May 03, 2016 by Raunak Kapoor and Sharada Ramanathan
Editor's note: This is the third post in a series on Grameen Foundation India’s journey with a microfinance institution, Margdarshak Financial Services Pvt. Ltd, as we help it transform from an organization that provides poor clients with credit as its only service, into one that provides a range of financial services by acting as a business correspondent of commercial banks.
This blog series is based on interviews with three leading banks in India who have rolled out the business correspondent model nationwide. These banks have a loan portfolio of approximately INR 20 billion each. Two of these banks have partnered with more than 40 microfinance institutions (MFIs) each, while the third has partnered with 12 MFIs on the business correspondent model.
Our first two blogs (blog 1 and blog 2) presented the perspectives of microfinance institutions (MFIs) as they adapt to become effective business correspondents of banks. In this blog and the next, we discuss the challenges banks face as they partner with MFIs, and how they are addressing these challenges and mitigating the associated risks.
Background: Why Partnership Makes Sense for Banks
Banks can realize tremendous advantages by partnering with MFIs to act as business correspondents. Business correspondents carry out transactions on behalf of a bank, and are paid commissions for the services rendered. The Business Correspondent model is one way to reach larger numbers of poor clients and connect them to banking services.
Because MFIs operate in areas where banks do not have branches, partnership allows banks to cost-effectively reach unbanked clients in far-flung areas without investing in brick-and-mortar branches. The model also allows banks to expand their offerings, as MFIs are geared towards the provision of low-ticket size financial products that have traditionally been a challenge for banks.
Crucially, the model also helps banks to meet the priority sector lending targets set by the Reserve Bank of India to ensure access to financing for development activities. These regulations specify that 40 percent of a bank’s loan portfolio should target sectors such as education, low-income housing, small farms, and micro-enterprises.
The business correspondent model is particularly critical for the survival of smaller and mid-tier MFIs as it allows them greater leverage on capital as compared to traditional loans that reside on their books. The model has helped many smaller MFIs survive the onslaught of the 2010 Andhra Pradesh microfinance crisis which led to a huge slow down in microfinance operations, loss of reputation, declining loans from banks, and loss of jobs in the sector. These smaller MFIs often operate in remote, rural areas and play a particularly key role in furthering financial inclusion initiatives.
However, there are also significant challenges to scaling the model to reach hundreds of millions of poor people across India.
The Challenges & Solutions of Partnering with MFIs
For banks, the business correspondent model also carries considerable risks. In essence, the bank permits a third-party agent to offer products and services on its behalf to clients.
Our interviews identified five top challenges that banks face in working with business correspondents: vetting partners; managing cultural differences; meeting compliance standards; aligning processes and technology; and adapting management structure. We turn now to discuss the first three, and will address the remainder in Part 2 of this blog.
Challenge: Vetting Partners
Partnering with credible entities is a key concern for most banks. Although poor clients in rural areas are sourced and served by the partner MFI, it is the bank that is ultimately accountable. Any customer service issues such as frauds or harsh collection practices ultimately pose a reputational risk for the bank. Our own observation is that most banks still give lot of importance to the growth potential of MFIs while evaluating partnerships, but a holistic evaluation of the partner is probably a more prudent approach.
Solutions: A bank’s risk assessment framework must include a few key aspects while evaluating a MFI for a potential partnership: a) governance structure, b) technology systems, c) capital structure d) efficiency parameters and e) alignment of social mission. In order to minimize reputational risk in particular, business correspondents and banks should make a concerted and joint effort to implement and enforce client protection principles.
Challenge: Managing Differences in Work Culture
The work culture at banks and MFIs can be vastly different, leading to divergent priorities and distinctive work styles. For banks, the culture is defined by an emphasis on credit discipline and standardization of processes for greater efficiency. In contrast, MFIs focus on personal relationships with individual clients and flexibility in response to their needs.
Solutions: Grameen Foundation’s experience is that effective change management is critical for the business correspondent model to succeed. The key is constant engagement. Banks must hold frequent, regular meetings with the senior management of their business correspondent partners to recognize cultural differences, agree upon the desired culture and behaviors, and provide support and encouragement.
The core principle of the business correspondent model is to leverage the complementary strengths of both banks and microfinance institutions. Partners should recognize their individual strengths by having clear working guidelines and distinct areas of responsibility.
Challenge: Meeting Compliance Standards
Stringent compliance regulations require banks to adhere to a high level of documentation that MFIs are unaccustomed to. For example: banks need to be able to vet the identity of clients with thorough documentation before opening a savings or a loan account. MFIs on the other hand, offer unsecured loans to clients, without collateral requirements. Their business model has not necessitated the adoption of thorough document collection and verification processes.
Solutions: Banks should insist on the maker/checker model of authorization, which ensures that at least two individuals are responsible for each part of the application process, and that complete documentation as per a standard checklist is sent to the bank. Banks should invest in regular compliance training sessions for their partners.
Several MFIs are also going a step further and leveraging technology to refine their processes. For example: one of the banks we interviewed shared that their partner has developed software that can read QR codes from a client’s biometric national identity card, the Aadhar Card. Another partner institution is using optical character recognition (OCR) software, which directly converts scanned documents into editable data, virtually negating the possibility of data entry errors. Banks must consider the use of such technologies, and ensuring that best practices are shared among all their partners. For example, banks could hold annual conferences recognizing outstanding practices by partners.
Stay tuned for Part 2 of this blog, as we round up the top five challenges and possible solutions for banking partners implementing the Business Correspondent model.