Microfinance

What is microfinance?

• Microfinance – It is a form of financial service which provides small loans and other financial services to poor and low-income households.
• Enhance access to financial services – Microfinance represents banking services for low-income individuals or groups who otherwise would not have access to financial services.
• Working – Like conventional lenders, microfinanciers charge interest on loans and institute specific repayment plans
• Safe lending practices – Microfinance allows people to take on reasonable small business loans safely and consistent with ethical lending practices.
• Data management – Microfinance client disbursement and recovery data is updated daily with Credit Information Companies (CIC), ahead of the 15-day regulatory requirement.
• Financial operations – Microfinance Institutions (MFIs) operate with thin profit margins.
• These institutions offer loans without collateral with small interest rate increases (e.g., 0.15%) attract significant attention.
• Globally influential – Most microfinancing operations occur in developing nations, such as Bangladesh, Cambodia, India, Afghanistan, the Democratic Republic of Congo, Indonesia, and Ecuador.
• In India – all loans that are below Rs. 1 lakh are considered as microloans.
• Based on the recommendations of Malegam Committee, RBI introduced a comprehensive regulatory framework for NBFC-MFIs in 2011.

What are its contributions?

• Increases banking penetration – Serves 75 million low-income clients across 720 districts including 112 aspirational districts.
• Last-mile financial service – Microfinance institutions frequently deliver loans and related financial services directly to borrowers’ homes or villages, especially in rural and remote areas.
• This “last-mile” servicing involves substantial expenses such as travel costs, field staff salaries, logistics, and time.
• Generates employment – Contributes 2.03% to India’s Gross Value Added (GVA) and generates employment for 13 million people (based on 2021 NCAER study with 2018-19 data).
• Empowers women – Promotes women’s empowerment, builds digital capabilities, and helps curb urban migration.
• Enhances accountability – The sector maintains transparency by publicly disclosing minimum, maximum, and average interest rates.

How they are regulated in India?

• Lending limits – The microfinance Industry Network (MFIN) restricts lending so that a borrower can have loans from no more than three regulated entities.
  • Additionally, the combined loan amount from all lenders cannot exceed ₹2 lakh, protecting borrowers from excessive debt.
• Repayment limits – The Reserve Bank of India (RBI) mandates that microfinance borrowers' total repayment obligations must not exceed 50% of their household income.
• This rule ensures borrowers retain enough income for daily expenses, preventing financial distress and promoting sustainable borrowing.
• Periodical monitoring – To enforce these protections, MFIN conducts quarterly reviews of Credit Information Company (CIC) data.
  • This ongoing monitoring helps ensure responsible lending practices and reduces risks of over-indebtedness among low-income borrowers.

Portfolio at Risk (1-90 days) is a key metric used in microfinance to assess the quality of loan portfolios. It represents the percentage of a microfinance institution’s outstanding loan portfolio that is overdue or at risk of default by 1 to 90 days. A lower PAR percentage indicates better portfolio health and effective recovery of loans.

What are the issues?

• Gaps in KYC process – After the 2017 Supreme Court ruling, regulated entities (such as microfinance institutions) were prohibited from storing or reporting Aadhaar numbers to Credit Information Companies (CICs).
• This limits effective customer identification and verification in microfinance.
• To comply, institutions use alternative IDs like voter ID as these are less reliable and prone to inaccuracies.
• Increasing risks of duplicate or fraudulent borrower records.
• The inability to fully use Aadhaar undermines the potential for seamless and accurate borrower verification in the sector.
• Funding crunch – Despite abundant liquidity in the banking system, bank funding to Non-Banking Financial Company-Microfinance Institutions (NBFC-MFIs) fell by 54%.
• Lending restrictions – This has restricted NBFC-MFIs’ ability to lend, resulting in nearly 7 million low-income clients losing access to formal microfinance services.
• Pricing perception – Public discussions often ignore key factors like interest rate benchmarks, the costs of offering doorstep services, and the risks of unsecured loans.
  • Comparing a single institution’s rates in isolation can be misleading; rates must be viewed relative to overall sector benchmarks to understand if they are reasonable or excessive.
  • This incomplete understanding muddies perceptions about fair loan pricing.
• Informal finance still accounts for 31% of rural loans, indicating the ongoing need for well-regulated microfinance.

What lies ahead?

• To keep helping low-income communities, it's important to make regulations clearer, improve Know Your Customer (KYC) processes, and tackle funding issues.
• Pricing talks may be more responsible and take into account the challenges and risks faced by microfinance providers, which are essential for financial inclusion.

Reference

The Economic Times| Microfinance