Ind-Ra: Credit Cost Overhang to Remain for MFIs for up to 3 Quarters

Microfinance institutions (MFIs) with significant exposure to the states worst affected by demonetisation such as Maharashtra, Uttar Pradesh, Madhya Pradesh, Uttarakhand and Karnataka would continue to face stress over the next three quarters, believes India Ratings and Research (Ind-Ra). However, Ind-Ra estimates that 50%-70% of the stress has been recognised by 1HFY18. Ind-Ra further estimates net non-performing assets to equity of the top six MFIs (sample including MFI NBFC turned small finance bank) is about 30% while the median is about 20%. Demonetisation and election-related political interference (in few states) had impaired the asset quality of most of MFIs as well as of those which have transitioned into banks, and credit cost overhang would continue even beyond 1HFY18.

While the event risks are unpredictable, Ind-Ra believes that the business model remains susceptible to idiosyncratic and systemic risks, as these have played out in one form or other over the last 10 years. The agency believes these need to be factored into the ratings adequately while assessing the credit profile of MFIs.

In its November report titled 'Microfinance: Borrower Overleverage Warrants Course Correction from MFIs', Ind-Ra had stated that the weighted average credit ratings (assuming a linear rating scale and weights assigned as per portfolio) of MFIs witnessed a multi-notch upgrade to 'A-' in FY16 from 'BBB-' in FY14. The weighted average rating of MFIs (including MFI-NBFC turned small finance banks) currently is about 'BBB+', indicating four rating transitions (three positive rating actions followed by one downgrade) in a span of five years. This probably did not adequately factor in the business, idiosyncratic and systemic risks that the sector is vulnerable to. Ind-Ra believes that management capability, quality penetration, low ticket size, diversification in terms of geography and product, vintage, capital quality and systems and processes are the key differentiators of MFIs and are important inputs in assessing credit strength.

2HFY17 onwards, the collection efficiencies of MFIs with exposures to affected states was severely impacted and the recovery has been moderately paced. This has led to higher credit costs (loan loss provisioning and write-offs) for MFIs. In its earlier market wire, Ind-Ra had stated that MFIs with significant exposure to the affected states could witness up to 15% of December 2016 assets under management as credit costs over FY18-FY19. Ind-Ra believes that even though the collection efficiencies are generally improving, the progress seems to be slow in a couple of states such as Maharashtra.

The agency believes that the business risks that the sector faces could manifest again, given the socio-political importance of the borrowers. MFIs that focus on key differentiators could mitigate the impact of similar events. Ind-Ra also expects some MFIs to either consolidate or develop capabilities (internally or through partnerships) to diversify product offerings over the medium to long term to ensure long-term business sustainability.

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