Poverty is a significant economic problem in the majority of the developing world. In most rural areas of India, agriculture is the principal source of revenue. Agriculture employed 42.6% of India’s workforce in 2019. However, the rural community has been largely cut off from official financial institutions, resulting in poor performance
Microfinance raises household income and lowers poverty levels, particularly among the poorest. Nevertheless, there are several problems of microfinance in India.
Microfinance’s financial viability is one of the primary concerns, despite an 8.1% median return on equity in 2016. In addition, due to costly credit risk management systems and small loan portfolios, operational expenditures are relatively high.
So, what is the way ahead for microfinance in India? Keep reading to find out.
What are Microfinance Institutions?
Micro Finance Institutions (MFIs) are a type of NBFC that focuses on the financial requirements of the poorest people in the country, primarily in rural areas.
The Reserve Bank of India is the institution’s sole regulator. The primary goal of establishing the Indian microfinance business was to provide financial inclusion to the poorest and more backward sections of society.
Since microfinance primarily serves the weaker sections of society, overindebtedness by such borrowers is a common and one of the significant problems of microfinance in India. Borrowers are always in need of money, therefore they borrow from all available sources.
Significant Problems of Microfinance in India
Microfinance institutions that serve retail consumers have a unique set of problems that commercial banking solutions cannot handle. The following are some of the issues:
1. High-interest rates
Compared to commercial banks, MFIs do not have the same financial success rate. One reason is that, whereas the banking system in India dates back centuries, microfinance is only a few decades old. Moreover, compared to commercial banks (8-12%), MFIs charge a significantly high-interest rate (12-30%).
The Reserve Bank of India (RBI) recently announced the removal of the 26% interest cap for MFI loans. This has enriched the industry’s players while worsening the situation for customers.
Microfinance institutions have a limited transaction volume, yet the cost of those transactions is fixed and substantial, posing a considerable problem for all of them.
Microfinance institutions offer financial services to the weaker members of society to help them improve their living standards. As a result, over-indebtedness is a huge problem. The microfinance crisis in India in 2008 was caused by a lack of risk management framework and repeated borrowings by most clients.
In some instances, there is no apex control over microfinance institutions. This sector provides loans without collateral which raises the risk of bad debts.
Furthermore, adequate infrastructure planning has not matched the sector’s rapid growth. Microfinance institutions are concerned about excessive debt since it has a detrimental impact on their portfolio, puts them in danger of credit, and increases the cost of monitoring.
3. Over-reliance on commercial banks
In India, most microfinance institutions are registered as Non-Governmental Organizations (NGOs). Their lending activities rely on financial institutions like commercial banks for stable funding.
Banks account for over 80% of their funds. The majority of these are private banks that charge high-interest rates and have shorter lending terms.
Banks frequently lend to micro-lending companies to satisfy their priority sector loan goals. However, the Indian microfinance industry’s excessive reliance on banks renders it inept and slow to respond to defaults and delinquencies.
4. Lack of financial services awareness
India, like all other developing and impoverished countries, has a very low literacy rate, which is even lower in rural areas. As a result, almost 76% of India’s adult population is unaware of basic financial principles.
The lack of understanding of the Indian microfinance industry’s financial services is difficult for both customers and MFIs.
This aspect makes it difficult for villagers to work with MFIs to address their financial needs, but it also makes them financially excluded. In addition, MFIs have the difficult challenge of educating the public and gaining their trust before selling their products.
Due to a lack of information, microfinance institutions struggle to make their businesses more financially sustainable.
5. Regulatory concerns
The Reserve Bank of India (RBI) is currently the governing agency for India’s microfinance industry. However, it has generally catered to commercial and traditional banks rather than microfinance institutions. Furthermore, the microfinance industry’s needs and anatomy are vastly different from banks’.
The industry has previously seen intermittent and unprecedented regulatory changes. Some have substantially improved the industry, but many issues remain unsolved, such as erecting entry hurdles to keep unworthy players out.
It has resulted in continual structural and operational changes, but it has also resulted in ambiguity in conduct norms. As a result, separate regulating authority for this business is required.
Regulatory concerns have resulted in suboptimal performance and the failure to produce new financial goods and services to help the poorest sections.
6. Self-help groups are expanding (SHGs)
Many MFIs use the SHG or Joint Liability Group (JLG) model. Unfortunately, these models are chosen at random irrespective of the situation, increasing the possibility of the weaker sections taking on more debt than they can handle, which is irreversible.
The government’s engagement in supporting self-help groups has witnessed rapid expansion, putting microfinance institutions under strain. This has long-term negative consequences for the MFIs’ viability.
7. Cost of outreach and missing targets
Microfinance institutions serve small-ticket loans to the urban poor and underbanked in distant hinterlands due to the model. However, there are logistical and field force costs associated with the outreach. As a result, margins are eroding, necessitating digitisation and process automation.
Moreover, MFIs frequently mistake ignoring the urban poor in favour of focusing on the rural poor. Only 800 MFIs have been identified in India that focus on the urban poor.
Problems of Microfinance in India: The Way Ahead
Microfinance has shown to be a significant tool in enhancing the welfare levels of the poor by increasing disposable household income during the last few decades.
However, broader benefits on social welfare, such as health, nutrition, education, and female empowerment, have yet to be widely recognised. Nonetheless, microfinance is widely regarded as a valuable instrument for reducing poverty in low-income countries.
The following are the solutions to overcoming the problems of microfinance in India and reaching more people:
1. Interest rate transparency
MFIs should adhere to an actual interest rate on products and amounts disclosed to clients.
2. Proper regulation
When microfinance was in its infancy and individual businesses were free to experiment with new business models, a restrictive environment requirement wasn’t a major problem.
However, the organisation now requires constraints to preserve stakeholders’ interests while promoting growth.
3. Rural poor focus
Instead of lowering the initial cost in places where MFIs exist, these institutions should begin focusing on the rural poor and open additional branches throughout the areas.
4. Range of products
MFIs should provide a comprehensive range of products, including credit, savings, remittance, financial advice, and so on, to help consumers transition away from commercial banks.
5. Use of technology
MFIs should use new technologies, IT tools, and applications to reduce operational costs.
Microfinance institutions should be encouraged to reduce their operating expenses by using cost-cutting methods.
6. Different fund sources
In the absence of sufficient finances, MFIs’ expansion and reach are limited, and to mitigate this disadvantage, MFIs may look for additional funding sources for their loan portfolio.
7. Field supervision
In addition to proper regulation of the microfinance sector, field visits can be used to monitor conditions on the ground and, if necessary, take corrective action.
This can be used to monitor MFI ground staff’s performance and loan recovery operations.
Microfinance institutions have undoubtedly proliferated and played an essential role in the cause of financial inclusion, but there is still much to be done.
The Indian microfinance sector is complicated, as evidenced by the foregoing research. And it requires prompt attention from the RBI in the form of a comprehensive regulatory framework designed to protect the help provided to the poor and financially marginalised.
Finezza lending management software is a well-integrated solution for microfinance institutions and non-bank financial companies (NBFCs).
The software solution enables MFIs to gain world-class banking capabilities, allowing them to compete effectively with mainstream commercial banks.
The 360-degree suite not only gives lenders a complete picture of the borrower, allowing them to make more balanced decisions, but the utilisation of AI and ML technologies also makes the process more risk-free.
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