Banks are repeating past mistakes by aggressively lending to India’s microfinance sector, risking financial instability.

What is Microfinance?

• As per the  Task Force on Supportive Policy and Regulatory Framework for Microfinance set up by National Bank for Agriculture and Rural Development (NABARD) in 1998:
  • Microfinance refers to the “provision of thrift, credit and other financial services and products of very small amounts to the poor in rural, semi-urban and urban areas for enabling them to raise their income levels and improve living standards”.

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• Regulatory Framework:  
  • MFIs are governed by the RBI’s Non Banking Financing Company–microfinance institutions (NBFC-MFIs)- Directions, 2022.
  • The Microfinance Institutions Network (MFIN) was started as a self regulatory body for the sector and all the NBFC-MFI are eligible for membership.
    • In 2014, MFIN was formally recognized as a self regulatory body by the RBI. 

Components of Microfinance

• Microcredit: Small loans given to individuals without any collateral, steady employment or verifiable credit history.
  • As per the Reserve Bank of India (RBI): A microfinance loan is defined as a collateral-free loan given to a household having annual household income up to ₹3,00,000.
• Microsavings: Small deposit requirements, no service charges for low income individuals.
• Microinsurance: Affordable low premiums and coverage insurance products to manage risks such as health emergencies, natural disasters, crop failure etc.
• Group Lending: A model where small groups jointly guarantee loans, fostering accountability and reducing default rates.
  • Example: Joint Liability Group (JLG) is an informal group of 4-10 individuals, primarily farmers or rural workers.
    • Loans are secured through mutual guarantees, with shared repayment responsibility.
• Microfinance Institutions (MFI): A large number of organisations with varied size and legal forms offer Microfinance services. 

Microfinance In India

• Microfinance’s contribution to India’s GVA: The microfinance sector contributed about 2% of India’s gross value added (GVA) in 2018-19, according to a study by the National Council of Applied Economic Research (NCAER).

• Geographic Distribution of Loans: 76% of the loan portfolio is in rural areas, while 24% is in urban areas.
• Growth in Microfinance Sector’s Loan Portfolio: As of March 31, 2024, the microfinance sector’s gross loan portfolio (GLP) increased by 24.5%, reaching ₹4.33 lakh crore from ₹3.48 lakh crore the previous year.
• Annual Growth in Microfinance Loans: Microfinance loans grew by 18.3% year-on-year as of June-end, although default rates have also increased.
• Decline in Loan Collections and Rising Delinquencies: Data from Microfinance Industry Network (MFIN) and India Ratings show a decline in loan collections and rising delinquencies.

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Significance of Microfinance

• Poverty Alleviation: Microfinance helps individuals start or expand small businesses, generating income and lifting families out of poverty.
• Women Empowerment: With a significant focus on women borrowers, it enhances their financial independence and decision-making power.
• Economic Development: By supporting small businesses, microfinance contributes to local economic growth and job creation.
• Social Impact: It enables better access to education, healthcare, and improved living conditions for families.
• Financial Inclusion: Microfinance institutions (MFIs) provide access to financial products and services to underserved populations, bridging the gap with mainstream banking.
  • Microfinance is a driver of financial inclusion and directly addresses SDG 1 (No poverty), SDG 5 (Gender equality), and SDG 8 (Decent work and economic growth). 

Reasons for Increased Microfinance Lending In India

• Reduced Credit Demand: Lack of corporate credit demand has driven banks toward retail and micro-finance lending.
  • The Reserve Bank of India (RBI) has tightened regulatory norms leading to stiffer funding conditions.
  • Therefore, the lending by banks and NBFCs is expected to slow down to 12%, totaling ₹19 lakh crore in FY25, down from ₹22 lakh crore last year.
• Priority-Sector Lending Pressure: Banks face mandates to meet lending targets in priority sectors.
  • Priority sector lending is a government initiative which requires banks to allocate a percentage of investments in specified priority sectors at a reduced interest rate. 
  • Currently only microfinance institutions registered as NBFC-MFIs are designated as a priority sector.
  • Targets under PSL:
    • Regional Rural Banks and Small Finance Banks: 75 percent of Adjusted Net Bank Credit (ANBC) or Credit Equivalent Amount of Off-Balance Sheet Exposure (CEOBE), whichever is higher.

• Regulatory Changes by RBI: Removal of interest-rate caps offered by non-bank microfinance institutions (NBFC-MFIs) has fueled rapid growth in microfinance loans.
  • With this, the underwriting of loans will be done on a risk-based analysis, and a risk premium will be charged based on the borrower.
• Bridging Credit Gaps: The rise in microfinance lending can be seen as  banks’ efforts to bridge credit gaps to provide last-mile credit delivery and empower underserved rural populations.
• Technological Advancements: The adoption of technology in loan disbursement, collection, and monitoring has made microfinance more efficient and scalable.
• Rise of Private Capital: With the sector’s proven potential and growing demand, private capital has increasingly been attracted to microfinance institutions (MFIs), fueling further expansion.

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Potential Risks to the Banking Sector Due to Increase In Microfinance Lending

• Reduced Profits: Higher provisioning for bad loans impacts profitability.
• Increased Interest Rates: Banks may charge higher rates across the board to protect margins.
• Credit Aversion: Rising defaults could make banks hesitant to lend to the sector, affecting underserved borrowers.
• Credit Risk: Over-indebtedness among microfinance borrowers can lead to higher default rates, affecting banks indirectly.
• Systemic Risk: Defaults in the microfinance sector could trigger wider financial instability, impacting the banking system.
• Regulatory and Compliance Risks: Increased microfinance lending may lead to stricter regulations, raising compliance costs for banks.
• Ever-Greening Loans: This practice involves lenders providing new loans to borrowers unable to repay existing ones, temporarily preventing default. 
  • However, it masks the borrower’s true financial health and can lead to over-leveraging, increasing the risk of future defaults.

Overall Challenges of Microfinance Institutions  

• Higher Interest Rate Compared To Mainstream Banks : Microfinance institutions have a limited transaction volume, yet the cost of those transactions is constant and substantial, posing a considerable problem for all of them. 
  • Serving remote and rural areas involves significant administrative and logistical expenses.
  • Operational costs of MFIs often translate into higher interest rates for borrowers.
• Default on a loan : These institutions  provide loans without requiring collateral, increasing the risk of default and bad debts. 
  • Borrowers often take multiple loans from different MFIs or informal lenders, leading to unsustainable debt levels.
• Skewed Distribution: The eastern and north-eastern regions of India hold the largest share of 37% in the loan portfolio, followed by the southern region at 27%, and the western region at 15%. 
  • As of 2022, 82% of the loan portfolio was concentrated in ten States.
• Limited Access to Capital: MFIs struggle to secure funds for their operations, especially in countries with underdeveloped financial markets.
  • Over-reliance on donor funding and grants can limit their ability to scale sustainably.
• Lack of Financial Literacy: Borrowers often lack an understanding of loan terms, repayment obligations, and financial management.
  • Poor financial literacy can lead to misuse of loans and an inability to repay.
• Inadequate Ground-Level Presence: Banks lack the on-ground infrastructure that micro-finance institutions (MFIs), small finance banks, and regional rural banks possess.

Initiatives to Improve The Microfinance Ecosystem In India

• SHG-Bank Linkage Programme (SHG-BLP): was launched by NABARD in 1992 Under this programme, banks were allowed to open savings accounts for SHGs.
  • Bank Sakhis, trained members from SHGs served as intermediaries, aiding SHG members in transactions and application processes.
• Micro Finance Development and Equity Fund by NABARD: NABARD  created the Micro Finance Development and Equity Fund (MFDEF) in 2006 to help MFIs with quasi-equity and subordinated debt instruments.

• Pradhan Mantri Mudra Yojana: It was launched by the government in 2015 for providing loans up to Rs. 10 lakh to the non-corporate, non-farm small/micro-enterprises.
• e-Shakti Programme of NABARD: The primary goal of the E-Shakti Project is to digitise the accounts of various SHGs and to bring the members of the groups under the fold of Financial Inclusion.
• PM Street Vendor’s AtmaNirbhar Nidhi (PM SVANidhi): The Ministry of Housing & Urban Affairs launched this scheme to facilitate collateral free working capital loans of up to INR10,000/ of one-year tenure, to approximately 50 lakh street vendors.
• Kudumbashree: It  is a women empowerment and poverty eradication program launched by the Kerala government in 1998. 
  • It focuses on microfinance, providing women in rural and urban areas with access to savings, loans, and financial support through self-help groups (SHGs). 
• RBI’s Regulatory Framework for Microfinance Loans: 
  • Creation of NBFC-MFIs in 2011: Created a distinct category for microfinance institutions with a focus on customer-centric practices, such as capping borrower indebtedness and transparent pricing.
  • Harmonised Guidelines in 2022:
    • RBI has now set a common household limit of Rs 300,000 for loans to qualify as microfinance. 
    • For entities to qualify for an NBFC-MFI licence, they should have at least 75% of assets in microfinance and the cap on NBFCs was increased to 25% of assets as against 10% earlier.
  • Advisories on Lending: Periodically issued advisories to prevent multiple lending and address unethical practices like “ever-greening” loans.
  • Continuous Monitoring: RBI emphasises real-time data submission to Credit Information Companies (CICs) for effective risk management and regulatory oversight.

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Way Forward

• Strengthening Regulatory Oversight: Enforce strict compliance with RBI’s harmonised guidelines to ensure uniformity in practices across all microfinance players.
• Need for Balanced Oversight: Policymakers and banks must heed early warning signs to ensure stability in the microfinance sector without stifling credit delivery.
• Loan Purpose Verification: Ensure loans are utilised as intended by monitoring their end-use.
• Enhancing Financial Literacy: Conduct large-scale awareness programs to educate borrowers on responsible borrowing, repayment obligations, and grievance redressal mechanisms.
• Improving Risk Mitigation: Promoting sharing of credit information among MFIs to prevent over-leverage by borrowers.
• Building Institutional Capacities: Invest in training and capacity building for MFIs, SHG facilitators, and Bank Sakhis to enhance service delivery.

Conclusion

Ensuring the health of the banking sector through prudent lending practices and robust oversight is crucial for sustainable microfinance growth and financial stability.

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