At a time when the Indian banking industry is experiencing a steep rise in bad loans, Bandhan – an MFI with a near 100% loan recovery rate – has converted into a bank. Based on a survey of 112 Bandhan clients in West Bengal, this column highlights the features of Bandhan’s lending model that have enabled it to keep its bad loans at negligible levels.
Bandhan Financial services Pvt. Ltd started full-fledged commercial banking operations on 23 August 2015. Bandhan has been working as a Microfinance Institute (MFI) for the past 15 years and is the first MFI to be converted into a bank in India. The emergence of Bandhan as a bank is happening at a time when the Indian banking industry is experiencing a steep rise in Non-performing assets (NPAs).
Overall NPAs or bad loans of the banks, including private sector lenders, increased from 2.43% in 2012 to 4.04% at present. Gross NPA of the public sector banks (PSBs) alone is even worse, rising from 2.77% in 2012 to 5.08% in 2015. The rising NPAs have set the alarm bells ringing all across.
At this juncture, when banks are thinking of various strategies to reduce bad loans, Bandhan, which has been successful in keeping its recovery at an unmatched rate of more than 99.5%, makes a foray into the banking industry. In 2014-15, Bandhan’s bad assets were only 0.1% of the loan book. As an MFI, Bandhan provides loan to the poorest of the poor without any collateral. Their loan size varies from Rs. 1,000 – Rs. 50,000 per individual and presently serves 6,717,331 borrowers. Bandhan has already disbursed loans amounting to approximately Rs. 11,000 crores. It is necessary to mention that Bandhan has been running its operations without any subsidies whatsoever. Consequently, its cost of funds is quite high, which along with the expenditure incurred on meticulous monitoring compel Bandhan to charge an interest rate of 22.5% per year. According to Bandhan’s Chief Executive Officer this leaves a very thin margin of profits for the company, which is somewhat compensated by the huge scale of operations. The high rate of interest, however, does not seem to discourage borrowers probably because the quick and hassle-free disbursement of loans actually make the effective cost of borrowing from Bandhan lower relative to PSBs.
Despite the huge number of borrowers some of whom are very poor, Bandhan has done exceptionally well in keeping their NPAs to a negligible amount. This sounds like a puzzle. It is certainly worth researching as to how Bandhan has been so successful, as opposed to other commercial banks, in keeping their NPA levels to a meager amount. In this column, we try to unravel this puzzle and also analyse some of the challenges that Bandhan might face in transforming from an MFI to a bank.
Bandhan’s lending model
Trying to address the puzzle of how Bandhan was successful in curbing the size of their bad loans, we first need to discuss the process through which they screen loan applications, their repayment methods, and supervision after credit disbursal. Bandhan provides loans to only female borrowers. A borrower who applies for a loan from Bandhan has to submit a detailed micro plan of the project along with the cash flow. A loan is sanctioned only when the authorities feel that the project is viable. Fifteen days after a loan is sanctioned, Bandhan officials visit the project to monitor whether the loan is being utilised properly. Bandhan’s loan model is one of individual liability through group formation: an individual borrower has to be in a group to obtain a loan but only she is individually liable for the loan. Individuals make repayments weekly at public meetings, which are held at one of the group member’s residence. A loan officer from Bandhan leads these meetings. Members are persuaded, if not required, to attend these meetings and most of them comply unless there is some medical or other perceptible emergency. When a member takes a loan from Bandhan, the weekly repayments start immediately after a week.
Let us now focus on how the above lending model can contribute to the high repayment rates of Bandhan. First, it is evident that the lending model involves a lot of external monitoring both at the stage of approval of loans and also after loan disbursement. They remain in constant touch with the groups of borrowers. Bandhan devotes a huge proportion of their revenues to monitoring, which they often cite as one of the primary reasons for the high cost of funds. Most banks lack strong and proper monitoring of loans and this may be a major reason for the huge proportions of bad loans.
Second, we believe that the group-lending model significantly contributes to high repayment rates for the following reasons. The group members are often neighbours or friends residing in the same locality and in most cases have a fair amount of knowledge about one another’s economic background, the purpose for which the loans are taken, the repayment schedule and also any difficulties a fellow member might run into in making the weekly repayment. In an ongoing survey that we are conducting of 113 Bandhan clients in West Bengal, we find that 55% of the respondents had an idea about the financial background of all or most of the members in their group. About 50% knew the reason for which loans were taken by all or most other members in the group. Moreover, in the group meetings, borrowers come to know about one another’s repayments in public and a default leads to huge social embarrassments for the defaulter. This kind of knowledge about fellow group members facilitates informal arrangements within the groups, which can lead to the observed high repayment rates. From our survey, we also observe that when an individual was on the verge of default, 23.8% of the times she obtained help from a fellow group member. When asked what steps the group members take if someone defaults, almost 43% responded that the group members shout at the defaulting member. 39% said that the group members cooperate and even try to help the defaulting individual in repayment. It is interesting to see that even though loans are individualised, group members try to help and even shout at the defaulting members. Also, the group members try hard not to default on their loans and we do not know the exact reason why they value repaying on time to Bandhan to such an extent even though there are no ‘late fees’ associated with delayed repayment. A possible reason could be that these clients consider Bandhan as the main potential source of credit available to them and recognise that their access to future loans would be compromised if they defaulted on loan repayment or were sufficiently delinquent.
Third, the weekly repayment schedule is the traditional model that MFIs have been following across the globe and microfinance practitioners argue that the fiscal discipline imposed by this system is critical to preventing loan default.
The biggest challenge for Bandhan now will be to strike a balance in keeping their NPAs at the existing level, use their expertise to check bad loans, and still emerge as a commercial bank that caters to all kinds of customers. Bandhan plans to cater to MFIs, MSMEs (micro, small and medium enterprises), SMEs (small and medium enterprises), the middle class, which is a huge segment, and the upper middle class, but not the corporate sector. These groups of customers may not be as tolerant to the high degree of monitoring from the bank as it has been the case for its present customers. Also the present lending model, which is feasible due to the unique social environment of rural areas, will no longer be there when Bandhan has to cater to a larger section of the society as a bank. However Bandhan’s Chairman and Managing Director, Mr Chandra Shekhar Ghosh is hopeful of striking the right balance; According to him, “…(with) close connections and weekly follow-ups with all our customers, we get to know their problems. It enables us to be helpful and them to be responsive. With the MSME and SME customers, we hope the same strategy will yield similar results. In fact, here we don’t need weekly follow-ups. Instead, we hope to have monthly critical meetings with our customers to cut down on any risk of loan repayment defaults. Building up trust through constant contact works to reduce the risks, not the profile of the customer”. Bandhan seems to maintain its focus on monitoring as the primary mechanism to avoid bad loans. However it has to find ways to keep monitoring costs low and still keep the lending model viable with low NPAs because it now has to compete with other banks that have much lower interest rates at present. On the other hand, by accepting deposits, especially in savings and current accounts, Bandhan would be able to reduce its cost of funds substantially. It is expected that this reduction in costs would be reflected in a reduction in lending rates as well.
How Bandhan handles this transition from an MFI to a bank will be a test case for other MFIs and the Indian banking industry as a whole. We have to wait and watch as we move towards a new beginning in the Indian banking industry.
The PCAOB, as a matter of policy disclaims responsibility for any private publication or statement by any of its Economic Research Fellows and employees. The views expressed here are the views of the authors and do not necessarily reflect the views of the Board, individual Board members, or staff of the PCAOB.
- Basu, S, S Dutta and A Sarkar (2015), ‘Informal Insurance under Individual Liability Loans: Theory and Evidence’, Working paper.
- Nayar, L (2014), ‘An interview with Mr. Chandra Sekhar Ghosh’, Outlook, 07 July.
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- The Institute of Cost Accountants of India (2015), “An interview with Mr. Chandra Sekhar Ghosh”, The Management Accountant, January, Vol. 50.