector, nomen est omen. Dropping interest rates in response to the AP tragedy constitutes an admission that both sectors’ ideal of profitability has been pursued on the backs of the poor.

Failure to regulate – even worse than a revolving door

Given such evident market failures in the stylised “market” for microfinance in India, the need for regulation is clear. Until now, the regulatory focus of Indian microfinance has been self-regulation. While some industry observers have worried about an emergent microfinance bubble since early 2010, industry chiefs like Mahajan have been professing their insouciance. Private regulation remains unenforceable.

In terms of formal regulation, the Indian government fence-sat for a long time on whether or how to regulate microfinance, stalling for years. In early 2010 finally a draft bill was circulated by NABARD with the call for input from “stakeholders” – the regulatees were supposed to tell the regulator how to regulate them. In that draft, a cap on interest rates was never proposed, and Non-Bank Financial Companies (the corporate form preferred by most Indian commercial MFIs) were exempt from the proposed regulation. The bill to date hasn’t been passed by the Indian national parliament, Lok Sabha.

After the mass suicides, the AP government’s heavy-handed clampdown on MFIs’ has to be seen in the context of Delhi’s failure. Hyderabad had to act to protect the poor, even if in a rushed and perhaps populist way. Vague in its wording, the AP ordinance created confusion and allegedly led MFIs to halt their activities – at least officially since, as arrests of MFI workers showed, debt collection was still going on locally. (According to the Times of India, even Vikram Akula of SKS was under risk of arrest for some time, until the AP High Court decided to quash the arrest clause.)

India’s federal system grants states power over security, but few powers for financial regulation. By forcing MFIs to divulge interest rates and register at the local level, the AP government took an important step towards finally enforcing transparency. Given the coercive tactics reportedly employed by MFI employees, there would surely have been more straightforward means available to preserve lives and prevent abuses than to issue an unclear ordinance which left open whether loan officers would be arrested for recovering loans, or not. But the resounding message from Hyderabad was not to MFIs to halt their business activities. The main message as I see it went to Delhi: Regulate!

This is part 1 of my explanation. Part 2 follows here, tracing the perverse incentives at the micro level which have contributed to the crisis.