COMMERCIAL BANK NEW PLAYER IN MICRO FINANCE

BACHELOR OF COMMERCE

(BANKING AND INSURARANCE)

SEMESTER V

2014-2015

SUBMITTED BY

SAYED ERAM

ROLL NO.33

K.P.B.HINDUJA COLLEGE OF COMMERCE

315, NEW CHARNI ROAD, MUMBAI-400 004

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 CERTIFICATE

This is to certify that Miss. SAYED ERAM Roll No: 33 of B.com. Bachelor in
Banking & Insurance V [2014-2015] has successfully completed the Project on
SOCIAL INSURANCE under the Guidance of MS. POOJA M. TALREJA

Project guide

Course Coordinator

Internal Examiner

External Examiner

Principal

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 DECLARATION

I Miss SAYED ERAM the student of B.Com. Banking & Insurance, V

semester (2014-2015) hereby declare that I have completed the project
on COMMERCIAL BANK NEW PLAYER IN MICRO
FINANCE. The information submitted is true and original to best of
my knowledge.

(Signature)

SAYED ERAM

ROLL NO.33

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 ACKNOWLEDGEMENT

The project on SAYED ERAM is a result of co-operation, hard work and good
wishes of many people. I student of K.P.B. HINDUJA COLLEGE OF
COMMERCE would like to thank The Principal and the Vice Principal of our
college.

I would like thank MS POOJA M. TALREJA for her involvement in my

project work and timely assessment that provided me inspiration and valued
guidance throughout my study.

I own my debt to MS. POOJA M. TALREJA Course coordinator for her

friendly guidance & constant encouragement.

I also take this opportunity to express my sincere gratitude to the library staff,
which provided me with right information and right material at the right
time.

I express my deep gratitude to all my college friends and my family members

whose efforts and creativity has helped me in giving me the final structure to
the project work.

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 CHAPTER1:

INTRODUCTION TO MICROFINANCE

1.1 DEFINATION AND JUSTIFICATION:

MICRO
FINANCE

MICRO-ENTREPRISE. BUSINESS AND

EDUCATIONAL LOAN.
SELF-EMPLOYPENT.
SAVINGS.
LOW INCOME POPULATION. MICRO-
INSURANCE.
EXCLUDED POPULATION
REMITTANCE.

Microfinance is a source of financial services for

entrepreneurs and small businesses lacking access to banking
and related services. The two main mechanisms for the delivery
of financial services to such clients are: (1) relationship-based
banking for individual entrepreneurs and small businesses; and
(2) group-based models, where several entrepreneurs come
together to apply for loans and other services as a group.

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1.2. INTRODUCTION:

Microcredit is a small amount of money lent to a person, whereas

microfinance is a provision of thrift, credit, financial service, and
products to the poor. .Dr. Md. Yunus, Nobel Prize winner has define
microfinance as "availability of rural people without obtaining
collateral for income generating purpose in order to reduce
poverty level. Micro-credit is also termed as collateral free
loans.In its report on the latest estimates on global poverty, the
World Bank has estimate that the poverty rate _those below
$1.25/day level _for India has come down from 59.8% of the
population in 1981 to 41.6% in 2005. This means that the poverty
rate in India is declining at a much slower rate. In contrast, while
India below 421 million $1.25-a-day levels in 1981, this number
has swelled to 456 million by 2005 .It may thus be seen that,
while there has been a decline in the poverty ratio, the ranks of
the poor are still swelling. In other words, nearly four out of 10
Indians live below what the worlds poorest countries consider the
poverty line.

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This brings us to the point that there is a growing need to evolve
a system to target these people living below the poverty line. This
is an effort to reaching out to the bottom of the pyramid . The
banking industry has shown tremendous growth in volume and
complexity during the last few decades. Despite making
significant improvements in all the areas, there are concerns that
banks have not been able to bring vast segment of the
population, especially the underprivileged sections of the society,
in rural and urban areas alike, into the fold of basic banking
services. The reasons may vary from country to country and place
to place within a country and hence, the strategy could also vary.
But, one thing is common .The opening up of opportunities for
self-employment by creating appropriate institutions and policies
to help in livelihood creation are unquestionably the best strategy.
Despite priority sector lending targets over the last decade ,
banks outreach to small borrowers in the bottom of the pyramid
has progressively declined, both as a proportion of credit and in
terms of total number of bank accounts. To fill this gap, MFIs have
emerged as key provider of financial service of the poor. Majority
of the MFIs are not for profit organization that facilitate the
formation of Grameen groups or SHGs and link them with formal
banks, often leading to activities that extend beyond
microfinance. This model accounts for about 70% of micro finance
in India

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1.3 HISTORY

YEAR EVENTS

1961 ACCION International was founded in Venezuela with

$90,000, raised from private companies by Joseph
Blatchford. Initially the funding was used to build
schools and water systems, before turning to
microcredit in 1973.

1971 Opportunity International, founded by Al Whittaker

and David Bussau, lend to micro entrepreneurs in
Indonesia and Columbia. In 1979 they expand
across southeast Asia and South America

1976 Another Milestone Prof. Muhammad Yunus, an

economist in Bangladesh, finds that a loan of $27
can change the lives of 42 families in an
impoverished village in Bangladesh. All loans are
paid back with interest.

1983 Prof. yunus creates Grameen bank. To date Grameen

has lent more than $6 billion (to 7.4 million

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 Bangladeshis). Its methods have become the basis
for modern microfinance that includes group
lending, women-focused, and good repayment rates

1992 Prof. yunus creates Grameen bank. To date Grameen

has lent more than $6 billion (to 7.4 million
Bangladeshis). Its methods have become the basis
for modern microfinance that includes group
lending, women-focused, and good repayment rates

1997 The National Microfinance Bank in Tanzania (NMB) is

created. Meanwhile, Deutsche Bank enters
microfinance as part of its drive to embrace social
investing. And, Grameen Foundation is founded in
the US.

2000 Bancosol in Bolivia becomes a regulated bank,

dedicated to microfinance

2001 The Microenterprise Access to Banking Services

initiative in the Philippines helps integrate rural
banks microfinance loan clients into the credit
system.

2005 The UN names 2005 the International Year of

Microcredit. Citibank opens Citi Microfinance, based
in London, New York, India and Colombia to broaden

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 the reach of its financial services.

2006 The Microfinance Summit Campaign Report

estimates that there are more than 3,000
microfinance institutions serving 106 million poor
people in developing countries. The total cash
turnover of these institutions worldwide is estimated
at $2.5bn.
2008 Microfinance continues going mainstream. Retail
investors/lenders participate in Kiva. Or and
MicroPlace.org that allows individuals to invest in
small loans to microfinance clients directly online

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1.4 THE NEED OF MICROFINANCE

1. India is said to be the home of 1/3 of the world poors, official

estimate range from 26 to 50% of more than one billion
population.

2. About 87% of the poorest households do not have access

credit.

3. The demand for the microcredit has been estimated up to

$30 billion, and supply less than 2.2 billion combined by all
involved in sector.

4. Therefore, the need of microfinance in India because:

Poor people need not just loans but also savings, insurance
and money transfer service.

Microfinance must be use full to poor household helping

them raise income, build up asset and cushion themselves
against external shocks.

Microfinance can pay for itself subsidies from donor and

government are scare and uncertain and so to reach large
no. of poor people, microfinance must pay for itself.

Microfinance builds permanent local institution.

Microfinance also integrates the financial need of poor

people in to a countrys mainstream financial system.

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 The job of government is to enable the financial services and
not to provide them.

Donor funds complete private capital not competes with it.

Microfinance institutions measures and disclose their

performance both financial and social.

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1960 to1980 1990 2000
PHASE 1: SOCIAL PHASE2: FINANCIAL PHASE3:
BANKING SYSTEM APPROACH FINANCIALINCLUSIO
N
1. Nationalization 1. Peer-pressure 1. NGOs, MFIs and
of private SHGs gaining
commercial more
banks legitimacy
2. Expansion of 2. Establishment 2. MFIs emerging
rural branch of MFIs a strategic
networks typically of non- partner to
profit origin . diverse entities
interested in
low income
segments
3. Extension of 3. Consumer
subsidies finance
credit emerged as
high growth.

4. .Establishment 1. Increased
of RRB policy
regulation
5. Establishment 2. Increasing
of apex commercializati
institution such on
as NABARD and

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SIDBI

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PHASE 1:

In 1960 the credit delivery system in India was largely

dominated by the corporative segment. The phase during 1960 to
1980 referred as social banking phase. This phase include
nationalization of private commercial banks, expansion of rural
branches network, extension of subsidized credit, establishment
of RRB and the establishment of apex institution s such as the
NABARD and SIDBI.

PHASE 2:

After 1990s, India witness a second phase of financial system

approach credit delivery. In this phase NABARD initiated the
SHGs bank linking program, formal banks. This concept held
great appeal for non-govt. organization (NGO). Working with the
poor, prompting many of them to collaborate with NABARD in the
program. This period also witnessed the entry of (MFIs), largely of
non-profit origins, with existing development programs.

PHASE 3:

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 In 2000, the third phase in the development of India MF
began marked by further changes in policies, operating format,
and stakeholder orientation in the financial services space. This
phase emphasizes on inclusive growth and financial inclusion.
The period saw many NGOs and MFIs transform in to regulated
legal formats such as (NBFCs) commercial banks adopted
innovative way of partnering with NGOs MFIs and other rural
organization to intent their reach into rural market. MFIs emerged
as strategic partner to individual and enties interest in reaching
out to Indias low income client segments.

1.6 SIGNIFICANCE

Community organizing: The ability to draw in and attract

active self willed participation of target communities is the
most important factors for the success of micro finance the
organization, which arises from the small size and
homogeneity among members, leads to the establishment of
mechanisms that turn lead to better screening of clients and
enforces repayment that makes the lending programme
more efficient than those of the bank.

Encouraging savings:There is increasing consensus that

service required by the poor is much more than credit and
include deposits and remittances. Such service enables them
to build asset and to leverage capital for emergencies that
confront them at regular interval. Currently microfinance
institution are not allowed to offer deposit product however,

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 the opening of insurance sector has led to an increase in the
provision of micro insurance.
Large outreaches:Within these complex diverse conditions,
NGOs and MFIs have managed to reach a large no. of clients.
From 55000 clients in 1996; the bank linkage programme
today covers approximately 22 million clients .the loan
portfolio of microfinance has grown from Rs.6crore to
Rs.1139crore.This growth may be viewed in the light of fact
that the microfinance movement has managed to draw to
the financial sector a set of client who did not ever
participate in the formal financial service market.
Multiple delivery models: An encouraging factor for
microfinance in the country is the multiple delivery models
adopted in the country. It is important to know that banks
have come forward in large no. to finance, directly self- help
group SIDBI has a scheme of refinancing MFIs/NGOs to lend
either directly to individuals or through Grameen and other
group.
Enterprise support design: NGOs, when involves use the
three broad options area sector of function focused
strategy. The approach may be described as limited to a
cluster of villages or within an urban settlement the sector
approach involves providing specialist inputs such as
marketing, technology etc. around a particular occupation.
The functional approach is limited to providing services, in
most cases, credit, which will help unlock the potential of
individual or families.

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1.7 ADVANTAGES OF MICROFINANCE:

1) Helping financially: By having a group lending model, the

group is able to pay for the loan of someone who is
undergoing severe financial strains due to illness,
unemployment, or numerous other factors.
2) Helping their businesses: By meeting with a large group
of small business owners each week, there are often
instances when one business owner shares some business
knowledge or gives a suggestion to another owner about
how to improve their businesses. This is often beneficial for
the whole group, as they are able to greatly learn from each
other.
3) Womens Empowerment: Many of the business owners
receiving loans are women, and therefore it is an opportunity
for these women to meet out of the house, and make an
income that allows them to not be completely reliant on their
husbands.
4) Social affair: It is also a chance for the business owners to
chat about life while drinking tea or coffee and eating
sweets.

1.8 DISADVANTAGES OF MICROFINANCE:

1) Micro lending depends upon ever increasing number of

lenders in order to be successful
2) Low repayments rate in comparison with traditional financial
institutions
3) Use of harsh and coercive method to push for repayment
and excessive interest rate
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4) The main disadvantage of micro finance is that the deal is
too small for the lender to devote ample time and money
doing proper due diligence
5) As the capital is low the profit are low.
6) Most micro finance programe target women [due to higher
repayment rate] which may result in man requiring wife to
get loan for them.
7) The inability to reach the poorest of the poor is a problem
that plagues most poverty alleviation programs .As
Greshams law remind us , if the poor and non-poor will
always drive out the poor to be effective, the delivery
system must be design and operated exclusively for the
poor.
8) To the bank the borrowers are few for the problem of
reaching out to the people.
9) Borrower seldom if ever give lender the full story of their
situation and with small amt. at risk it does not made sense
for lender to spend a lot of money to checkout story. When
lender gets burned they decide to stop lending and the new
round of lending must be done by greenhorns who have no
idea what they getting into.

1.9 ROLE OF MICROFINANCE

The micro credit of microfinance programe was first initiated
in yr. 1976 in Bangladesh with promise of providing credit to
the poor without collateral, alleviating poverty and
unleashing human creativity and endeavor of the poor
people microfinance study have demonstrated that:

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 Microfinance have poor household to meet basic needs
and protect them from risk
The use of financial services by low income households
leads to improvement in household economic welfare
and enterprise stability and
By supporting womens economic participation,
microfinance empower women, there by promoting
gender equity and improving household well-being
The level of impact relates to the length of time client
have access of financial services

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1.10PRINCIPAL OF MICROFINANCE:

Some principal that summarize a century and a half of

development practice were encapsulated in 2004 by consultative
group to Assist the poor (CGAP) and endorsed by the group of 8
lenders at the G8 summit on June 10, 2004

Poor people need not just loans but also saving insurance
and money transfer services.

Microfinance must be useful to poor household helping

them raise income, build up asset and / or cushion
themselves against external shocks.

Microfinance can pay for itself subsidies from donors

and government are scare and uncertain, and so to reach
large number of poor people microfinance must pay for
itself.

Microfinance means building permanent local institutions.

Microfinance also means integrating the financial needs of

poor people into a countrys mainstream financial system.

The job of government is to enable financial services, not

to provide them.

Donors funds should complement private capital, not

compete with it.

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1.11 ACTIVITIES OF MICROFINANCE:

1. Micro credit: It is a small amt. of loaned to the client by

bank or institution. Microcredit can be offered often without
collateral, to an individual or through group lending
2. Micro savingThese are the deposits service that allow one
to same amt. of money for future use often without minimum
balance requirement these savings account allow household
to save in order to meet unexpected expenses
3. Micro insurance: It is a system by which people, business
and other organization make a payment to share risk. Access
to insurance enables the entrepreneur to concentrate more
on developing their business
4. Remittances: These are transfers of funds from one place
to another, usually across borders to family and friends
compared with other sources of capital that can fluctuate
depending on the political or economic climate, remittances
are relatively steady sources of funds.

1.12 FINANCIAL PRODUCTS:

1. Insurance plans: This is basically a risk coverage product. It

works a way traditional insurance work.

2. Pension plans: This includes retirement plan contribution are

made by plan holder and MFIs for benefits of plan holder.

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3. Trade microcredit: provides working capitals for poor
entrepreneur to keep their business

4. Group microcredit: provide loan to poor people in groups for

which groups act as collateral.

5. Emergency microcredit: provide instant cash flow to tackle

with emergencies.

6. Micro mortgage: Micro sector customer ranging from

seasonal crop financing, purchasing inventory of buying of
machinery and tools for business use have this kind of
products available.

7. Micro savings: time deposits ranging from 3 months to 1yr.

as offered on return up to 13.25 is given

8. Term deposits: MFIs also offer term deposits ranging from 3

months to 12months with upfront profit and backload profit.

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1.13DEVELOPMENT PROCESS THROUGH MICROFINANCE

Donors and Bank Microfinance

Govt. and Bank

Implementing Organization

Individual Awareness/ Promotional Work

Individual

Promotion and
formation of SHGs

Microenterprise consolidation of SGHs

Microenterprise

Savings

Consumption need credit delivery

consumption

Recovery
need

Follow up monitor

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Farm related Income generation
Non- farm related

(Sustainability and growth

oriented)

Self- sustainability of SHGs

Economic empowerment through

Use of microcredit as an entry

Point for overall empowerment

1.14 MICROFINANCE INTERVENTION THROUGH DIFFERENT

ORGANIZATIONS:

National financial bank Government funded

Donor/Bilateral

Institution programs
project

IMPLEMENTING
ORGANISATION

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Resource support directly related
indirectly related

Organizations

Individual

SHGsMember

1.15KEY PLAYERS OF MICROFINANCE:

1. NABARD:NABARD is an apex institution, accredited with all

matters concerning policy, planning and operations in the
fields of credit for agriculture and other economic activities
in rural areas in India. NABARD was established in 1982as a
Development Bank, in terms of the Preamble of the Act, for
providing and regulating credit and other facilities for the

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 promotion and development of agriculture, small scale
industries, cottage and village industries, handicrafts and
other rural crafts and other allied economic activities in rural
areas with a view to promoting integrated rural development
and securing prosperity of rural areas and for matters
connected therewith or incidental thereto. The corporate
mission set by NABARD for making available microfinance
services to the very poor envisages coverage of one third of
the rural poor through one million SHGs by the year 2006-07.

In November 1998 a high-powered Task Force on supportive Policy

and regulatory framework for Micro finance (henceforth referred
to as the Taskforce) was set up by NABARD at the instance of RBI.
The objective of the Task Force were among others, to come up
with suggestions for a regulatory framework that brings the
operations of the Microfinance Institutions into the mainstream, to
access the possible role of self-regulatory organizations and to
explore the need for a separate legal framework for micro finance

2. Reserve Bank of India (RBI):-The earliest reference to

micro credit in a formal statement of monetary and credit
policy of RBI was in former RBI President Dr.
BilalJapansMonetary and Credit Policy Statement of April
1999. The policy attached importance tithe work of NABARD
and public sector banks in the area of micro credit. The
banks were urged to make all out efforts for provision of
micro credit, especially forging linkages with SHGs, either at

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 their own initiative or by enlisting support of Non-
Government Organization (NGOs). The micro credit extended
by the banks is reckoned as part of their priority sector
lending, and they are free to device appropriation loan and
saving products in this regard considerable work had been
done by RBI in this sector since 1991. In 1991-92 a pilot
project for linking up SHGs with banks was launched by
NABARD in consultation with the RBI. In 1994, the RBI
constituted a working group noshes. On the recommendation
of the SHGs would be reckoned as part of their lending to
weaker sections and such lending should be reviewed by
banks and also at the State Level Bankers Committee
(SLBC) level, at regular interval.
3. Self Help Groups (SHGs):-The origin of SHGs is from the
brainchild of Grameen Bank of Bangladesh, which was
founded by Mohammed Yunus SHG was started and formed
in1975. The establishment of SHGs can be traced to the
existence of one or more problem areas around which the
consciousness of rural poor is built and the process of group
formation initiated. Since SHGs have been able to mobilize
savings from persons or groups who were not normally
expected to have any saving and also to recycle effectively
the pooled resources 41

Amongst the members, their activities have attracted attention as

a supportive mechanism for meeting the credit needs of the poor

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4. Micro Finance Institutions (MFIs):-A range of institutions
in public sector as well as private sector offers the micro
finance services in India. Based on asset sizes, MFIs can be
divided into three categories: 1. 5-6 institutions which have
attracted commercial capital and scaled up dramatically
when last five years. The MFIs which include SKS, SHARE and
Grameen Style program but after 2000, converted into for-
profit, regulated entities mostly Non-Banking Finance
Companies (NBFCs). 2. Around 10-15 institutions with high
growth rate, including both News and recently form for-profit
MFIs. Some of MFIs are Grameen Koota, Bandhan and ESAF.
3. The bulk of Indias 1000 MFIs are NGOs struggling to
achieve significant growth. Most continues to offer multiple
developmental activities in addition to microfinance and
have difficulty accessing growth trends. Private MFIs in India,
barring a few exceptions, are still fledging efforts and are
therefore unregulated. They secure micro finance clients
with varying quality and using different operating models.
5. Non-Government Organizations (NGOs):-The Non-
Government Organizations involved in promoting SHGs and
linking them with the Formal Financial Agencies (FFAs)
perform the following functions:- Organizing the poor people
into groups- Training and helping them in the organizational,
managerial and financial matters- Helping them access more
credit and linkage with formal financial agencies-
Channelizing the group effort for various development

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 activities- Helping them in availing opportunities, widening
the options available for economic development

1.16 ISSUES RELATED TO MICROFINANCE IN INDIA

A. Problems faced by Borrowers:-

1. Coercion: One of the most important moral issues being

raised in relation to microfinance is that of coercion. After 54
people killed themselves in the state of Andhra Pradesh in
October 2010, Indian authorities placed microfinance institutions
(MFI) under a microscope, and drafted new rules the MF
companies must follow. The farmers were reportedly deep in debt
to microfinance institutions (MFIs). "Microfinance institutions
charge exorbitant interest rates. The poor are driven to take their
own lives because of their burden of debt and the brutal methods
used to call in the loans", the chief minister of Andhra Pradesh
said.

2. Brutal and Aggressive Debt-Collection Tactics: -"The

people calling in the loans are often not aware of the code of
conduct of the MFIs. Many of the MFIs have been resort to brutal
methods for collection of debt from these borrowers. News items
like the one below are quite common in India. Unable to repay
Rs. 235, Farmer kills self. MFI Loan Suicide, Hyderabad News A
farmer committed suicide by consuming pesticides, allegedly
after being harassed by the collection agents of a microfinance
institution at in Nalgonda district, Andhra Pradesh.

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3. Joint Microfinance: Joint microloans are granted to a group of
people who are jointly responsible for repaying the loan.
Individual failures to pay (due to illness or a bad week)are
avoided and group pressure serves as a strong incentive in
ensuring responsible behavior by making loans to individuals
within a lending circle. The individuals meet regularly, ostensibly
creating a self-help group. In reality, all the borrowers in the group
are responsible for making the loan repayment if a member
defaults, so peer pressure is a very strong factor. However, in
case of default either due to business failures, unproductive
expenditure or greed to consume more, all members is troubled.

4. High Interest Rates: -Many in the urban centers would

commit suicide if the banks start charging us24 per cent rate of
interest. Even at 8.5 per cent rate of interest, those who have
drawn housing loans, find it difficult to make monthly EMI
payments. Imagine the stress and threat under which the poor in
the rural areas are being made to borrow at 24 per cent rate of
interest. Whatever the justification for charging 24 per cent rate
of interest, how can human beings exploit a hungry stomach in
the name of a successful business model?

5. Not aimed at lifting people out of poverty: -Micro finance

serves not to lift people out of poverty but, assist those near or
slightly above the poverty line. Money is given to those people
who have possibility of returning the principle amount. This leads

31
to the fact that lending money to these people is feasible and
sustainable, while lending to the poorest of the poor is not.

6. Poverty alleviation mission has now been reduced to

Moneymakingof MNCs:Micro finance has now, become a
weapon for multinational companies to sell their products, by
collaborating with such institutions. This in turn, is destroying
the spirit of micro credit.MFIs have reached 20 million people
in a few years, a success owing something to light regulation
that facilitated much innovation and experimentation. Some
MFIs have become large institutions, and large ones need
tougher regulation. But care should be taken to give MFIs,
especially smaller ones, continued scope for innovation and
experimentation.

B. Problems faced by Lenders:-

1. Sustainability: -The first challenge relates to sustainability.

MFI model is comparatively costlier in terms of delivery of
financial services. An analysis of 36 leading. MFIs by Jindal
&Sharma shows that 89% MFIs sample were subsidy dependent
and only 9 were able to cover more than 80% of their costs. This
is partly explained by the fact that while the cost of supervision of
credit is high, the loan volumes and loan size is low. It has also
been commented that MFIspass on the higher cost of credit to
their clients who are interest insensitive for small loans but may
not be so as loan sizes increase. It is, therefore, necessary for

32
MFIs to develop strategies for increasing the range and volume of
their financial services.

2. Lack of Capital: -The second area of concern for MFIs, which

are on the growth path, is that they face a paucity of owned
funds. This is a critical constraint in their being able to scale up.
Many of the MFIs are socially oriented institutions and do not have
adequate access to financial capital. As a result they have high
debt equity ratios. Presently, there is no reliable mechanism in the
country for meeting the equity requirements of MFIs.The IPO issue
by Mexico based Comparators was not accepted by purists as
they thought it defied the mission of an MFI. The IPO also brought
forth the issue of valuation of an MFI

3. Financial service delivery: - Another challenge faced by

MFIs is the inability to access supply chain. This challenge can be
overcome by exploring synergies between microfinance
institutions with expertise in credit delivery and community
mobilization and businesses operating with production supply
chains such as agriculture. Theater players who bring with them
an understanding of similar client segments, ability to create
microenterprise opportunities and willingness to nurture them,
would be keen on directing microfinance to such opportunities.
This enables MFIs to increase their client base at no additional
costs. Those businesses that procure from rural India such as
agriculture and dairy often identify finance as a constraint to
value creation. Such businesses may find complementarities

33
between MFIs skills in management of credit processes and their
own strengths in supply chain management.ITC Limited, with its
strong supply chain logistics, rural presence and an innovative
transaction platform, the e-copal, has started exploring synergies
with financial service providers including MFIs through pilots with
vegetable vendors and farmers. Similarly, large FIs such as Span
Dana foresee a larger role for themselves in the rural economy
ably supported by value creating partnerships with players such
as Mahindra and Western Union Money Transfer. 28ITC has
initiated a pilot project called pushcarts scheme along with
BASIX (microfinance organization in Hyderabad). Under this pilot,
it works with twenty women head load vendors selling vegetables
of around 10- 15 kg per day.BASIX extends working capital loans
of Rs. 10,000/- , capacity building and business development
support to the women.

ITC provides support through supply chain innovations by:

i. Making the Chou pal Fresh stores available to the vendors,

this avoids the hassle of bargaining and unreliability at the
traditional mantis (local vegetable markets).

ii. Continuously experimenting to increase efficiency,

augmenting incomes and reducing energy usage across the value
chain. For instance, it has forged a partnership with National
Institute of Design (NID), a pioneer in the field of design education
and research, to design user-friendly pushcarts that can reduce
the physical burden.

34
iii. Taking lessons from the pharmaceutical and telecom sector
to identify technologies that can save energy and ensure
temperature control in push carts in order to maintain quality of
the vegetables throughout the day. The model augments the
incomes of the vendors from around Rs.30-40 per day to an
average of Rs.150 per day. From an environmental point of view,
push carts are much more energy efficient as opposed to fixed
format retail outlets.

4. HR Issues Recruitment and retention is the major challenge

faced by MFIs as they strive to reach more clients and expand
their geographical scope. Attracting the right talent proves
difficult because candidates must have, as a prerequisite, mindset
that fits with the organizations mission. Many mainstream
commercial banks are now entering microfinance, who are
poaching staff from MFIs and MFIs are unable to retain them for
other jobopportunities.85% of the poorest clients served by
microfinance are women. However, women make up less than half
of all microfinance staff members, and fill even fewer of the senior
management roles. The challenge in most countries stems from
cultural notions of womens roles, for example, while women are
single there might be a greater willingness on the part of
womens families to let them work as front line staff, but as soon
as they marry and certainly once they start having children, it
becomes unacceptable. Long distances and long hours away from
the family are difficult for women to accommodate and for their
families to understand

35
5. Micro insurance First big issue in the micro insurance sector
is developing products that really respond to the needs of clients
and in a way that is commercially viable. Secondly, there is strong
need to enhance delivery channels. These delivery channels have
been relatively weak so far. Micro insurance companies offer
minimal products and do not want to go forward and offer
complex products that may respond better. Micro insurance needs
a delivery channel that has easy access to the low-income
market, and preferably one that has been

Engaged in financial transactions so that they have controls for

managing cash and the ability to track different individuals.
Thirdly, there is a need for market education. People either have
no information about micro insurance or they have a negative
attitude towards it. We have to counter that. We have to somehow
get people - without having to sit down at a table - to understand
what insurance is, and why it benefits them. That will help to
demystify micro insurance so that when agents come, people are
willing to engage with them.

6. Adverse selection and moral hazard: -The joint liability

mechanism has been relied upon to overcome the twin issues of
adverse selection and moral hazard. The group lending models
are contingent on the availability of skilled resources for group
promotion and entail a gestation period of six months to one year.
However, there is not sufficient understanding of the drivers of
default and credit risk at the level of the individual. This has

36
constrained the development of individual models of micro
finance. The group model was an innovation to overcome the
specific issue of the quality of the portfolio, given the inability of
the poor to offer collateral. However, from the perspective of
scaling up micro financial services, it is important to proactively
discover models that will enable direct finance to individuals.

37
 CHAPTER 2:

OVERVIEW OF COMMERCIAL BANK

2.1 DEFINITION

A financial institution that provides services, such as accepting

deposits, giving business loans and auto loans, mortgage lending,
and basic investment products like savings accounts and
certificates of deposit. The traditional commercial bank is a brick
and mortar institution with tellers, safe deposit boxes, vaults and
ATMs. However, some commercial banks do not have any physical
branches and require consumers to complete all transactions by
phone or Internet. In exchange, they generally pay higher interest
rates on investments and deposits, and charge lower fees.

2.2 INTRODUCTION:

In simple worlds commercial banks accept deposits from

depositors and lend them to individuals and businesses.
Commercial banks charge higher interest on lending as compared
to the interest that they provide their depositors with. The
difference between two interest rates is called spread or profit of
commercial bank. This is the basic business philosophy of
commercial banks. I am not touching any other details in order
not to confuse you.

Investment banks on the other hand are not allowed to take

deposits like commercial banks and then lend them consequently
FDIC does not come to play its role here because The basic
38
purpose of FDIC is to avoid losses on the part of depositors due to
consequences of events like bank runs of 1930`s and that is what
commercial banks are prone to not investment banks The basic
business model of investment banks revolve around underwriting
and Advisory services. They provide real and advisory services to
governments, corporations and institutions regarding highly
specialized areas such as mergers and acquisitions, spin off, fund
raising etc.

2.3 FUNCTIONS OF COMMERCIAL BANKS

Primary functions: The primary functions of the

commercial bank are given in Banking Regulations Act, 1949.

39
(1) Accepting deposits of money: The most important function
of the commercial bank is to accept deposits from the public. A
banker provides interest on all types of deposits and the public
feel secured when their money is with the bank. People deposit
their money in the form of (1) Savings account, (2) Current
account, (3)Fixed deposits, (4) Recurring deposits. The interest
provided by the bank is known as 'borrowing rate'.

(2) Advancing loans: Another important function of this bank is

to make loans and advances to the needy people. The loans may
be in the form of call loans, over draft, cash credit, term loan and
discounting of bills. It charges higher rate of interest for these
loan. The interest charged by the bank for its lending is known as
'lending rate'.

(3) Transfer of deposit: This is the most important function of a

commercial bank. A bank has to transfer money of the depositor
when demanded by them. Money can be transferred from one
account to another account of the same person, or from one place
to another, from one person to another. This can be done by the
customer by using checks. In case of non- customer, they can do
this by using demand draft.

(4) Permitting withdrawals of money: Bank allows the

depositors to withdraw either the entire or a part of it by using

40
withdrawal slips checks etc. These withdrawals are allowed as per
certain conditions of the bank for certain accounts.

Secondary functions: In addition to the above banking or

primary functions, bank does the following non-banking or
secondary functions also.

(1) Agency services provided by Commercial Banks:

Commercial Banks perform a number of agency services to their
customers. They are:

Purchasing and selling of shares, securities, bonds etc.

Collection and regular payments of bills, checks and other

commercial instruments, dividends, interest etc. as per the
standing instructions given by their customers.

Collection and payment of rents, insurance premium and

other charges.

Remittance of funds on behalf of their customers.

Acts as trustees, representatives and executors of their

clients.

41
 Act as income tax consultants and they prepare and finalize
the income tax returns of their clients.

Procedure tickets and passports for their customers.

(2) General Utility services rendered by Commercial

Banks:
Modern nationalized banks render certain additional utility
services to their customers. They are as follows:

Safety vaults or lockers to provide security to their valuables

like ornaments, documents etc.

Provides traveler's checks to tourists.

Issuing letter of credit to businessmen.

Issuing credit card to their customers.

Providing the facility of withdrawing cash anytime through

ATM.

Underwriting for shares and debentures issued by the

companies.

Providing educational loans, scholarships, book bank facility,

arranging or sponsoring for exhibitions to students.

Providing consultancy services regarding share, taxation etc.

to the companies.
42
 Lending advice as a merchant banker to the businessmen
and industrialists about their new projects, issue of shares
and capital structure etc.

2.4 Types of commercial banks

TYPES OF COMMERCIAL BANKS:

Scheduled banks

Non- Scheduled Banks

Scheduled Banks:

A scheduled bank is one which is registered in the second

schedule of the Reserve Bank of India. The following conditions
must be fulfilled by a bank for inclusion in the schedule:

1. The banker concerned must be in business of banking in

India;
43
2. It is either a company defined in Section 3 of the Indian
Companies Act, 1956, or corporation or a company
incorporated by or under any law inforce in any place
outside India or an institution notified by the central
government in this behalf;
i) It must have paid-up capital and reserves of an
aggregate role of exchangeable value of not less
than rupees five lakhs;
ii) It must satisfy the Reserve Bank of India that its
affairs are not conducted in a manner detrimental to
the interests of its depositors. Scheduled banks come
under the purview of the various credit control
measures of the Reserve Bank of India. They are
required to maintain a certain minimum balance in
their accounts with the RBI, and do certain things
prescribed by law. The Scheduled banks are entitled
to borrowings and rediscounting facilities from the
RBI. These are similar to the member banks of the
U.S.A. - Non- Scheduled Banks: Banks, which are not
included in the Second Schedule of the RBI, are
known as non-scheduled banks. They may be
classified into 4 groups:

a) Banks with paid-up capital and reserves in

excess of Rs. 5 lakhs;

b) Banks with paid-up capital and reserves

ranging between Rs. 50,000 and one lakh of rupees;

44
 c) Banks with paid-up capital and reserves
ranging between one lakh of rupees and 5 lakhs;

d) Banks with paid-up capital and reserves below

Rs. 50,000. Non- Scheduled banks are not entitled to all
those facilities that the scheduled banks avail of from the
Reserve Bank of India.

Since the enactment of the Banking Regulation Act in 1949, non-

scheduled banks have also come under the ambit of the RBI
control. It has become obligatory on the part of these banks to
carry a portion of their deposits with the RBI or in the vault with
the bank itself, and prepare their annual accounts and balance
sheets in accordance with the requirements stipulated in Section
29 of the Banking Companies Act. Scheduled Banks may be
classified into two groups: Indian Scheduled Banks and Foreign
Scheduled Banks. The Indian Scheduled Banks are those which
have their registered officers in India and are registered in the
second schedule if the RBI. As against this, foreign scheduled
banks comprise those commercial banks which are registered in
the said schedule but have their registered offices outside India.
These banks have played a prominent role in Indias foreign trade;
in fact, they had complete sway in this sphere until the Second
World War. Since then, a number of leading Indian scheduled
banks entered the field of foreign trade and have in the course of
time achieved an important position in this field. Indian scheduled
banks may be distinguished in two broad sectors:

45
a) Public sector commercial banking comprising the State Bank of
Indian and its subsidiaries and the twenty nationalized banks;

b) Private sector commercial banking comprising all the other

Indian scheduled banks that do not fall in the above group.

2.5 COMMERCIAL BANKS PLAY AN IMPORTANT ROLE IN A

MODERN ECONOMY

1) They constitute the very life-blood of modern trade, commerce

& industry, as they provide the necessary funds for their working
capital such as to buy raw materials, to pay wages, to incur
current business expenses in marketing of goods, etc.

2) These banks encourage peoples savings habit through their

various savings deposit schemes.

3) They also mobilize idle saving resources from households to

business people for productive use.

4) They transmit money from place to place with economy and

safety.

5) Their agency services are, no doubt, of immense value to the

people at large, as they case their difficulties, save their time &
energy &provide them safety & security.

2.7 CHALLENGES BEFORE INDIAN COMMERCIAL BANKS

Major challenges which Indian commercial banks are facing today

and which are likely to be more poignant in the ensuing years in

46
view of the irreversible process of the reforms and resultant
verisimilitude of more players entering the banking sector are
discussed below.

Problem of pressure on profitability: The greatest

challenge which PSBs are facing in recent years arises out of
pressure on their profitability. With continuous expansion in
number of branches and manpower, thrust on social and rural
banking, directed sector lending, maintenance of higher reserve
ratios, waiver of loans under ARDR-type concessions, repayment
defaults by large industrial corporate and other borrowers etc.
had their telling impact on the profitability of the banks. Further
with the introduction of prudential norms, to be effective from
March 1993 a majority of the commercial banks balance sheets
had shown huge losses. In order to improve financial health of
these banks the Government provided a dose of hybrid capital
and in return these banks were made to sign a memorandum of
understanding with RBI. Accordingly, the focus of operation of
banks shifted from deposit mobilization to services marketing.
Further, accent of banks operation shifted to non-fund based
business with an eye on capital adequacy achievement and other
ancillary business which may cross subsidize the cost of certain
unremunerated services, the banks have to offer.

Problem of low productivity: Another furious challenge

which Indian commercial banks are confronting is low productivity.
The low productivity has been due to huge surplus manpower,

47
absence of good work culture, and absence of employees
commitment to the organization. . The management has
continued to prefer not to see the problem in its proper
perspective due to the fear of strong unions. They have
camouflaged the issue by diverting their attention to such
apparent face saving devices like redeployment, repositioning,
retraining, etc... There are various ways of minimizing the size of
the staff, such as voluntary retirement scheme or golden shake
hand. The problem before the management at present is how to
cut size of the staff and improve productivity of the bank.

Problem of Non-Performing Assets (NPA): A serious threat

to the survival and success of Indian banking system is
uncomfortably high level of non-performing assets. In its Report
on trend and Progress of banking In India, 1997-98, the RBI
reported that gross NPAs as percentage of advances of PSBs was
16 percent as on March 31, 2000 with a colossal amount of about
Rs. 52,000 core being locked up. This might have recently
recorded further increase due to default in repayment by the
industrial units affected by the two-year old recession. This is
much higher than the international level of below 5%. Spiraling
non- performing assets are hurting banks profitability and even
the basic inability of the banking system by way of both non-
recognition of interest income and loan loss provisioning.

Problem from customers: In view of unleashing of

competitive forces and fast changing life styles and values of

48
customers who are now better informed and more sophisticated
and discerning and who have a wide choice to choose from
various banking and non-banking intermediaries have become
more demanding and their expectations in terms of products,
delivery and price are increasing, the PSBs lacking in customers
orientation are finding it difficult to even retain their highly valued
customers what to talk of attracting the new clients particularly
when the foreign banks are also the new breed of private sector
banks have embarked upon aggressive marketing programme
aiming at niche markets. The telebanking, anywhere banking,
virtual or internet banking, ATM, credit cards and newly
introduced interest rate swap, forward rate agreements, etc. are
some of the products innovated by the new players. Although the
PSBs are trying to computerize their operations, the pace of
progress in this direction has been decidedly slow. The rather
tardy progress in the area has been due to the initial reservation
of the staff unions against computerization for the lurking fear of
employment cut, as also the existence of huge number of
branches in the rural areas, where suitable logistics are not
available. Market share of PSBs both in deposits and lending has
declined. This has already become a serious cause of concern for
PSBs regulating strategic efforts for thwarting the challenges from
the new players.

Competition from New Banks: The commercial banks in

India which enjoyed monopoly position until recently are facing
perilous challenges particularly on quality, cost and flexibility

49
fronts from the newly emerging players who by dint of their
invigorating ambience and work culture supported by pragmatic
leadership committed, courteous, affable and trained staff and
modern ultra-gadgets are offering excellent customers services
and making inroads in the business centers. The new banks have
set the tone and to extent also the standard for technological
improvements and product innovations which the vastly
dominating PSBs will have to bring about in their own operations
if they have to maintain their present position of dominance. For
instance, Bank of Punjab has opened a new savings bank product-
swag at with a minimum balance requirement. HDFC has
launched q new retail account-Freedom-for customers who would
be using the non-branch infrastructure of the bank like ATM,
phone banking and internet banking. The ICICI Bank has product
offerings tailor-made to specific categories of customers, such as
students, traders, NRIs as well as the salary customers. It is going
to offer a special scheme for senior citizens. By resorting to latest
methods in human resources management as well as information
technology, the new entrants in the field have suddenly sensitized
even the ordinary user of the banking services in India to the type
and quality of services he can expect from his bank. The market
has become highly competitive and largely customers centric.
This calls for an ability to reach the client at his door step and
meet his requirements of products and services in a customized
manner. The race for customers could at times lead to adverse
selections. This situation demands aggression laced with caution,

50
in turn, calls for highly efficient management by the banks of both
liabilities and assets. These banks have to work in a market which
will not know any geographical barriers and therefore will have to
develop abilities of product innovation and delivery comparable to
the best in the world.

Competition from global majors Globalization and

integration of Indian financial market with world and the
consequent entry of foreign players in domestic market has
infused, in its wake, brutal competitive pressure on the Indian
commercial banks. Foreign players endowed with robust capital
adequacy, high quality assets, world-wide connectivity, benefits
of economies of scale and stupendous risk management skills are
posing serious threats to the existing business of the Indian
banks. In order to compete successfully with the new entrants,
Indian banks need to possess matching financial muscle, as fair
competition is possible only along the equals. Average size of an
Indian bank is niggardly low in comparison to a foreign bank. The
question before the major Indian Commercial Banks, therefore, is
how to acquire competitive size.

Problem of Managing Duality of Ownership: Managing

duality of ownership is a peculiar problem which the PSBs have to
encounter because of participation of the private shareholders in
their capital. A public sector bank to survive and grow
successfully is expected to operate according to the expectations
if one of its principal shareholders. In the changed scenario, there

51
would be two major groups of shareholders, viz., the government
of India and RBI on the one hand and the private shareholder, on
the other. Since the expectations of these two categories of
owners are not necessarily identical, the bankers will have to
manage conflicting interests.

2.8 OPPORTUNITIES FOR INDIAN COMMERCIAL BANKS

Challenges are the driving forces that keep on going. They

prevent us from being vagary because they also bring in their
wake opportunities. In fact, challenges & opportunities are like
healthy twins, knocking at our door steps. The process of
globalization and liberalization have thrown open tremendous
opportunities for the banks in terms of widening of scope of
business, greater freedom to operate in financial markets both
national and international freedom to delay relatively largest
funds because of reduction in preemption requirements. The
Commercial banks are now enjoying greater autonomy in
reviewing & revising existing branch network & greater discretion
to reduce amplitude of cross subsidization to priority sector.
Indian Commercial banks have also got the autonomy in respect
of pricing of bank products. In the regulated regime, interests
rates on both deposits and advances of Commercial banks were
tightly regulated and so was the product range. With gradual
deregulation of interest rates, banks are blessed with more power
in pricing and structuring their products. As we know, Commercial
banks are in the business of providing banking services to

52
individuals, small businesses and large organizations. While the
banking sector has been consolidating, it is worth noting that far
more people are employed in the commercial banking sector than
any other part of the financial services industry. Jobs in banking
can be exciting and offer excellent opportunities to learn about
business interact with people and build up a clientele. If you are
well-prepared and enthusiastic about entering the field, you are
likely to find a wide variety of opportunities open to you.

2.9 STRENGTHS OF INDIAN COMMERCIAL BANKS:

Indian commercial banks possess the following strengths which

are distinct from others:

i. Tremendous branch network giving an access to

almost entire spectrum of customers
ii. High market coverage
iii. Diversified operations
iv. Intimate knowledge of local environment
v. High class human resource pool

2.10 WEAKNESS OF INDIAN COMMERCIAL BANKS:

Indian commercial banks have been ailing from the following

weakness because of which they are finding it too difficult to out
beat the new players and exploit the emerging opportunities:

i. Lower Profitability
ii. High Operating Costs
iii. High NPAs
iv. Low Productivity
v. High Provisioning

53
vi. Complex and Non- responsive organizational structure
vii. Poor asset management
viii. Inadequate HRD strategy
ix. Low work culture
x. Action flippant and inward looking management and
employees
xi. Strong, militant and non-responsive unions
xii. Limited automation.

2.11 BASIC PROBLEM OF A COMMERCIAL BANK

The basic problem facing a bank manager is to have a

satisfactory tradeoff between liquidity and profitability - the two
principal but conflicting goals of a bank. A bank deals in the
money of the people. The success of the business of a bank
depends partly on the efficiency with which it can provide
services to its creditors (depositories), but mainly on the
confidence it inspires among the depositors. It has been able to
attract the deposits of the people not only by promising some
returns on their money but also by committing itself to
repayment on demand. This is why the public accepts bank
deposits as being as good as cash. The banker must,
therefore, ensure an adequate amount of liquidity in his assets
so that he may be able to meet any claims upon it in cash on
demand. The perfectly liquid asset is cash itself because it can
fully satisfy the depositors claims. The more cash a banker
holds, the more obviously he can, without difficulty of any kind,
offer cash in exchange for deposits. Further, the banker with an
adequate amount of cash in hand can meet the credit needs of

54
 the community and can make speculative gains. However, cash
is a sterile asset which earns no income at all.

CHAPTER3:

THE CHALLENGES AND PROBLEMS FOR THE

COMMERCIAL BANK

3.1. INTRODUCTION.

Few reports have been written about the role of commercial banks
in microfinance. The reason is simple: there has been little to tell
because commercial banks have been so notably absent from this
field. In their absence, microenterprise lending has developed on
an alternative track through a large number of nongovernmental
organizations (NGOs) and other specialized financial institutions.
Dedicated to improving the lot of the poor in developing
countries, these micro lending NGOs began serving
microenterprises in the 1980s, responding to the critical income
and employment opportunities of their urban and rural clientele.
Today some leading NGOs have created financial methodologies
that serve increasing numbers of the poor and generate
repayment rates that compare favorably with the loan
performance of many traditional commercial banks. By using
these methodologies, NGOs have achieved increasing levels of

55
sustainability, even to the point of outright profits without
subsidies.

Surprisingly many commercial banks in developing

countries are beginning to examine the microfinance market. Stiff
banking competition in many countries has forced some to
diversify into new markets. Some seek a new public image.
Others have heard about the profits of successful microenterprise
banks in Indonesia and financial NGOs-turned-banks in other
countries. During the last five years, their exploration of this new
market has been facilitated by donor-funded loan guarantees,
central-bank rediscount lines, and specialized technical
assistance. Although the initial resources for loan frequently came
from donor-funded credit programs, commercial banks in time
began to draw on their own deposit sources for a growing share of
their total funds for microloans.

While traditional commercial banks and finance companies

are beginning to look at ways to service the large number of
potential clients for small loans, many microenterprise lending
NGOs with heavy caseloads have begun to scale-up operations by
transforming themselves into regulated banks or specialized
financial institutions offering micro deposit facilities as well as
microloans. The new NGOs-turned-banks and the traditional banks
are beginning to converge on a single potentially profitable
market but from two sharply contrasting financial worlds.

56
 NGO and bank operations, however, hardly begin to cover the
demand for microfinance services .NGO programs are generally
minuscule in each country, and the banking sector is still by and
large just entering this market niche, although in some countries
banks already are larger providers of loans to micro entrepreneurs
than NGOs (Almeyda, 1996).

The U.S. Agency for International Development (USAID) has

been concerned with the question of how to expand services to
microenterprises on a sustainable basis, and in November of 1996
it sponsored a conference with 17 regulated financial
intermediaries from 16 countries. Among the participants were
state-owned banks, private commercial banks, regulated finance
companies, and NGOs that had transformed themselves into
banks. The event was a first attempt to convene bankers involved
in microfinance to share their experiences, learn best practices
from one another, and discuss obstacles to further expansion.
This study draws principally from interviews held with these
bankers, documenting some fledgling and diverse experience.

3.2. WHY BANKERS HAVE NOT OFFERED MICROFINANCE

SERVICES.

Private, domestic commercial banking is a relatively recent

phenomenon in many developing countries, especially in Africa.
Although limited domestic banking existed in some Asian and
Latin American countries in the past century, the subsidiaries or
agents of foreign banks dominated in foreign trade activity. From

57
the 1950s through the 1970s, financial systems in many
developing countries were predominantly composed of state-
owned banks and of branches of foreign-owned commercial banks
that provided short-term commercial and trade credit. The state-
owned banks promoted economic development priorities through
a network of financial institutions such as agricultural banks,
development banks, and export banks, while borrowing heavily
from multilateral and foreign private banks to support these
efforts. The private local banks that did exist were typically small,
and often served a closed set of business groups.

Until the 1980s, the regulatory repression of formal financial

markets in most developing countries interest rate ceilings, high
reserve requirements, and directed credit lines largely
precluded established banks from servicing a higher-cost and
riskier microenterprise clientele. With the advent of structural
adjustment and financial liberalization in the 1980s, private
domestic commercial banking expanded rapidly. Many new
private banks were founded by large business groups to access
funds for their own businesses and corporations. As such, they
naturally favored the large accounts of an established clientele.
When granting loans to less familiar clients, banks protected
themselves with asset (mostly real estate) collateral two to three
times the value of the loans. Although the new regulatory
environment was more favorable, these new commercial bankers
were unlikely providers of loans to small businesses, small
farmers, and micro entrepreneurs.

58
Competition is growing, however, as new banks enter the market
under banking laws that allow more freedom of entry and a less
repressed regulatory environment. For example, Honduras has 18
commercial banks for an economically active population of 1.7
million people; most of these institutions were licensed in the last
decade and are still small. The struggle to survive is forcing many
of these banks to look at new markets, including the microfinance
market, and the deregulation of financial markets is creating an
environment in which these opportunities can now be explored for
the first time.

Most bankers have not regarded microfinance as a genuine

option, however, because they have believed it unprofitable.
When asked why they do not pursue microfinance, traditional
commercial bankers have typically expressed three basic
concerns:

1. Too Risky: Bankers perceive small businesses and

microenterprises as bad credit risks. Many insolvent state-
owned agricultural banks seemed to prove that small farmer
clients could not or would not repay their loans. The
perception is that small clients do not have stable, viable
businesses for which to borrow and from which to generate
repayment. Moreover, these potential clients lack traditional
collateral to guarantee their loans. Finally, banks no doubt
also recognize they do not have appropriate lending
methodologies to serve these clienteles

59
 2. Too Expensive: Bankers also believe that because
microloans are small and have short terms, bank operations
will be inefficient and costly. It takes the same amount of
time and effort to make a US$1,000 loan as a US$100,000
loan, but the return on the larger loan is much greater. So
why make a small loan?

3. Socio-economic and Cultural Barriers: According to

bankers, micro and small enterprise clients have difficulty
approaching a bank because they lack education and do not
possess business records to demonstrate cash flow. In many
developing countries, social, cultural, and language barriers
do not allow for an easy relationship with a modern banking
institution. It is hoped, however, that with a more
widespread diffusion of innovations in financial
methodologies, reducing the risks and costs of micro
lending, more banks will begin to incorporate micro
entrepreneurs into their portfolios.

3.3. COMPARATIVE ADVANTAGES OF COMMERCIAL

BANKS IN MICROFINANCE

At first glance, banks appear well positioned to offer financial

services to ever-increasing numbers of microfinance clients and to
earn a profit. Banks have several advantages over nonbank, micro
lending NGOs:

60
 They are regulated institutions fulfilling the conditions of
ownership, financial disclosure, and capital adequacy that help
ensure prudent management.

Many have physical infrastructure, including a large network

of branches, from which to expand and reach out to a substantial
number of microfinance clients.

They have well-established internal controls and

administrative and accounting systems to keep track of a large
number of transactions.

Their ownership structures of private capital tend to encourage

sound governance structures, cost-effectiveness, and profitability,
all of which lead to sustainability.

Because they have their own sources of funds (deposits and

equity capital), they do not have to depend on scarce and volatile
donor resources (as do NGOs).

They offer loans, deposits, and other financial products that are,
in principle, attractive to a microfinance clientele.

All of these advantages could give banks a special edge over

micro lending NGOs in providing microfinance services.

61
3.4. OBSTACLES FOR COMMERCIAL BANKS IN
MICROFINANCE

Banks lack, however, some key ingredients - most of all, the

financial methodologies to reach a low-income population. They
also face thorny internal constraints that must be overcome
before they can produce a large, successful microfinance
program. Our study of banks in microfinance identified at least six
key related issues banks need to resolve to enter the
microfinance market successfully:

Commitment: the commitment of commercial banks

(particularly the larger banks) to microenterprise lending is
often fragile, and generally dependent on one or two
visionary board members rather than based solidly in its
institutional mission.
Organizational structure: Microfinance programs need to
be inserted into the larger bank structure in such a way that
they have relative independence and, at the same time,
have the scale to handle thousands of small transactions
efficiently.
Financial methodology: Banks need to acquire an
appropriate financial methodology to service the
microenterprise sector financial innovations that permit a
cost-effective analysis of creditworthiness, the monitoring of
a large number of relatively poor clients, and the adoption of
effective collateral substitutes.

62
 Human resources: Given that microfinance programs differ
so radically from traditional banking, banks must recruit and
retain specialized staff to manage these programs. Issues of
recruitment, training, and performance-related incentives
require special consideration.
Cost-effectiveness: Microfinance programs are costly
because of the small size of their loans and because banks
cannot operate them with their traditional mechanisms and
overhead structures. Strategies must be found to minimize
processing costs, increase staff productivity, and rapidly
expand the scale of their microenterprise portfolios that
is, increase the number of loans. Banks must cover the costs
of microfinance operations and specialized training through
scale economies.
Regulation and supervision: Banks must communicate
with banking authorities to ensure that reporting and
regulatory requirements take into account the specialized
nature of microfinance programs.

3.5. ISSUES FOR COMMERCIAL BANKS IN MICROFINANCE.

1. TYPES OF BANKS IN MICROFINANCE:

The banks reviewed in this study differ from one another in many
respects. Each operates in a different cultural and economic
context, and each has a somewhat different institutional structure
and mandate. In general, there are four main types of
intermediaries:

63
1. Full-service private commercial banks. Most have a
national presence and offer a host of financial products and
services through an extensive branch network.

2. State-owned banks. These large banks provide multiple

services according to government priorities. They often act as a
channel for government transfers, payments, or receivables and
usually serve a large number of depositors.

3. Finance companies and specialized banks. These smaller

financial institutions focus on a particular sector, such as housing
or consumer lending, and generally have a regional rather than a
national presence.

4. Micro lending: NGOs transformed into regulated banks or

specialized financial institutions. These small institutions have
limited regional presence and highly specialized programs.

Because of their different origins and ownership structures,

each of these types of institutions approaches microfinance
slightly differently, and each faces somewhat different obstacles.
For our analysis, we found it useful to merge the first two bank
types into one group and the second two specialty institutions
into another group. Both the size and degree of specialization of
the bank heavily influence its approach to the microfinance
market and its ability to resolve the key

ROSTER OF BANKS INTERVIEWED WITH CHARACTERISTIC

OWNERSHIP

64
STRUCTURE AND MICROLENDING INDICATORS IN 1996

LARGE MULTI SERVICE BANKS

Banco Agrcola El Salvador Private bank with 3.3% of portfolio
Commercial many in ML
shareholders
Banco del Chile Private bank with 100%of portfolio
Desarrollo many in ML
shareholders
Banco del Pacfico Ecuador Private bank with 2% of portfolio in
many ML
shareholders
Bank of Nova Guyana Private 9% of portfolio in
Scotia international bank ML, 100% for
with microfinance
subsidiary
Banco Wiese Peru Private bank with 10% of portfolio in
few ML
shareholders
Bank Rakyat Indonesia State-owned bank 100% of portfolio
Indonesia with a Unit for in ML Desa
Unit Desa programe
program
Multi-credit Bank Panama Private bank with 10 % of portfolio
few shareholders in ML
National Bank for Egypt Private bank with 3.7% of portfolio
development many in ML

Standard Bank South Africa Private bank with Negligible ML

many portfolio, large
shareholders savings program

65
Workers Bank Jamaica Private bank with New credit
many program,
shareholders large micro
savings

Small and Specialized Banks

BancoSol Bolivia NGO 100% of portfolio

transformation in ML
Bank Dagang Bali Indonesia Family-owned 83% of portfolio
bank in ML
Banco Guatemala Private bank with 11% of portfolio
Empresarial few shareholders in ML

Caja de Ahorro y Bolivia NGO 100% of portfolio

Crdito transformation in ML
Los Andes

Centenary Bank Uganda Private bank with 83% of portfolio

few shareholders in ML

Family Finance Kenya Housing finance 85% of portfolio

Building company with few in ML
Society shareholders

Financier Familiar Paraguay Consumer lending 20% of portfolio

company with few in ML
shareholders
Panabo Rural Philippines Rural bank with 27% of portfolio
Bank few shareholder in ML
shareholders

66
The 10 large multi-service banks indeed, in most cases they
rank among the largest banks in their respective countries
record assets and deposits many times greater than those of the
small, specialized banks. Not surprisingly, their capital or equity
base consists of many shareholders and, with the exception of the
state-owned Bank Rakyat Indonesia (Unit Desa program); micro
lending constitutes a relatively small share of the banks total
portfolio.

In this institutional setting, microfinance will not rank high among

the operational divisions within the bank, and the future of these
programs will strongly depend on the support of a few important
shareholders or bank officers. Furthermore, even programs that
break even and generate earnings are not necessarily secure.
They still have to compete with other divisions with even higher
earnings for use of the banks scarce deposit funds. In contrast to
free-standing micro lending NGOs, microenterprise programs in
commercial banks must meet a demanding opportunity cost
criterion to continue growing with bank resources. At the same
time, some banks, to protect their image, may find it difficult to
charge a sufficiently high interest rate on microloans to cover
their costs.

The eight small specialized banks, in contrast, have

incorporated microenterprise lending as an important mission for
the institution. These banks consist of former micro lending NGOs
that are becoming banks or bank-equivalent institutions;

67
consumer lending or housing finance companies; or private banks
with a few shareholders, all of whom are generally committed to
micro lending. Micro and small loan activity constitutes a far more
important share of their total portfolios as these institutions
penetrate the niche markets of microenterprise lending.

1.6 THE POLICY ENVIRONMENT AND SIX KEY

OBSTACLESBANKS FACE IN MICROFINANCE.

This preliminary review of banks in microfinance first documents

how the financial market policy environment has improved
substantially in practically all the countries where the banks in
this study operate. This positive development was necessary but
not a sufficient condition for microfinance institutions to emerge
in the formal banking world. Banks still face six related obstacles
as they seek to operate successful microfinance programs. The
discussion of these issues is still preliminary. The information on
each bank was gathered from a brief interview of one bank officer
attending the conference and from responses by banks to a
written questionnaire. Detailed field case studies were not
performed for the 17 banks attending the conference.

The Policy Environment

The policy arena is of strategic importance for commercial

banks. Non-bank micro lending NGOs can operate in a repressed
financial market environment because they are not subject to the
regulatory interest rate ceilings, high reserve requirements, and

68
selective that is, targeted credit policies characteristic of
these markets. Commercial banks, however, cannot escape these
regulations, which, in the end, reduce their profit margins. Rarely
have commercial banks considered microfinance initiatives while
operating under a regime of financial repression. In contrast,
markets experiencing substantial financial liberalization offer a far
more promising opportunity for experiments in microfinance.
Banks are able to charge the relatively high interest rates on
microloans required to cover lending and default costs and the
opportunity cost of funds.

REMAINING OBSTACLES.

Although important, a favorable policy environment is not

sufficient for a successful commercial bank involvement in
microfinance. At the level of the financial intermediary, six
conditions contribute to success in microfinance. These conditions
are discussed below.

1. Commitment and Bank Culture: Commitment at the

highest levels of the bank is necessary to make a
microfinance program work successfully. Without this
support, microfinance programs will not receive the human
and financial resources they require to consolidate and
expand. Especially for the large, multi-service banks, the
issue of commitment is a true constraint. Microfinance
programs are so different from conventional
corporatebanking that they are generally not understood by

69
 most mid-level bank managers, and sometimes they are
even considered a second-class activity. For corporate
bankers, career advancement is generally a functionof
success with large loan placements, which is rewarded with
increased delegation of authority to make even larger loan
decisions.

Nevertheless, most of the large banks are funding their

microenterprise programs out of their own deposit resources with
relatively minor reliance on donor or government funds. Most of
the large banks are risking millions of dollars of their own deposit
or equity base to fund these programs. The high opportunity cost
of using the banks own resources, however, still remains an
issue.

As already pointed out, small and specialized banks appear

to have a stronger institutional commitment to microfinance.
These banks generally have few shareholders and are able to
formulate narrower institutional missions. All of the small and
specialized banks have small ownership structures, and most
have larger percentages of their portfolio in microfinance. Thus,
their institutional culture is geared toward servicing a lower-
income clientele with specialized products.

2. Administrative Structure
For the large, multi-service banks, the administrative
structure of the microfinance unit is particularly difficult to

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 design. Among the large banks in our study, we found four
administrative approaches:

a. Independent Structures

Fully independent microenterprise retail centers, affiliated

to the bank but with their own lending policies, staff,
and information systems, which report to the larger bank
Lending through NGOs that, in turn, on-lend to
microenterprise clients.

b. Integrated Structure:

Semi-independent microenterprise units lending directly

and/or with specialized windows in each bank branch,
staffed with a microfinance credit officer. Administrative
and financial functions are integrated into the larger bank.
. Fully integrated operations, wherein the small-business
credit officers also handle microenterprise clients. All
administrative, personnel, and financial systems are
integrated.

c. Financial Products and Methodologies

Over the years, NGOs in microfinance have developed innovative

lending methodologies to reach poor clients with microloans. They
have borrowed many of their practices from informal finance.
Absence of these methodologies explains, in part, why formal
lending institutions suchas banks have traditionally had difficulty

71
reaching micro clients. Some of the principal characteristics
ofMicro lending are:

Short-term, working-capital loans;

Lending based on character, rather than collateral;

Sequential loans, starting small and increasing in size;

Group loan mechanisms as a collateral substitute;

Quick cash-flow analysis of businesses and households,

especially for individual loans;

Prompt loan disbursement and simple loan procedures;

Frequent repayment schedules to facilitate monitoring of

borrowers;

Interest rates considerably higher than those for larger bank

customers to cover all costs

Of the microfinance program;

Prompt loan collection procedures;

Simple lending facilities, close to clients;

Staff drawn from local communities with access to information

about potential clients;

Computerization with special software to allow loan tracking for

larger programs.

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 The large, multi-service banks have important comparative
advantages to reach out to large numbers of clients through
branch networks. It is not enough simply to reach further down
with the conventional banking methodology. Large banks that
have successfully made the jump to specialized microfinance tend
also to be those that have radically separated their micro lending
programs from the rest of the bank.

Many of the banks had not adopted other microfinance best-

practice methodologies. The terms of their loans were too long,
from 12 months to six years. Bank offices were somewhat
removed from the microenterprise clientele. Collection procedures
emphasized past-due letters as opposed to prompt visits from
credit officers. Collection responsibilities were assigned to the
banks loan collection department rather than to the microfinance
program. Loan procedures were centralized and did not
differentiate between first-time and repeat loans. Most banks
provided loans without requiring real estate collateral.

The small and specialized banks had adopted more elements

of the financialmethodology described above, and some had even
instituted interesting innovations.

The new microfinance bankers knew relatively little about deposit

mobilization methodologies that reach the low-income and/or
microenterprise client. There were some notable exceptions.
Perhaps best known is the Bank Rakyat Indonesia Unit Desa
savings program, which has the following characteristics:

73
Features attractive to the micro client:

Liquid passbook savings accounts and low minimum balances;

Depositories conveniently located;

Secure deposits; and

Real, positive interest rates on deposits.

Operational features of the program:

Savings accounts with very low minimum balances;

Lower levels of interest, compared with commercial banks,

because of higher administrative costs;

Simple, hospitable buildings and mobile units with low

overhead;

Simple administrative forms and procedures;

Courteous and friendly staff; and

Incentives for savings, such as lotteries.

d. Human Resources

Until recently, microfinance methodologies have been labor-

intensive, and all the bankers interviewed evinced special concern
for recruitment, training, and motivation of staff.

1. Recruitment.

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 Most banks hired microfinance staff from outside the bank
and preferred younguniversity graduates with little, if any,
banking experience. The lack of a banking background
apparentlymade them more receptive to the special mission
and practices of the microfinance program. This findings
consistent with those from other microfinance institutions.
There was somedisagreement over the minimum
qualifications for a credit officer. Some banks considered that
credit staffshould have university degrees, coupled with a
social service mind-set. Unfortunately, such qualifications
drive up operating expenses, because salaries are the single
largestexpense item in microfinance programs. The most
common feature among loan officers was that they were
typically recruited from the localareas where the banks
microfinance unit operated and microloans were made. This
feature theoreticallyallowed loan officers to conduct
theirloan screening and monitoring efforts efficiently
because they were familiar with the local clientele and their
activities
2. Staff Training.
Fourteen of the seventeen banks (both large and small)
reported in-house,
On-the-job training for new staff. This specialized training is
costly, but probably a necessity. All banks require their staff
to be familiar with microfinance methodologies and
operating systems and procedures, and they hold meetings
clearly articulating the institutional mission in microfinance.

75
 Of the sample bank studied, the Bank Rakyat Indonesia had
the most highly developed training program. To maintain a
staff
Of 14,000, the Unit Desa program has five regional training
centers at which approximately 6,000 employees are trained
each year. BancoSol and Caja Los Andes have also expanded
rapidly, ranking among the most successful originators and
adapters of new microfinance methodologies in the banking
world. The former stands out as one of the preeminent
programs in group loan methodology, the latter as one of the
leaders in individual loan methodology. Both institutions had
strong staff training programs as
A catalyst to incorporate these methodologies successfully,
drawing heavily on specialized foreign assistance NGOs/firms
ACCION International for BancoSol, and IPC/Frankfurt for
Caja Los Andes.

3. Staff Remuneration and Incentives.

Studies of successful microfinance NGOs reveal that credit
officers salaries tend to be lower than those found in
conventional commercial banking. This finding stems from
the fact that these programs, by nature, are highly labor
intensive and hence costly. For large banks with integrated
microfinance programs, however, salary levels can presence
some difficulties. In one case, salary scales were different
and a performance-based bonus remuneration scheme
existed for the microfinance staff. This disparity created
some tension with non-microfinance bank staff who earned

76
conventional, fixed salaries. Most others use the same salary
structure of the rest of the bank. In at least three cases, no
bonus system existed, perhaps because the salaries were
considered adequate already. Banks that have independent
microfinance units are able to have their own lower salary
scale and introduce bonus schemes without drawing much
attention from the rest of the bank staff.
More generally, institutions implementing best practices
have strong incentive systems in place to motivate
productivity. Programs must be productive to lower costs.
Among the bank sample, only 5 out of 17 banks did not have
some kind of bonus system. Four of those five banks were
large national banks with extensive branch networks. Those
that had incentive systems generally had either:

Bonuses for the individual or a team, based on productivity

and profitability; or
Distributions to all staff based on profitability of the overall
bank.

The small and specialized banks and the fully independent

subsidiaries of banks tend to offer bonuses oriented
specifically to enhance the individual or teams productivity.
Financiers Familiar in Paraguay, Centenary Bank in Uganda,
and Caja Los Andes in Bolivia reported staff incentive
systems based on a formula of three key variables quality of
portfolio, volume of lending, and number of active loans. The

77
Financiers Familiar reviewed staff performance monthly, and
paid bonuses to each individual officer.
Bonus remuneration schemes are justified for individual
microloan methodologies since loan officers are engaged in
demanding and time-consuming client evaluation practices.
Given the highly discretionary element of individual
judgment and commitment to hard work to carry out this
task satisfactorily, it is felt that a good part of the loan
officers remuneration should reflect how well he or she
carries out this task. Good judgment in client selection and
evaluation and diligent work to ensure effective monitoring
and loan recovery are essential for a well-performing
individual loan portfolio. Some of the larger, multi-service
banks had general distributions depending on whether the
bank had a good year.
In summary, the most important question is not how to
reduce costs by limiting the level of salaries. Rather, it is how
to stimulate productivity through the optimal mix between
the fixed salary and bonus portion of the remuneration. The
purpose here is to solve important principal-agent problem
that is, create incentives for loan officers to carry out their
highly discretionary credit evaluations of clients responsibly.
The measurement and monitoring of staff productivity are
not trivial in microfinance, and many of the most important
efforts of client evaluation cannot be easily observed by
supervisors. Hence, performance-based bonus incentives
become an important part of loan officer remuneration,

78
 particularly for programs emphasizing individual loan
methodologies.

e. Cost-Effectiveness

Yet another issue of concern at the microfinance conference was

cost reduction. Although most bankers claimed that their
programs were profitable, they werenevertheless under the
impression that costs were still too high.

There are several strategies to reduce costs. First, many banks

could more fully implement themicrofinance methodologies
mentioned above. A caveat is in order, however, because the
salary savings gained through hiring less-educated staff could be
more than offsetby lower productivity. Other banks could
experiment with alternatives to lengthy individual
businessanalysis techniques.

f. Regulation and Supervision

All of the participants at the conference were regulated by

banking authorities in their respective countries. While none of
the bankers questioned regulation, most felt there were important
issues that required further attention. Three worries
predominated: high legal reserve requirements, burdensome
reporting requirements and inappropriate criteria for loan portfolio
classification and provisioning.

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 Legal reserve requirements. In many developing
countries, legal reserves on deposits are extremely high,
discouraging deposit mobilization. Banks are less likely to
utilize their own, scarcer funds for microenterprise programs
in this environment. As, reserve requirements have been
lowered in most countries from those the banks experienced
in the late 1980s.

Reporting requirements. Bank regulatory and

supervisory authorities generally require frequent and
detailed reports from commercial banks. These reporting
requirements were originally designed for institutions with
fewer, larger transactions. Because microfinance programs
tend to have thousands of loans, reporting data on each loan
is costly and impractical.

Loan classification and provisioning. In most countries,

authorities require that banks establish reserves based on
the quality of their loan portfolio. A number of bankers spoke
of the difficulties encountered with bank examiners as they
sought to classify hundreds of tiny, short-term, and
unsecured loans. Invariably the tendency of the examiner is
to push for greater provisioning of the unsecured microloans,
despite the fact that delinquency levels are similar to or
better than the rest of the bank's portfolio.
A recent study has identified some additional issues that
present problems for regulated institutions engaging in
microfinance in different countries. Primarily affecting

80
smaller, specialized banks, which have larger concentrations
of microloans in their overall portfolios, these issues include:

On-site examination and loan documentation. Bank

examiners usually review 30 percent of a bank's loan
portfolio to ensure asset quality, accuracy of reports, and
adequacy of loan approval procedures. This of course makes
sense for banks with large loans, but is impractical for
microfinance portfolios. Moreover, guidelines on what
documentation should exist for each loan, which examiners
frequently spot check (such as credit history records,
mortgage documents, financial statements, business plans),
are also inappropriate for microloans. This is a perfect
example of the mismatch between regulators' conception of
prudential practices and the best practices developed to
reach a microfinance clientele.

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 CHAPTER4:

NATURE OF COMMERCIAL BANK WITH RESPECT OF

MICRO FINANCE

4.1. INTRODUCTION:

Poverty is one of the few challenges that every single country in

the world has to deal with and the numbers say it all. According to
the World Bank, 2.7 billion people lived on less than$2 a day in
2001. Despite the difficulties involved in changing this situation,
there are solutions and microfinance is one of them. Starting with
the Grameen Bank founded by Mohammad Yunus in the 1970s,
microfinance represented a method of lending that was tube
tailored specifically to the worlds poorest populations.
Throughout the years, microfinance has proved to be a viable
solution for the alleviation of poverty. In fact, nowadays, the
industry is facing a new phase in its history:

Commercialization Microfinance was initially a form of voluntary

help to the most deprived populations. However today, it also
represents a market solution to the mitigation of poverty. The
success rates and achievements of microfinance fueled the
interest of various institutions, NGOs,banking groups and
governments throughout the years and continue to do so.
However, in order to accommodate this interest, microfinance
needs to become a structured, transparent and regulated industry
where everyone can find a role for themselves. Individuals who

82
have been working in microfinance for a long time express their
discontent about the commercialization aspect, of the notion of
profit entering the field. Nevertheless, the increase in the
participation to microfinance, whether it is on behalf of a non-
profit organization or bank, is the only factor that can make a
significant change in the alleviation of poverty.

At the present stage, individuals involved in microfinance agree

that the demands of the clients of MFIs correspond to services
offered by the formal financial sector. In the words of Malcolm
Harper and Suk winder Singh Arora, this would mean that
Microfinance institutions are redundant. What the poor have
always needed is the extension of the formal financial sector for
their use, what is now being called the commercialization of
microfinance. According to Jean-Philippe de Schrevel, founder and
Chief Operating Officer of BlueOrchard Finance,
Commercialization is not a goal in itself but a means of ensuring
that financial intermediation products or services delivery are
efficient. Indeed, Schrevelsuggests that microfinance can be a
profitable business with interest rates at market level and
repayment rate of 97% (larger than most commercial banks).
Consequently, I shall argue that commercial banks are the most
qualified to provide an extension of financial services to these
new clients. The need for commercial bank

4.3. FINANCING MODEL ADOPTED BY BANK IN

MICROFINANCE INDUSTRY

83
 Direct lending:Firstly, banks can directly lend to micro
entrepreneurs. Usually, a participation of this sort is
observed in banks founded with the aim of solely serving the
microfinance sector. The pioneer in this field is the Grameen
Bank founded by Muhammad Yunus in 1976, with the sole
goal of helping the impoverished through the provision of
small loans to a group of borrowers. Group lending consists
of the attribution of a loan to each person in the group, but
the loans are not renewed to anyone in the group if ever one
borrower defaults on the loan. Consequently, through social
pressure, the group lending method gives individuals
incentives to be financially disciplined and to repay their
loans. Another example is the Pro-Credit group which
provides loans to small and medium-sized enterprises
through its 19 development oriented banks in Africa, Europe
and Latin-American.
A microfinance subsidiary Secondly, banks may choose to
separate their microfinance operations through the creation
of a new subsidiary. Primarily, such subdivisions can help
banks mitigate the levels of risks associated with lending to
the poor. Nevertheless, it can also be seen as a necessary
step for banks providing both consumer finance and
microfinance, as each sector requires a different approach to
business and a distinct training of the employees.
Furthermore, from the perspective of the borrower,
separating the microfinance services from the consumer

84
 finances might generate more trust and acknowledgement of
the banks commitment to the goal of reducing poverty. In
this respect, Sogesol is the microfinance subsidiary of the
commercial bank Soge bank, the largest commercial bank in
Haiti. The many years of experience of Sogebank, bring
some important advantages to Sogesol. The loans that
originate from the microfinance subsidiary can be repaid
through the branches of Soge bank. Furthermore, the parent
company also provides other types of support to Sogesol
such as human resources, legal affairs, auditing and
marketing.
Partnership with a microfinance institution: Thirdly,
banks can build partnerships with microfinance institutions.
Banks can lend to microfinance institutions in the form of
wholesale banking, and in turn, MFIs can employ the capital
to lend to the poor. In the partnership, the bank usually
provides the loan funds, the technology and evaluates the
pricing and the levels of risk involved with the loans. On the
other hand, the MFIs undertake the origination, monitoring
and collection of the loanOne such example is the case of
ICICI Bank in India which currently has partnerships with 72
MFIs throughout the country and aims to increase the
number of its alliances to 200 by 2010. This kind of
partnership can be the most beneficial and efficient for both
the bank and the MFI.
A microfinance fund securitization: Fourthly, commercial
banks can raise funds in domestic or international capital

85
 markets for the lending operations of microfinance
institutions. These funds can be raised in the form of bonds
in domestic markets

4.4. ORGANIZATIONAL STRUCTURE AND REGULATION:

Governance Structure and Commitment.

All the private commercial banks with the exception of the

Bank Rakyat Indonesia, which is a state-owned institution Larger
banks, such as the National Bank for Development in Egypt,
Standard Bank in South Africa, Banco del Desarrollo in Chile,
Banco Agrcola Commercial in El Salvador, and the Workers Bank
in Jamaica, are characterized by a large number of shareholders.
In contrast, smaller banks, such as the Family Finance Building
Society in Kenya, Bank Dagang Bali in Indonesia, Panabo Rural
Bank in the Philippines, BancoSol and Caja Los Andes in Bolivia,
Multicredit Bank in Panama, and Financiers Familiar in Paraguay,
are characterized by a small number of shareholders. The trend
exhibited by the banks under study reflects a small degree of
commitment to microfinance activities within the banks with
many shareholders, mainly the large multi-service banks. Banks
with few shareholders that is, the small and specialized banks
exhibit a modest to strong degree of commitment to their
microfinance activities.

It should be noted that the number of years the banks have

been active in the microfinance area does not seem to have a

86
direct bearing on the degree of commitment to this activity. The
experience of most private commercial banks in microfinance has
been limited, covering only a handful of years. Five out of the
seven largest programs in have a strong commitment to
microfinance lending. These are also programs with relatively
longer institutional histories, from 6 to 26 years. Four out of the
six youngest programs, which are also among the smaller-sized
programs, also document an extensive commitment. Hence,
neither age nor size of program is systematically associated with
strength of commitment. Finally, one should still recognize that
even a small share of micro lending and limited commitment can
still generate a large number of micro clients in absolute
numbers, as can be seen for the National Bank for Development
in Egypt.

It is not uncommon to find commercial banks and non-bank

institutions engaged in microfinance as a result of significant
donor support, both in terms of access to funds for on-lending at
below-market interest rates as well as free technical assistance,
particularly during the first few years of the inception of these
activities. Whether few or many shareholders are involved, many
organizations have started their microfinance programs based on
donor support either in separate units or as an integrated part of
the portfolio of the bank. The National Bank for Development in
Egypt and Workers Bank in Jamaica received support from USAID
to initiate their microfinance activities. Centenary Bank in Uganda
and Caja Los Andes in Bolivia received support from GTZ.

87
Financiers Familiar in Paraguay received support from the IDB,
and the Banco del Desarrollo in Chile benefited from subsidized
funds through interest rebates from the government. Such
support allows for an initial subsidy for these programs that
along with some of the banks sunk costs, such as use of existing
infrastructure, utilities, and the banks reputation gives an
advantage to microfinance activities within these organizations
until they break even.

Several questions emerge from this use of donor resources and

technical assistance to develop microfinance programs in banks:

(1) What is the most efficient instrument for the

subsidy (cheap funds, technical assistance, guarantees,
etc.)?
(2) What is the most appropriate level of the subsidy
and for how long should it be granted? In large part, the
answers depend on each banks need to launch its
respective programs.

Finally, several bankers, particularly those from downscaling

institutions attempting to incorporate microfinance services into
their lending activities, agree that microfinance has a different
culture than their traditional banking services. This condition has
pushed many bankers to create separate microfinance units and
not integrate them within their traditional banking organizations.
This tendency could have implications on the viability of such
units. A stand-alone operation is likely to be more costly initially

88
than one that could be successfully integrated as a part of the
banks ongoing branch lending. 6South Africa still maintains a
usury interest law that prohibits banks from charging interest
rates higher than 10 percentage points above the prime rate.
Nevertheless, the bankers at the conference who had
independent units at their banks claimed these were indeed
profitable.

Regulatory Environment:

The regulatory environment in the countries in which these

banks operate. With one exception, South Africa, all interest
rates had been deregulated, creating the opportunity to freely
charge the higher, more realistic interest rates required for
micro lending. Moreover, these rates have allowed substantial
intermediation margins for a number of these banks, as can be
seen by comparing average deposit rates with effective
microloan rates.

Maintaining a two-tiered interest rate structure was not

always a simple process for most banks. High effective loan rates
incorporated additional commissions, fees, and even insurance
policy premiums in some cases, reflecting the true cost of lending.
Micro and small loan interest rates were generally higher than the
commercial lending rates, as seen by comparing. This was
necessary to cover the higher cost of microfinance lending, as will
be discussed subsequently. This two-tiered interest rate structure,
however, was reported by a number of banks to be looked on

89
unfavorably by the clients and the community. The rate structure
and reaction to it created an ongoing tension and potential threat
from political and regulatory authorities in these countries.
Standard Bank in South Africa was always experiencing this threat
from the inception of its microcredit program.

Technical AssistanceTechnical assistance has played a

very significant role in setting up the microfinance units, in
educating and training staff members in these units, in
transferring the microfinance methodology to the banks, and
in monitoring the progress of their operations for a period of
time. Typically, donors cover the costs of the technical
assistance experts brought in to support the organization in
learning about microfinance. A number of organizations have
experimented with different lending methodologies such as
group versus individual loans until they decided that
individual loans were the most appropriate lending
methodology for their institutions. The transfer of
microfinance methodologies and products, therefore, is not
exactly duplicated from one setting to another. Technical
assistance, in some cases, works with local bank managers
to reach a viable bank-specific model for delivering
microfinance services.
Human ResourcesThe average case load or number of
clients per loan officer varied from 200 to 300, although the
range was from as few as 50 cases to as many as 1,000
cases. Programs with low caseloads had just recently

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 launched operations. The unusually high loads are
associated with longstanding programs operating in very
densely settled areas. These numbers could vary among
loan officers within the same bank, as performance-based
remuneration schemes were used by a number of banks
particularly for their microfinance activities. Although most
of the banks had staff incentive schemes, a few
organizations that had a small number of credit officers did
not feel it was necessary. Monthly remuneration ranged from
US$100 for the National Bank for Development in Egypt to as
high as US$1,300 for Financiers Familiar in Paraguay. Most
salary levels, reflecting diverse market conditions for bank-
trained staff, fell between US$250 and US$800 per month.
Whether individual or team-based, remuneration incentives
in some cases allowed loan officers to almost double their
base salaries, as can be seen in comparing column 2 to
column 1. In a few cases, bankers reported these incentives
were a source of tension for other bank employees, who did
not receive these bonus remunerations. Most banks stated
this was not yet a problem since the microfinance staff
salaries plus their maximum incentives did not yet exceed
the salaries of other bank employee

4.5. MICROFINANCE PRODUCT AND METHODOLOGY

1. Lending types: individual, group and village

Individual-based lending: draws on traditional banking
practices and involves a standard bilateral relationship
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 between the bank and customer. It is mostly predominant
in East Asia and the Pacific. This method appears as the
most vulnerable one to weak enforcement policies and
information asymmetries. Only for this type of lending the
authors observe a positive return on assets. Furthermore,
less than half of the customers are womenin general,
individual-based lending is practiced for larger loan and
therefore with less severe poverty levels. Furthermore, this
method has proven to help MFIs become financially self-
sufficient. It was found that labor costs are associated with
higher profitability with this method of lending as borrowers
would receive larger loans once they are identified as
reliable customers.
Group lending: Initially employed by the Grameen Bank,
and is comprised of the voluntary gathering of several
individuals who then assume a joint liability for the
repayment of the loans given to the group members. Group
lending is practiced for individuals under more sever poverty
situations as opposed to individual-based lending and
therefore costs are relatively higher than for individual-based
lending. Furthermore the majority of the customers for group
lending are formed by women.
Village banking: Is a form of group lending where each
branch forms a single, large group and is given a degree of
self-governance. They make the smallest loans in size they
charge the highest interest rates and face the highest
average costs according to the survey. Village banks are the

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 least profitable lending type as they serve the poorest and
their customers are largely women. Village banks are the
lending method to be comprised of the highest share of
subsidies in the capital Indeed, the authors observe that the
higher the share of subsidies for a MFI, the lower the
profitability.
2. Loan Sizes, Maturity, and Interest Rates

Microloans are distinctly different from traditional bank loans.

Commercial loans as well as consumer loans are typically secured
loans offered at interest rates that are lower than those
associated with microloans. some bank provide microloan of
maturity up to two years while Some banks offer a maximum
microloan term for as long as 3, 4, or even 5 years. Some
institutions offer microloans through a separate window or part of
the branch office that handles only these products, and not
through a common bank branch window. This practice allows both
staff and clients to recognize the differences between the terms
and conditions of microloans and commercial loans more clearly
and reduces the confusion that might arise otherwise. The
different microfinance culture, discussed earlier, also contributes
to this arrangement.

Some banks, although offering microloans distinct from

commercial loans, nevertheless offer all their financial services at
the same branches. Again, commercial loans at these
organizations are collateralized and offered at interest rates lower
than microloan rates. Microloans are generally provided with

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terms and conditions different from those associated with the
traditional loans provided by private commercial banks.

3. Repayment, Disbursement, and Collateral

Among the similarities between commercial bank and NGO

microloans is the frequent repayment schedule that banks seem
to have adopted for their microloans. Bi-weekly, weekly, and even
daily repayments are associated with microloans in a number of
institutions, in addition to the more traditional monthly
repayments. This shorter time period facilitates monitoring and is
usually calibrated to the cash flow in the business. At the other
end of the loan process is the significantly shorter time spent in
processing microloans, ranging from one to seven days. This short
disbursement time has been adopted by most organizations. The
quick loan disbursement procedure is similar to the quick
turnaround practiced by many micro lending NGOs. It is
noteworthy that many organizations assume part of the
transaction costs by going to their borrowers rather than
requesting that their borrowers come to the branches, particularly
during the loan-processing period. Interestingly, some microloans
are offered without tangible collateral. In general, uncollateralized
microloans are granted by organizations to their longtime-saver
clients. Collateral foreclosure in case of default usually encounters
lengthy and difficult legal procedures. Hence, many banks avoid
foreclosure of collateral on defaulted loans.

4. Deposit Services

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 The importance of deposit services for downscaling private
banks. This stands in contrast to the minor role of savings
accounts in the one former NGO, non-bank institution, Caja Los
Andes in Bolivia. However, it should be noted that Caja Los Andes
has only recently begun to mobilize savings under its new charter,
which allows it to capture deposits. The relatively large number of
savings accounts below US$500 indicates that deposit services
are also contributing substantially to the outreach performance of
these institutions. Indeed, there are many more micro client
depositors evident than there are micro-borrowers. The rapid
increase in savings accounts in BancoSol to almost 46,000
accounts is noteworthy.

This is a creditable performance when one keeps in mind that,

until 1992, BancoSol was a credit-only NGO with no deposit
services. Compulsory savings are enforced for clients with
microloans by only a few banks, namely the National Bank for
Development in Egypt, Family Finance Building Society, Scotia
Enterprise, and Banco del Desarrollo. These institutions require
their borrowers to deposit a part of their Bloats in a savings
account, ranging from 10 percent at the National Bank for
Development in Egypt to 30 percent for large loans at Scotia
Enterprise in Guyana. Savings, in other cases, are used partially in
the loan screening and monitoring process. Although Family
Finance Building Society in Kenya does require that all borrowers
be savers for at least six months, organizations such as the Bank
Dagang Bali and Panabo Rural Bank in the Philippines do not

95
require borrowers to save, but nevertheless independently
encourage savings. The Bank Dagang Bali, along with Banco
Empresarial, Multicredit Bank, Standard Bank, and Centenary
Bank, have individual savings incentives such as lotteries, or very
low minimum-balance requirements, or overall rewards for bank
managers for successful savings promotion. The Bank Dagang
Bali, Panabo Rural Bank, and Family Finance Building Society,
among others, reported that savings provide information about
prospective borrowers that makes loan screening and monitoring
procedures somewhat less difficult and more efficient.

5. Screening and Monitoring

Typical screening techniques of micro clienteles receiving

individual loan services involve credit officers making personal
reference checks about prospective borrowers with informed
individuals in the communities, with suppliers in the markets, and
with other informal as well as formal lenders. Inspecting the
business premises and the borrowers residence are also
important means of verifying information and marking permanent
locations for the borrowers. Cash-flow analysis of the business
and expenditure flow documentation of the household establishes
the parameters within which feasible loan repayments can be
scheduled. These business and household analyses of cash flow
are essential features of the lending methodology given that
collateral is less important in screening these clients. In most
cases, this screening process is done on an individual basis.

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Nevertheless, in the case of the Panabo Rural Bank in the
Philippines, microloans made to vendors in the market are
screened in a batch processing format where the loan officer
verifies information with market suppliers and other lenders for a
whole list of borrowers at the same time. Loan repayments are
also used as an indicator in screening for repeat borrowers. At
Centenary Bank, Caja Los Andes, and Financiers Familiar,
borrowers who have fully repaid two to three loans on time get
access to an automatic line of credit, thereby reducing lending
costs substantially for this repeat-borrower clientele. Borrower-
monitoring techniques are largely aided by daily, weekly,
biweekly, or monthlyrepayment schedules generated by
computerized loan-tracking systems. Most banksstated that
effective computer technology is essential to track and monitor
loan repayments once themicroloan program grows beyond a
rudimentary scale of activity. Loan officers conduct follow-ups
throughtelephone calls and personal visits in case of even one-
day delinquencies. These measures are taken veryseriously
because many microloans are granted with little to no collateral.

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 CONCLUTION

The experience of private commercial banks in microfinance is

still relatively limited. Nonetheless, a few patterns are emerging,
and a number of challenges continue to require attention.

The current outreach of commercial banks in microfinance is at

best modest in scope.

Most commercial banks largely use their own deposit base for
microloans. Donor funds and government rediscount lines still
represent cheaper sources of funds for a number of organizations,
but some conditions and limitations restrict use of these
resources. Although all organizations started by cross-subsidizing
microfinance units and activities for various periods of time, good
repayment rates and high effective interest rates that far exceed
the cost of funds allow most organizations to at least break even
in the use of their own funds for microlending.

Commitment to microfinance among commercial banks appears

to be more likely in small, specialized institutions with few
shareholders, or in large institutions that have created an
independent unit or subsidiary dedicated exclusively to
microfinance.

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 Microfinance within commercial banks is largely attributed to
the efforts of a single person or to a small group of people to
promote these activities. Some of these individuals have been
close to and aware of the NGO operations in microfinance

Prudential regulation, with two to three exceptions, does not

seem to discourage microfinanceactivities in most of these banks.
No additional requirements, other than what is typically reported
by commercial banks to the supervisory authorities, are requested
of commercial banks because of their microfinance activities. The
larger commercial banks are able to engage in sufficient self-
provisioning to manage these activities properly. Most banks have
the flexibility to price their products to break even and cover their
costs as well as to make profits.

Commercial banks offer microloans that are different from their

typical collateralized commercial and consumer loans. These
microloans, although they share similarities with NGO microloan
products, such as frequent repayments and quick and inexpensive
disbursements, are slightly larger in size and are granted for
longer maturities than are typical NGO loans. Moreover,
microloans provided by commercial banks are granted with
different terms and conditions than traditional bank loans.

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 RECOMENDATION

To conclude this discussion it is instructive to review the possible

role for the donor community in encouraging successful bank
initiatives in microfinance. The key obstacles facing commercial
banks in microfinance, outlined in Chapter three, can serve as a
useful framework within which to review donor opportunities.

Policy and Legal Environment

Donors should advocate microfinance in their dialogue with

government authorities. This advocacy has three components.

Donors should argue for the elimination of all repressive

financial regulations, such as interest rate ceilings and unusually
burdensome reserve requirements or detailed directed credit
schemes.

Donors should encourage policy reform creating a prudential

regulatory framework that recognizes the idiosyncratic features of
institutions engaged in providing microfinance services.

Donors should urge more rigorous contract enforcement

institutions in the countries in which microfinance initiatives are

100
operating. Whereas a number of microfinance institutions
emphasize group-loan products, many promote individual loans,
especially the commercial bank community, and a few attempt to
deal in both products.

Commitment and Bank CultureDonors are best advised to

have a tool box of various offerings, such as pilot loan funds,
funds forstart-up expenses, technical assistance, information
seminars on the microfinance market, and trips tosuccessful
programs a mix of which could be provided, depending on the
nature of the institutions

Financial Methodologies, Human Capital Formation, and

Productivity Enhancement

Methodology, human resources, and productivity can be logically

joined from the point of view of the donor community. Human
capital formation and the knowledge of innovative credit
methodologies that generate improved productivity in the supply
of microfinance services have properties of a public good. The
training and knowledge acquired by personnel in microfinance
institutions is disseminated widely as these trained employees
move to other institutions and programs. Hence, social benefits
are greater than private benefits as those institutions that did not
invest in the training and knowledge generation nevertheless
benefit from the spillover benefits from other institutions that did.
In light of these positive economic externalities, subsidies may be
legitimatecommitment and needs.

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Regulation and SupervisionLarge

Large private commercial banks with an established regulatory

track record and a long history of operating from an ample
deposit base are subject to much less risk than smaller, more
specialized financial institutions, especially former microlending
NGOs just launching their first deposit mobilization efforts. Larger
banks typically make their own provisions for their
microenterprise units.

BIBLIOGRAPHY

www.adb.org

www.bis.org

www.chemonics.com

www.grameenfoundation.org

www.microfinancegateway.org

www.mixmbb.org

www.mixmarket.org

www.microlinks.org/

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