Can MFIs successfully transition to digital banks?

The financial sector of Bangladesh is experiencing drastic transformations through bank mergers, emergence of digital banks and the concept of a cashless society. The reduction in the number of banks through mergers aligns with the central bank's objective to strengthen the sustainability and competitiveness of the banking industry and mitigate non-performing loans.  

Simultaneously, the emergence of digital banks presents optimistic prospects for extending financial services to underprivileged segments of the population, who are currently mostly served by microfinance institutions. 

Despite all of the benefits it provides to millions of people and SMEs in Bangladesh, the MFI sector is underdeveloped as a formal sector. This promising but overlooked part of the financial sector can be well utilised in digital banking. Moreover, to achieve a cashless society by 2031, this huge portion of underserved people cannot be left behind or ignored.

Nonetheless, the transition of clients to digital banks from Microfinance Institutions (MFIs) in Bangladesh may face challenges due to digital skills issues, as the digital literacy of our population is still minimal. 

Fundamental principles of microfinance, such as personal interaction, door-to-door collection, and group-based lending, could also be hampered in transitioning to a digital MFI. The human touch and personalised approach are inherent to MFIs, as they promote trust, cultural sensitivity, and client allegiance. Transitioning to a digital model could risk losing these traditional aspects of microfinance.

Be that as it may, the potential transition of MFIs into digital banks could bring some opportunities. In June 2023, MFIs had an average of 9% administrative expenses of the average loan outstanding. Moving towards digital operations can significantly reduce administrative costs for MFIs. 

As loan disbursement and collection is completely monitored manually, digital transformation could reduce the overhead cost in loan. Automation of processes could also give leverage in loan processing, credit worthiness, and account management. 

With reduced administrative costs, MFIs can potentially offer lower interest rates to their clients. By leveraging digital technologies, they can compete more effectively with traditional banks and other financial institutions and can participate in expediting a cashless society.

The success of M-pesa in Kenya, even as far back as 2014, is highlighted in the report named 'Digital Financial Services in Africa: Beyond the Kenyan Success Story'. A joint study by the European Investment Bank and United Nations Capital Development Fund (UNCDF) shows that all the relevant stakeholders in the financial market must add value to each other to sustain the financial ecosystem. 

A similar study was conducted in Bangladesh in 2019 by UNCDF titled 'Digital Transformation of MFIs Bangladesh'. It shows the promise of an optimistic transition to digital options like cashless disbursement, digital loan applications, core banking solutions, and database management systems that could leverage their operations smoothly and cost-effectively.

Currently, eight MFIs in Bangladesh are collecting loan instalments through MFS, such as BRAC, Sajida Foundation, Shakti Foundation and Uddipon etc. More than 200 MFIs are using their own operational software or rented software from vendors for their day-to-day operations. So, the transition is already in place. 

According to a TBS report on April 30, 2024, titled 'Microfinance an important part of Bangladesh's development journey: IFC', MRA, along with IFC, are conducting research on digital transformation and digital financial services under the Microfinance sector development diagnostic study. This indicates the goodwill of the regulators towards embracing digital transformation.

MRA has already started the piloting of Microfinance Credit Information Bureau (CIB) with the top 100 MFIs to formalise the sector for effective data integration of clients and better report generation. 

The current state of microfinance sector 

The websites of Microcredit Regulatory Authority (MRA) revealed primary approvals granted to 390 institutions by April 2024, who had applied in the 2019 phase. 

Before 2019, there were another two phases of application. Data shows that out of 881 institutions licensed in two phases before 2019, 155 licences have already been cancelled due to non-operation and non-compliance issues. Currently, there are 737 licensed Microfinance Institutions (MFIs) actively providing financial services to four crore marginal people.

Up until the third phase of application in 2019, the initial loanable fund for an institution to apply for a licence in the MRA was Tk30 lakh. A temporarily approved MFI could obtain final approval by maintaining a minimum of 1,000 borrowers and Tk1 crore in outstanding loans. 

However, the MRA website now indicates that in order to obtain temporary approval, institutions need to have an initial loanable fund of Tk1 crore, along with comprehensive documentation. Consequently, the requirements for final approval have also increased to 1,200 borrowers and Tk3 crores in outstanding loans.

The Global Findex database 2021 by the World Bank exhibits that about 47% of the adult population of Bangladesh does not have any bank account. These unbanked people are mostly served by MFIs. MFIs are specialised in collateral free loans, door to door services, and group lending concepts. 

People prefer microfinance for its hassle free, speedy access, personalised services, and lower requirements. Microfinance works as a pathway to women's empowerment, opportunity, and socioeconomic change. 

Over the years, microfinance has flourished in this region of the world.  A report called 'Microfinance in Bangladesh, June 2023, Annual Statistics' shows that in the last 15 years, MFIs licensed by MRA alone have had significant growth over the years. If Grameen Bank is added, microfinance has almost 10% of the total market share of loans and advances in the financial sector. 

Over the years, from 2009 to 2023, the total number of branches increased steadily from 17,252 in FY10 to 25,336 in FY23, indicating a significant expansion in outreach.

MRA data indicates 4.086 crore people are registered as clients of MFI in FY23 up from 2.528 crore in FY10. Likewise, 3.153 crore borrowers in FY23 increased from 1.921 crore in FY10. 

There's been a significant increase in loan disbursement over the years, from Tk30,672 crore in FY10 to Tk2,49,302 crore in FY23. 

Moreover, savings mobilisation by client's to MFIs also saw significant growth, reaching Tk62,055 crore in FY23 from Tk5,136 crore in FY10. 

A significant contribution of the MFIs to the financial sector of Bangladesh is in catering to the needs of the Micro, Small, and Medium Enterprises (CMSME) sector. The CMSME sector often struggles to access funds from scheduled banks. In FY23, MFIs disbursed approximately Tk63,000 crore in this sector, which constitutes around 42% of their total loan portfolio of MFIs. 

Moreover, MFIs disbursed about Tk70,800 crore in the agriculture sector, amounting to approximately 47.06% of their total loan portfolio. This indicates the significant focus of MFIs on supporting agriculture-related activities, which are vital for the country's economy and food security. 

On the contrary, the Financial Stability Report of 2022 by the central bank shows banks disbursed Tk61,779 crore to the agriculture sector, which accounts for only 6.42% of their total loan outstanding. 

The significant contribution of MFIs to the CMSME sector highlights their role in promoting financial inclusion and supporting the growth of small businesses and agriculture activities, which are vital for economic development and poverty reduction in Bangladesh.

While adopting digital financial services, MFIs need to ensure cyber security, data privacy, and regulatory compliance, keeping the fundamentals of microfinance in mind. Building internal capacity, training staff and investing in technology solutions can strengthen the organisation's readiness for the digital era.

The evolving role of MFIs in Bangladesh's financial sector underscores their significance in driving financial inclusion and economic empowerment. While transitioning to a digital financial service or digital MFI model offers chances of competitive positioning and cost reduction, MFIs must carefully consider the potential trade-offs in terms of preserving the basic principles of microfinance and personalised ties. 

Md Rabiul Islam is the Assistant Director of the Microcredit Regulatory Authority. 

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.