The Indian microfinance sector has grown due to regulatory reforms, technological advancements, and government initiatives, extending credit to millions of previously underserved households
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The Indian microfinance sector has arrived at a major landmark, celebrating its 50th anniversary. Set up in 1974 in Gujarat with the main purpose of extending financial services to poor women, the Self Employed Women’s Association (SEWA) Bank was India’s first microfinance institution (MFI). Since then, microfinance has played a critical role in boosting financial inclusion, particularly among poor households and small enterprises in rural areas.
Microfinance, also known as microcredit, is a kind of banking service extended to poor individuals or groupings who otherwise would be unable to avail of financial services. Like normal bankers, MFIs must earn interest on credit and structure definite repayment schemes with instalments due at periodic intervals. Microfinance encompasses multiple services like savings accounts, checking accounts, fund transfers, micro insurance, and microcredit.
MFIs must earn interest on credit and structure definite repayment schemes with instalments due at periodic intervals.
While beneficial, microfinance is characterized by many inherent risks like credit risk—the risk of debtors defaulting on their loans; operational risks including those resulting from internal processes, people, and systems, e.g., insufficient staff training, fraud, or loan processing errors harming the institution’s operations; liquidity risk arising from cash flow mismanagement and the consequent inability to service short-term obligations; market risk such as that arising from the effects of interest rate fluctuations or economic downswings; foreign exchange risk associated with exchange rate fluctuations for MFIs involved in operations using multiple currencies, especially those institutions borrowing in one currency and lending in another; reputation risk such as that resulting from negative publicity or erosion of trust among clients, causing the client base to shrink and/or financial instability; and regulatory risk arising from the impact on operations and profitability of changes in laws or government regulations. Indeed, one or more of these issues have plagued India’s microfinance sector for much of its five-decade existence.
The early development of microfinance in India mostly relied on small credit schemes such as the Differential Rate of Interest (DRI) and the Integrated Rural Development Programme (IRDP) in the 1980s, intended to extend financial services to the poor. However, they were mostly plagued by elevated costs and inefficiencies. The sector expanded quickly during the 1990s and 2000s, especially with the ascendency of MFIs and Self-Help Groups (SHGs), but with this growth afflicted by its own set of issues as follows:
The Indian government’s unanticipated demonetisation of high-value currency notes exerted an immense adverse impact on the microfinance sector.
In 2010, one of the most noteworthy crises in Indian microfinance occurred in Andhra Pradesh, caused by allegations of coercive loan recovery methods by MFIs and their elevated interest rates. The state government responded with stringent regulations, resulting in a steep fall in microfinance activities in the region. In 2016, the Indian government’s unanticipated demonetisation of high-value currency notes exerted an immense adverse impact on the microfinance sector. Many debtors, who mostly transacted in cash, encountered difficulties in servicing loans. This caused heightened defaults. More recently, the COVID-19 pandemic—beginning in 2020—imposed unprecedented hardships on the microfinance sector, with lockdowns and economic disruptions impacting the repayment capability of debtors, causing liquidity problems for MFIs. The sector was forced to adapt rapidly to digital transactions and loan restructuring.
The 2010 crisis in Andhra Pradesh led the Reserve Bank of India (RBI) to institute the Malegam Committee to scrutinise problems and concerns in the microfinance sector. The committee’s recommendations resulted in the creation of a holistic regulatory framework for NBFC-MFIs (Non-Banking Financial Corporation-Microfinance Institutions), including interest rate caps, margin caps, and guidelines on fair practices.
The RBI introduced harmonised regulations for all regulated entities (REs) engaged in microfinance, aimed to create a level playing field, address matters of over-indebtedness, and guarantee transparent pricing and fair practices.
In 2014, the RBI recognised the Microfinance Institutions Network (MFIN) and Sa-Dhan as Self-Regulatory Organizations (SROs), which fulfil a critical role in guaranteeing regulatory compliance and advancing best practices. More recently in 2022, the RBI introduced harmonised regulations for all regulated entities (REs) engaged in microfinance, aimed to create a level playing field, address matters of over-indebtedness, and guarantee transparent pricing and fair practices.
Taken together, these regulations aim to protect debtors, foster the sustainability of MFIs, and boost financial inclusion. They have, in fact, been instrumental in enabling significant transformation of India’s microfinance sector over the past decade.
The Indian microfinance sector has witnessed rapid growth, with its gross loan portfolio growing roughly 16.5 times from INR17,000 crore to INR2.85 lakh crore from 2012 to 2022. NBFCs have increased their lead over traditional banks in the microfinance segment, commanding a 39.1 percent market share versus a 33.5 percent share for banks as of FY23.
Despite challenges such as the COVID-19 pandemic, the sector has displayed resilience. Portfolio delinquencies have reverted to pre-pandemic rates, signalling better portfolio health. The number of unique debtors has also grown significantly to 7.4 crore, with 14.6 crore loan accounts as of December 2023. Underlying this growth are efficient business operations and prudent lending practices. Crucially, profitability has been increasing on the back of increased yields and reduced credit costs, with RBI’s 2022 revised regulations granting greater leeway to MFIs in setting lending rates.
NBFCs have increased their lead over traditional banks in the microfinance segment, commanding a 39.1 percent market share versus a 33.5 percent share for banks as of FY23.
Despite the phenomenal growth, the Indian microfinance sector continues to face some of the following issues:
The COVID-19 pandemic aggravated some of these challenges, with heightened defaults and financial strain among borrowers. Alleviating these issues requires a multi-pronged strategy involving an improved regulatory architecture, financial literacy initiatives, and innovative financial offerings customised to the requirements of the underprovided.
The sector continues to face many difficulties, however, including restricted availability of inexpensive funding, low financial and digital literacy amongst debtors, and risks associated with customer data security.
Indian microfinance’s journey toward profitability has been long and difficult. The significant growth witnessed by the sector has been driven by regulatory reform, technological progress, and government action, enabling the extension of credit to crores of poor households previously outside the reach of conventional financial services. The sector continues to face many difficulties, however, including restricted availability of inexpensive funding, low financial and digital literacy amongst debtors, and risks associated with customer data security. Over-indebtedness and the lack of innovative customer-focused solutions also present major challenges. Yet, profitability has been rising in recent years due to higher yields and lower credit costs, bearing testimony to the sector’s resilience in the face of adversities such as those witnessed during demonetisation and the COVID-19 pandemic.
Aditya Bhan is a Fellow at the Observer Research Foundation.
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Dr. Aditya Bhan is a Fellow at ORF. He is passionate about conducting research at the intersection of geopolitics national security technology and economics. Aditya has ...
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