1. Key development issues and rationale for Bank involvement

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized DRAFT PROJECT INFORMATION DOCUMENT (PID) APPRAISAL STAGE Report No.: AB5278 Project Name India: Scaling Up Sustainable and Responsible Microfinance Project Region SOUTH ASIA Sector General Financial Sector 100% Project ID P Borrower(s) Small Industries Development Bank of India for IBRD; Government of India for IDA Implementing Agency Small Industries Development Bank of India Environment Category [ ] A [ ] B [ ] C [x] FI [ ] TBD Date PID Prepared November 30, 2009 Date of Appraisal December 11, 2009 Authorization Estimated Date of Board March 11, 2010 Approval 1. Key development issues and rationale for Bank involvement Background: Notwithstanding a stable, dynamic and growing financial sector, increasing access to finance for millions of India s financially underserved segments remains a challenge. This challenge has been accentuated further by the financial crisis when despite stable policies, increasing efficiency, strong factor endowments and a dynamic financial market India s economic growth slowed from 9.7 percent in to 5-6 percent in the second half of accompanied by a slowdown in credit growth. In recent years there have been numerous initiatives to improve access to finance to financially underserved segments. Amongst these initiatives, is the Government of India (GoI) program to support the revitalization of the rural credit cooperatives, initiatives to increase access to finance for small and medium enterprises (SMEs) and to support infrastructure finance, and initiatives to introduce enabling guidelines to support financial inclusion, through measures such as the opening of no-frills savings accounts for underserved clients, provisions to expand the outreach of micro-insurance and the use of banking correspondents. Access to financial services for India s poor still remains a key development challenge, as a significant part of the population is underserved by the formal banking sector. 1 Despite a well developed banking system and significant progress in banking sector reforms, performance and stability, approximately two-thirds of the population are still without access to any financial services. While there have been several initiatives by commercial banks to reach out to underserved clients, given the scale of the challenge to provide basic financial services to all Indians, there is a need for multiple approaches and mechanisms. One example is the use and 1 India: Scaling-up Access to Finance for India s Rural Poor. World Bank, 2004 and

2 support of microfinance initiatives that can help deepen the penetration of financial services amongst the poor and underserved. The microfinance sector, which bridges the access gap by providing thrift, credit and other customized financial services to the underserved, and thus helps raise incomes and living standards, has been growing exponentially in India. While small microfinance initiatives in India date back to the 1970s, the sector did not really gain a foothold until the late 1990s. Facilitated by a benign approach towards regulation since 1997, and with a focus on the southern states, microfinance institutions (MFIs) have been scaling up fast in recent years, although from a small base. Growth in loans outstanding to clients has been at rates over 65 percent per annum over the past three years, and disbursements by MFIs have been estimated at US$1.9 billion in financial year (FY) The figure for FY 2009 is expected to be around US$3 billion. However, two over-arching challenges remain: (i) a large unmet demand for financial services by India s underserved segments still exists, particularly in states where market penetration has been extremely low; and (ii) rapid expansion introduces the dual challenge of maintaining good quality growth while promoting responsible finance amongst MFIs. Conservative estimates from Sa-Dhan, India s main network of MFIs, indicate an unmet credit demand amongst potential microfinance clients at Rs80,000 crores (US$16.8 billion). Rapid expansion to meet this large demand could lead to funding gaps, potentially erode credit discipline, and introduce risky market behavior. The end result could be external interference in the sector which would threaten short- and medium-term sustainability. To address these challenges, three key issues need to be tackled: Appropriate financing that tackles the growing equity gap and the need for more patient debt instruments: The fast-paced growth of Indian microfinance has been largely driven by commercial bank debt to MFIs. The share of debt in total funding of MFIs is over 80 percent, most of which is sourced from commercial banks at commercial rates. As a result, the fast debtfunded growth without sources and amounts of equity growing at a commensurate pace has led to a situation where many Indian MFIs face a severe shortage of equity capital which limits their ability to take on more debt and increase lending outreach to more clients. A recent International Finance Corporation (IFC) Intellecap study (2008) estimates that even with conservative assumptions, the minimum equity/quasi equity needed is US$1.3 billion over the next four years. 2 Bank team projections show that even with conservative growth assumptions, there is a need of US$294 million in equity funds by end-march Furthermore, with such capital structure constraints, MFIs have less of an incentive to focus on underserved areas, as this will increase their cost, which in turn will have a negative impact on the capital adequacy. A responsible finance agenda that fosters transparency, good governance, and adherence to codes of conduct: The high growth rates of many large and medium MFIs have fueled intense competition amongst MFIs in some pockets of the country. Competition has its benefits such as lower interest rates, but experiences in the region and globally, highlight risks. In some markets the rate of growth is too fast, which potentially comes at the expense of sound credit management. With increasing scale of operations and resulting increasing visibility, the possibility of external stakeholders wanting to intervene becomes stronger. Much more could be 2 Inverting the Pyramid.(IFC, 2008). 2

3 done to ensure healthier microfinance market expansion and to mitigate some of these potential risks. This agenda needs to be grounded in transparent reporting to funders and clients, strengthened credit reporting infrastructure, improved coordination between MFIs possibly through strengthening national and state-level associations, increased focus on risk management and credit discipline, and more widespread adherence to the microfinance code of conduct. Balanced geographical outreach so that expansion leads to more access for clients in underserved areas: Microfinance outreach in India is notable for its uneven geographic coverage. Three southern states Andhra Pradesh, Karnataka, and Tamil Nadu account for over 51 percent of all borrowers. Even within high-penetration states, underserved districts exist, where microfinance penetration is relatively thin, and expanded outreach is greatly needed. As microfinance continues to grow, it will be important to ensure this growth is inclusive with improved geographical coverage. World Bank Support: The rationale for Bank involvement revolves around three main issues: (i) contribution of the Project to the goal of inclusive growth, consistent with the Country Strategy (CAS), (ii) long-term funding constraints that threaten continued and balanced growth of the sector, and (iii) need for a stronger responsible finance agenda that is undertaken by the sector. The World Bank Group s CAS for India highlights the need for inclusive growth. Microfinance, by addressing the financial service needs of underserved clients, forms an important tool for poverty reduction, private sector development and inclusive growth. Economic and sector work undertaken 3 emphasize the need for the development of the microfinance sector in India. The Bank has also recently completed a microfinance strategy Financing the Bottom of the Pyramid, South Asia Regional Microfinance Strategy, FY The strategy highlights the Bank s comparative advantage in supporting the microfinance agenda in the region, including working with apex institutions to crowd in commercial finance, increase standards, reporting, and efficiency of MFIs, and ease crisis-related liquidity constraints. The GoI recognizes that scalingup microfinance in a responsible and sustainable manner will require diverse modalities for expanding the flow of financial services to the poor. Towards this objective, the Small Industries Development Bank of India (SIDBI) is poised to take a more active leadership role in growing the industry to the meet the unmet demand for financial services. SIDBI is the most prominent and influential apex organization for microfinance in India and among the better performing microfinance apexes globally. Support to strengthen SIDBI s leadership role is well suited to the World Bank s country and regional microfinance strategies. Secondly, the role of the Bank is justified on grounds of the market failure that exists with respect to lack of appropriate funding instrument needed at this stage of development. As mentioned above Indian microfinance is faced with a situation where many Indian MFIs face a severe shortage of equity capital which limits their ability to take on more debt and increase lending outreach to more clients. Availability of longer term funding sources would help SIDBI 3 Examples include: India: Scaling-up Access to Finance for India s Rural Poor (World Bank, 2004 and 2006), Microfinance in South Asia (World Bank, 2006), India: Regulation of Microfinance (World Bank, CGAP 2006) and Inverting the Pyramid (IFC, 2008), Bharat Microfinance Report (Sa-Dhan, 2009), annual Microfinance India: State of the Sector Report (Access Development Services, 2006, 2007, 2008, 2009).. 3

4 in introducing appropriate financial instruments that would contribute to strengthening the balance sheets of the MFIs. The accumulated Bank know-how and lessons learned from previous lending operations, both in India (rural livelihoods projects, financial intermediary loans to SIDBI directed to small and medium enterprises financing and development) and globally, provide useful experience to draw on. Additionally, the Project would support India in its response to the financial crisis, which has affected lending to microfinance institutions (MFIs) as observed by a slowdown in fresh disbursements to smaller and medium size MFIs. Thirdly, microfinance in India has entered a phase of rapid growth, but as a younger industry still has numerous vulnerabilities. High growth can erode credit discipline and can potentially introduce risky market behaviors such as client over-indebtedness and poor risk management. Timely leadership from SIDBI supported by the World Bank project to promote more responsible finance, can improve transparency and add to new market information and infrastructure that can serve to mitigate these risks during a crucial period of expansion. Such leadership can ensure that microfinance becomes a nationwide industry contributing to balanced and inclusive growth across India. 2. Proposed project development objective(s) The objective of the project is to scale up access to sustainable microfinance services to the financially excluded, particularly in underserved areas of the country, including through introducing innovative financial products and fostering transparency and responsible finance. Progress towards achievement of the project objective would be monitored using the following indicators: Extent and depth of outreach: Measured by the number of loan accounts/clients, average outstanding loan balances and percent of female borrowers; Breadth of outreach: Measured by growth rates within underserved areas; Operational efficiency: Measured by operational cost benchmarks; Responsible Finance: Measured by the number of MFIs disclosing operational/ financial information on a web-based information platform 3. Preliminary project description The project will achieve its objective through: (i) supporting expansion of financial services, particularly in underserved states or underserved areas within states; (ii) facilitating responsible and sustainable growth through the provision of more patient capital sources of funding, including longer term debt, and equity and quasi-equity instruments with funding inter-linked to responsible finance actions (for example, actions on transparency, good governance and adhering to codes of conduct, CoC). The project will use an incentive approach and link the three components described below such that maximum additionality is attained while also addressing the key issues facing the Indian microfinance sector. The incentive approach will involve the provision of appropriate financing instruments, access to which would be conditional not just on satisfactory appraisal of the MFI 4

5 based on a detailed appraisal system, but also based on case-by-case agreements with MFIs on responsible finance or other actions on capacity improvement that they would need to complete, to ensure continued access to funding under the project. The carrot or incentive to be used will be in the form of a commercially priced, but attractive funding product, including a quasiequity/sub-ordinate product which is currently not available in the India market and which will help address equity-gap issues for Indian MFIs. In return to access to this funding, the responsible finance or capacity building actions could include commitments to increase MFI portfolios in underserved areas, adoption of improved governance practices, reporting to an information platform, initiating a CoC Assessment, and adoption of improved accounting practices where relevant. Through this inter-linkage between a financing component and a responsible finance component, the project funding will seek to contribute to the objectives of promoting sustainable but more responsible finance. Component 1. Scaling Up Funding Support for MFIs (US$290 million) This Component would provide funding for MFIs to scale up their operations. Funding from SIDBI to MFIs is proposed to be structured as debt or quasi-equity, to support their operations and growth, enhance their financial strength and enable them to leverage and crowd-in private commercial funds to on-lend larger amounts to the underserved. Limited equity support may also be considered from SIDBI to MFIs. The total funding thus mobilized will enhance MFIs ability to reach out to larger numbers of underserved segments of the population through microfinance services. In particular, the quasi-equity/equity funding will also help address the equity gap in Indian MFIs, while providing SIDBI with the leverage to promote the responsible finance agenda amongst the MFIs funded by the Project. Component 2: Strengthening Responsible Finance (US$5 million) The Component would promote transparency and responsible microfinance through the development of the India Microfinance Platform (IMFP). The IMFP is envisaged as a common information platform for MFIs to provide and disseminate valuable information that would inform policy-makers, MFI managers and funders. As part of the responsible finance initiative, SIDBI will seek to bring together a Lenders Forum comprising key MFI funders to agree on common actions which could include those on transparency and good governance by MFIs. The Component could also potentially support the development and piloting of a CoC Assessment, which could serve as an innovative rating tool measuring performance of MFIs as pertaining to their CoC adherence. This Component will be cross linked with the Microfinance Fund, such that MFIs accessing Component 1 will need to commit to data sharing to the common information platform and possibly other responsible finance initiatives that will be defined as performance criteria in the Operations Manual (OM). Component 3: Implementation and Monitoring Component (US$5 million) Implementation support which would include support to SIDBI for: (i) implementing the project including operating expenses and costs of the monitoring work; (ii) commissioning an impact evaluation exercise (to be carried out through an external research agency); and (iii) SIDBI s own capacity building. This component would also include support for a communication strategy 5

6 which would help ensure the benefits from this intervention will be shared with the wider microfinance sector. 4. Safeguard policies that might apply Environmental Safeguards: No potential indirect and/or long term impacts are expected due to anticipated future activities. Social safeguards: No potential direct or indirect negative impacts either in short or long term are anticipated against the social safeguards policies by the proposed activities in the project. Environmental Category: [] A [] B [] C [ ] FI [ ] TBD Safeguard Policies Triggered Yes No TBD Environmental Assessment (OP/BP 4.01) Natural Habitats (OP/BP 4.04) Forests (OP/BP 4.36) Pest Management (OP 4.09) Cultural Property (OPN 11.03) Indigenous Peoples (OP 4.10) Involuntary Resettlement (OP/BP 4.12) Safety of Dams (OP/BP 4.37) Projects on International Waterways (OP/BP 7.50) Projects in Disputed Areas (OP/BP 7.60) 5. Tentative financing Source: ($m.) BORROWER/RECIPIENT 30 IBRD 200 IDA 100 Total 330 Contact points Niraj Verma and Mehnaz Safavian Title: Senior Financial Sector Specialist and Senior Economist Tel: nverma@worldbank.org, msafavian@worldbank.org Location: New Delhi, India and Washington DC, USA 6