Poverty, a raging economic issue, exists in most of the developing countries. The actual reason for severe poverty lies in the inequality in income distribution, which is chronic in developing countries, especially in India. Agricultural sector still plays a major role in Indian economy, despite the remarkable progress made in the service and manufacturing sector in last two decades. According to Census 2011, still 50% of the Indian population depend on agriculture and allied activities and approximately 69% of India’s population is in rural areas. This population has been largely deprived of formal financial services leading to lackluster performance of the agricultural sector (Karthik, 2017). For this reason the concept of microfinance was introduced. The main aim of introducing Indian microfinance industry was financial inclusion of poorer and backward section of the society.
In the previous articles it was reviewed how micro finance is important for rural India, especially women. The growth of Indian microfinance industry has been remarkable. In addition support of National Bank for Agriculture and Rural Development (NABARD) to link banking system with the self-help groups led to further success in the sphere of micro finance in India. But compared to the roaring success of commercial banks, micro finance institutions have a long way to go. They lag behind in terms of structural, operational, and financial processes. In this article the challenges faced by Indian microfinance industry which restrain it from achieving their full benefits, are reviewed.
Major challenges faced by Indian microfinance industry
As this sector mainly deals with the poorer section of the country, over-indebtedness is a common and serious challenge. Some of the other challenges are:
- high rates of interest,
- over-dependence on the banking system,
- illiteracy and lack of awareness about the products.
Over-indebtedness due to multiple borrowings and inefficient risk management
Microfinance institutions (MFI) provide financial services to the poorer section of the society in order to improve their standard of living. Therefore over-indebtedness is major issue. Lack of risk management framework and multiple borrowings by most clients led to micro-finance crisis in India in 2008. In some cases, it has been seen that there is no apex control over the MFIs’. This sector gives loans without collateral which increases the risk of bad debts. Moreover the fast paced growth of the sector has not been met with proper infrastructure planning. This kind of problems has been reported in states like Andhra Pradesh, Karnataka, and Madhya Pradesh (Singh, 2016). Over indebtedness is a cause of concern for MFIs’ as it negatively affects their portfolio. It also makes them vulnerable to credit risk and increases the cost of monitoring (Schicks 2013).
High rates of interest as compared to mainstream banks
MFIs’ when compared to commercial banks do not enjoy the same rate of financial success. One of the reason is that while banking system is centuries old, micro finance is only a few decades old in India (Pathneja, Narwal and Kumar, 2015). MFIs’ charge a very high rate of interest (12-30%) as compared to commercial banks (8-12%). Recently, the RBI (India’s regulatory bank) announced the removal of upper limit of 26% interest on MFI loans (ET, 2014). This has benefited the industry’s players but left the customers in a worse situation than before. Due to the issues of over-indebtedness caused by the charging of high interest rate, rate of suicide of farmers increased in states like Andhra Pradesh and Maharashtra
Over-dependence on banking system for funding
Majority of the MFIs’ in India are registered as Non Governmental Organizations (NGOs). They are dependent on financial institutions such as commercial banks for stabilised funding for their own lending activities. Around 80% of their funds come from banks. Most of these are private banks which charge a high rate of interest and also the term of loans is of shorter period. Most of the times, banks lend to microlending firms in order to meet their so-called priority sector loan targets (Unnikrishnan, 2012). The over dependence of Indian microfinance industry on banks make them incompetent and less reactive towards dealing with default and delinquencies (Sapundzhieva 2011)).
Lack of awareness of financial services
Like all other developing and underdeveloped countries, the literacy rate in India is very low and the rate is much lower in the rural areas. Nearly 76% of India’s adult population does not understand basic financial concepts (Sud, 2017). Lack of awareness of financial services provided by the Indian microfinance industry is a challenge for both, customer and MFIs’. This factor not only causes hindrance for villagers to join hands with MFIs’ to meet their financial needs but also makes them financially excluded. MFIs’ are faced with the task of educating the people and establish trust before selling their product. Micro finance institutions struggle to make their business more financially viable due to this lack of awareness (Ancona 2014).
Presently the Reserve Bank of India (RBI) is the regulatory body for the microfinance industry in India. However it has traditionally catered to commercial and traditional banks rather than MFIs’. Moreover the needs and the anatomy of micro finance industry is supremely different from that of banks (Business Standard, 2016). In the past the industry has undergone sporadic and unprecedented regulatory changes. Some of these have benefited the industry greatly, but a lot of issues were unaddressed, like creating barriers for entry to restrict unworthy players (PwC, 2016). Not only has it led to constant structural and operational changes but also created ambiguity in norms of conduct. Therefore there is a need for a separate regulatory authority for this industry. Regulatory issues have led to sub-optimal performance and failure in the development of new financial products and services through which the poorer section can be benefitted.
Problem in identification of appropriate model
In India, most of the MFIs’ follow Self-Help Group model (SHG model) or Joint Liability Group model (JLG model). The problem is that most of the time, selection of model are not scientific in nature. The models are selected randomly, not according to the situation and also the decision of selection is irreversible in nature. So, it affects the sustainability of the organisation in the long-run and also increases the risk of borrowings for the poorer section beyond they can bear. This is also one of the main reasons of crisis of microlending in the state of Andhra Pradesh. It has been repeatedly stressed that the industry needs to undergo business process reengineering to effectively reach out to the under-financed (PwC, 2016).
Information technology can help in financial inclusion
Information and technology can induce massive impact on the state of credit market accessibility which remains the most significant issue when it comes to availability of formal loans at market price. Inaccessibility of credit at reasonable market price is the reason behind weak financial inclusion of the backward section of the population. A lack of suitable financial infrastructure provides the main bottleneck and it can be successfully tackled with innovative implementation of information technology keeping unique circumstances of rural population in mind. A very good example towards such a step would be introduction of mobile banks, where the growing telecommunication connectivity provides not only convenience but also reduction in cost of providing financial services,. This makes it feasible for different banking entities to provide special services keeping the target market in mind.
Government should play a major role
Indian microfinance industry came a long way from 1975 with the development of RRB (Regional and Rural Banks). It is one the major steps taken by the government to reach the poorer section of the society who are not part of the formal financial system. During the course, the industry faced various highs and lows and which can be seen through a spate of crises over the years. This industry needs to improve the quality of services and its operational structure.
Government has to involve in the course of the action in order to make this industry thrive. Smooth functioning of Indian microfinance industry can be enabled through setting up of a separate regulatory authority to discourage malpractice and political influence. Strengthening the credit check and debt collection processes and educating the villagers about products and consequences is important. Specific representatives of the legal system should be appointed who will visit the villages on a regular basis. The government is trying to aid this sector by helping the linkage between the self-help group and banks to grow through NABARD, the section of RBI that regulates the micro finance industry. However the stakeholders should take a lot more measures to address the issues identified above.
- Business Standard (2016) ‘India needs a specialised regulatory authority for microfinance: Muhammad Yunus’, 7 February. Available at: http://www.business-standard.com/article/finance/india-needs-a-specialised-regulatory-authority-for-microfinance-muhammad-yunus-116020700604_1.html.
- Dinesh Unnikrishnan (2012) ‘Banks raise loan costs for MFIs – Livemint’, pp. 1–5.
- Emily Levi-D’Ancona (2014) ‘Financial Literacy and Financial Inclusion of Women in Rural Rajasthan’, Independent Study Project (ISP) Collection.
- ET (2014) ‘RBI removes 26% interest rate cap on MFI loans’, Economic Times.
- Jessica Schicks (2013) ‘The Definition and Causes of Microfinance Over-Indebtedness: A Customer Protection Point of View’, Oxford Development Studies.
- Karthik, A. (2017) ‘Micro Finance In India: Comprehensive Development’, Golden Res. Thoughts, 6, pp. 1–8.
- Pathneja, S., Narwal, K. and Kumar, M. (2015) ‘Performance Analysis of Banks and Microfinance Institutions in India’, Int. J. Manag. Bus. Res, 5(1), pp. 9–18.
- PwC (2016) Shifting trends in the microfinance ecosystem. Available at: https://www.pwc.in/assets/pdfs/publications/2016/shifting-trends-in-the-microfinance-ecosystem.pdf.
- Singh, P. (2016) ‘Understanding the structure of Micro Finance Institutions in India and suggesting a Regulatory Framework’.
- Subrata Kumar Mitra (2009) ‘Exploitative Microfinance Interest Rates’, Asian Social Science, 5(5).
- Sud, R. (2017) Why India needs to work on financial literacy now more than ever.