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INVOLVEMENT OF FINANCIAL INSTITUTIONS IN MICROFINANCE
INDUSTRY IN SRI LANKA


COUNTRY PAPER
J.M.AMEER
SENIOR ASSISTANT DIRECTOR
REGIONAL DEVELOPMENT DEPARTMENT
CENTRAL BANK OF SRI LANKA
COLOMBO-1 
 SRI LANKA.

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SriLanka is a tiny island, located in southern tip of Indian sub continent. Total land area is 65,610 square kilometers. Climate is topical and four season does not exit Sri Lanka. The clouds and rains rumble in more seriously at the two times of the year that come as close as anything to being seasons – Monsoons. Two monsoon seasons ( South west and North east) can be seen in the country. The total population is 18.5 Mn. and country can be classified as multi ethnic country. Majority religions are Buddhism, Hinduism, Islam and Catholic. Sri Lanka economy can be classified as an agricultural economy but because of globalization and the innovation of the nature of the economy is changing rapidly from agriculture to industries. Most of the industries and agricultural enterprises are small and medium scale. 

There has been an increase in the level of participation of the financial institutions in credit savings to poor rural communities in developing countries. This is mainly because of large-scale foreign aid contributions by the donor agencies to promote micro credit services. For instance, multilateral (IBRD,ADB,EC,UNDP,and IFAD) funding agencies have committed a substantial amount of funds for micro credit related activities. 

In Sri Lanka Commercial Banks, Development Banks and Regional Development Banks are included in Financial institutions. Although there is a role for Financial institutions, most of the microcredit activities are under taken by non-formal banking sectors and non government organizations (NGOs). This paper provide some empirical evidence of a financial institutions which has allocated a significant proportion of its portfolio for microcredit programme. Microcredit refers to small scale borrowing and saving activities conducted by individuals groups and small enterprises (generally self employed poor) who would not normally be reached by the formal banking sector.  

Micro business employ up to 5 people, often family-labor. Typically, they  have fixed workshop and capital investment but the character is still small and most of the production is meant for local markets. It is important to note that the number of employees is not the only measure of the size of a micro credit enterprises. Other factors such as output, sales and asset levels may be equally appropriate indicators of the size of the firm's operation. Currently, most of the loans to micro-entrepreneurs are provided primarily through the government, foreign aid  assisted non-governmental agencies or informal money lenders. Financial institutions must recover their cost of servicing loans by interest charges and they must be confident borrower's intent ability to repay. Financial institutions are also hampered by lack of formal collateral.  This means the standard criteria used by the financial institutions are  inappropriate for micro enterprise lending. To over-come this problem Otero and Rhyne suggested three measures to be successful in lending to micro-entrepreneurs.  

1)      Know the market

2)      Keep administrative costs as low as possible

3)      Ensure high portfolio quality. 

      Interest in developing Small & medium enterprises (SMEs)  in Sri Lanka commenced in 1980 with the establishment of National Development Bank (NDB) to provide medium to long term SME project financing. During the 1980s most of lines of credit for the SMEs were channeled through the NDB and its competitor the DFCC Bank. In 1991 the World Bank rated Sri Lanka as number 1 amongst 31  countries for most successful operation of lines of credit for SMEs. However the privatization of these institutions not only changed their focus but also their portfolio mix. This means that these institutions have moved considerably away from servicing micro-entrepreneurs. 

      Government often use financial institutions as a channel to direct their own programmes with the objective of achieving social welfare and micro enterprise development. The Samurdhi Development Credit Scheme developed by the Ministry of Rural Development in Sri Lanka has used two state owned commercial banks ie: People's Bank, and Bank of Ceylon, to distribute approximately Rs. 500 million (US $ 6 Million) This scheme was intended to serve the rural community through village level task forces called " Samurdhi Task Forces" which operated as a social intermediary. The task force used its members called "Samurdhi  Niyamaka" to select recipients of the subsidized loans ranging from SL Rs. 2,500 to SL Rs. 10,000 ( approximately US $ 28 to US$ 110) 

      The Hatton National Bank (HNB) in Sri Lanka is one of the leading commercial bank involved in lending to commercially viable micro-enterprises. The HNB uses the concept of barefoot banker to set up a number of village level schemes (Gami Pubuduwa or Village Awakening) to distribute loans. The village level officers or village awakening advisors function as intermediaries between the bank and rural entrepreneurs.  

      Loans up to SL Rs 15,000 (approximately US $ 165) can be approved without formal collateral and this amount can increase to SL Rs 25,000 if the applicant is guaranteed by two villagers. The role of bank branches is kept at a minimum because most of the transactions are carried out at village level. The interest rate on loans ranges from 17 to 25 percent per annum. In some cases NGOs are allowed to use the multiple deposits of its members in the bank to raise funds for further development of micro-entrepreneurs. Despite this evidence on the possibility of  financial institutions involvement in micro-credit, their ability to serve the sector has been widely debated. However, any attempt to get financial institutions  into micro finance requires a careful assessment  of the issues faced by the financial institutions of the developing countries. In addition to HNB there are six Regional Development Banks also involving granting loans to rural poor. These banks have been specially established for helping to the rural poor.  

      Most of the current donors are interested in funding microfinance programme through financial institutions. Since most of foreign funding is channeled through governments, the financial  institutions have to decide whether they should implement lending programmes as commercial ventures or as required by the government. Expanding market power and profitability are the main objectives of the financial institutions. It is also important to reorganize that there is significant gap in financial dept and efficiency between low income and high income countries.  

      The domestic credit are generated from the savings of house holds and institutions. The ratio of domestic credit provided by the banking sector to GDP measures the growth of the banking system it reflects the extent to which savings are financial. This ratio indicates that banks in the low income countries have not performed to level to close to the rest of the world. However the ratio does not capture the activities of the informal financial sector and the non-banking savings culture of the low income countries. 

      Lending to micro-entrepreneurs is not a new concept. Financial institutions often consider lending to micro-entrepreneurs or to a group of micro-entrepreneurs is either too risky or too expensive. Lending to micro-enterprises means creating a portfolio largely comprising small loans.  

      Lack of formal collateral and the previous experience of non payment by low income borrowers have led the financial institutions and their staff to distrust the micro-entrepreneurs. Most bankers have underestimated the capacity of micro – entrepreneurs to save and have not examined the feasibility of an alternative lending formula. Furthermore, less rigorous informal lending criteria have made non-bank borrowing attractive to the micro-entrepreneurs in low income countries. 

      The Financial institutions in low income countries have been subjected to regulation such as interest rate caps and reserve requirements. These regulations not only reduce the competition between banks but also prevent banks from servicing micro- entrepreneurs with innovative lending/savings products. Regulations has also prevented financial institutions from borrowing from overseas. Further more most of the government supported lending programmes have combined the objectives of social service and enterprise development. Although this is theoretically possible, most of these programmes have not provided the anticipated benefit as a result of political intervention and corruption. 

      The last decade has seen a revolution in the banking system. With the introduction of technology and privatization, banks have moved from labor intensive institutions to labour saving or technology intensive institutions. However, most financial institutions in Sri Lanka are still labor intensive. Eventual introduction of technology, privatization and possible bank mergers will impose considerable threats on the labor input of the banks in low income countries.  

      Lack of competition in the banking sectors in Sri Lanka is the major reason for low involvement in micro enterprise lending. A banking system's role is to intermediate between household savings and investment. Competition among bank makes borrowing more attractive. It also promotes the access of micro entrepreneurs to the formal banking sector. 

      The major service needs for micro-entrepreneurs are saving and credit for liquidity and working capital. Supporting this group creates considerable positive externalities. This is because it creates a basic economic environment in which  households can economically survive through self employment with a possibility of creating further employment or reducing unemployment within family units. 

      Since micro-entrepreneurs reduce the problems of unemployment, government and other international donors who are trying to promote employment are particularly interested in them. Therefore microfinance justifies intervention and support

 

      Previous experience on subsidized lending indicates that it has led to poor repayment and high failure rates. At the same time the informal lending sectors which lend at substantially high interest rates are thriving in most of low income countries. For this reason some practitioners have argued that subsidized lending for micro- entrepreneurs is inappropriate because they can afford high interest rates.    

The provision for loan losses seems to be understated. This may be due lack of accurate data on previous loan losses. The impact of loan losses can be significantly reduced by providing adequate insurance to cover risks. However insurance products in micro-finance are yet to be introduced. The lower rate of loan losses will certainly encourage private investment but government assisted insurance provision will bring more benefits than interest rates subsidies.  

      The financial system in the developing countries are highly regulated through prudential requirements which do not promote entry and competition. The  Financial institutions involved in micro finance require competitive wholesale borrowing.  Only a wholesaler available in Sri Lanka ie: National Development Bank. The potential benefits of financial institutions lending to micro-enterprises can not be achieved without reforms to existing prudential regulations and facilitating the functions of small financial institutions. The reforms should be include abolition of rigid banking  supervision, interest rate restrictions, reserve requirements capital adequacy ratios etc.  

      Government in low income countries also emphasize on the concept of community banking which is a popular concept even within high income countries. A community bank or an independent bank is a commercial or saving whose operations are limited to its immediate city or country area. Community banks have the capacity to differentiate themselves by building on the strength of community associations and leadership to serve the financial needs to those communities. Governments in developing countries may be able to obtain better economic benefits by divorcing enterprise development programme from social welfare driven programmes so that political influence on lending  can  be kept at minimum.  

       The basic problem of the banking sector of the less developed countries is insufficient diversification. Increased competition for profitable loan assets has resulted in growing portfolio concentration in narrow range of lending. Banks are also lenient on following government  mandated policies on lending than independent assessment of credit risks of the borrowers. These problems are further exacerbated by the weakness of supervisory framework.      

      The banking institutions in low income countries normally do not pay attention to potential micro-entrepreneurial clients because they do not fit into the traditional perception of what constitutes a good client. The inability to provide clear collaterals. has led the financial institutions to believe that funding micro-enterprises should be a charity activity or a part of the governments welfare schemes. This means banks do not use appropriate credit risk assessment of micro –entrepreneurs.     

      One way to over come this problem is work with other organizations (charity or thrift societies or community banks suggested above) that already involved in successful enterprise development programmes. By networking these groups to lending programmes bank can not only reduce the cost of the loan administration but also reduce the burden on supervisory staff. The most appropriate way to promote banks in rural communities is by promoting micro-savings of the micro-borrowers. 

       This paper has examined whether commercial banks in low income countries are capable of delivering micro financial services. There are strong incentives for financial institutions to be involved micro-finance. A summary of the key points covered is given below.  

  • In order to facilitate financial institutions' interest in microfinance , government  sponsored income support programmes should be separated from the microfinance.

  • Subsidized lending does not encourage microfinance and leads to poor loan repayment and portfolio quality. Introduction of insurance cover to micro-entrepreneurs provide grater benefits. The insurance can also be a part of the portfolio of the banks

  • Government should acknowledge the social contributions of developing micro-enterprises. Therefore government should provide a  suitable regulatory environment to promote micro lending. This should include competitive wholesale borrowing, introducing micro-insurance systems, and minimizing the restrictions on entry by the small banks serving micro-entrepreneurs.

  • Banks should change their visions. Micro-finance can be a profitable item in banks' portfolios provided that they use cost effective methods for the delivery of loan products. Considerable gains in efficiencies are possible through incorporating NGOs in micro enterprise development. In order to maintain an effective supervisory framework, banks should use a system of bench marking.

  • Banks should combine micro lending with micro saving.

References 

Journal of Co-operative Development  
Annual Report - Central Bank of Sri Lanka 2000 & 2001
National Microfinance study of Sri Lanka.