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Liliana Rojas-Suarez, Senior Fellow, Center for Global DevelopmentThis is a guest post from my colleague Liliana Rojas-Suarez based on her presentation at last week's public discussion of the global implications of the microcredit crisis in India.

The crisis in Andhra Pradesh has indeed been unnecessary and costly. Unnecessary because it was fully avoidable and costly because it’s harming both financial sector suppliers and most importantly demanders of this valuable product called microfinance. To put it boldly, the operations of a valuable market have been damaged.

With every crisis there are lessons and recommendations. Indeed, a basic question for crisis prevention is: are there a number of key principles that ANY innovation for financial access should meet?

Here at CGD, we thought about that question, and under my leadership (together with Stijn Claessens and Patrick Honohan) we produced the Principles for Expanding Financial Access. Other members that participated in the production of the Principles include renown experts in the subject of financial inclusion such as Jonathan Morduch and Nachiket Mor as well as David and Beth Rhyne.

I strongly believe that these Principles (10 in total) are an extremely useful tool to assess success and sustainability of an initiative for financial inclusion. And the events in Andrah Pradesh serve to illustrate my point. Let me put the Principles to work:

We can divide the events in two periods: the pre-Ordinance period (the crisis-incubation period) and the post-Ordinance period (the crisis eruption and resolution period). In the pre-Ordinance period at least 4 Principles were violated.

  1. Principle 8: Balancing government’s role with market financial service provision. This principle welcomes the role of the state in complementing the role of the private sector, but requires government intervention to be sustainable and respect the commercial market logic as much as possible. The continuous problems for many years now between the private MFIs and the government-led Self Help Groups programs testify to violation of this Principle.
  2. Principle 2: Building legal and information institutions and hard infrastructure. Among other things, this principle calls for the collection and availability of information through credit registries and credit bureaus. If adequate credit bureaus could have been in place, actually as recommended some time ago by a Commission led by professor Raghu Rajan, information about multiple loans and over-indebtedness would have been available to all service providers (public and private), and the problem would have been avoided.
  3. Principle 5: Protecting low-income and small customers against abuses by FSPs. MFIs in India are regulated institutions. But if concerns about abuses have been in the region for a number of years now, are the consumer protection rules and regulations appropriate or is there an enforcement problem?  In any case if consumers were not protected, this violates Principle 5.
  4. Principle 10: Ensuring data collection, monitoring and evaluation. Issues regarding transparency will always be there if information is lacking and if evaluations of success are not done continuously. It’s not enough to count with some rigorous impact evaluation from time to time. A continuous process is required.

Since the announcement of the Ordinance further Principles were violated:

  1. Principle 4: Ensuring safety and soundness of financial service providers. As is well known, the Ordinance induced defaults and practices that will endanger the stability of financial institutions. As it’s also well known, this is extremely dangerous.

For one, one never knows the linkages with the rest of the financial system and the magnitude of the problem that can be created. In other words, at this stage we don’t know what the extent of the potential contagion to the rest of the financial system is. There are some estimates about the exposure of banks to MFIs, but not definite figures. Also, banks provide liquidity (through short-term credit lines) to MFIs and this is a serious channel of contagion. Moreover, if a culture of no repayment is encouraged a moral hazard problem will develop. This happened during the banking crisis in Mexico. In the future, debtors might expect similar interventions from the government.

  1. Principle 6: Ensuring usury laws and rate controls if used are effective and don’t lead to distortions. Setting caps on interest payments without full knowledge of the costs to deliver the service and riskiness to costumers both kills the business nature of microfinance and encourages further usage of moneylenders.

What we’re observing is a bad crisis resolution process and if history has something to tell, this process will be reversed because it’s unsustainable (hopefully before too much damage is created).

Will the events at Andhra Pradesh have consequences to the rest of the world? It depends whether countries follow the CGD Principles that I have just discussed. For example, I predict that this crisis will have no consequence on Latin America, where most of the Principles (not all, especially not on quality of institutions) are met.

At CGD, we believe that the set of guidelines contained in the Principles are useful tools for both governments and providers of financial services to assess successes as well as the eruption of dangers.

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CGD blog posts reflect the views of the authors, drawing on prior research and experience in their areas of expertise. CGD is a nonpartisan, independent organization and does not take institutional positions.