Credit risk faced by microfinance institutions (MFI) in India

The microfinance industry of India is a major enabler of financial inclusion in the country. It has also been a blessing for small scale industries which act as an important source of income for a significant population. However, microfinance institutions (MFI) are faced with many problems which restrict their potential. These issues, mainly associated with credit risk, are discussed here.

Credit risk and its types

Most financial institutions face risks while loaning to customers, which is called ‘credit risk’.  Credit risk can be defined as the risk of incurring a loss due to borrower’s failure of returning the loaned amount. Broadly, this risk can be divided into two types, transaction risk and portfolio risk (GTZ, 2000):

  • Transaction risk: It is related to a particular borrower. A borrower may not be trustworthy and hence can be a wilful defaulter or unable to repay due to financial constraints.
  • Portfolio risk: It arises when lender loses a particular class or portfolio due to a number of reasons.

Credit risks for Indian MFI is mainly with respect to transaction risk, since majority of the customers are from the financially weaker sections of the society. Moreover, the size of average loan amount given by Indian MFI has increased from, Rs 10,364 in 2014 to Rs.16,394 in 2016, suggesting a rise in risk too (ASSOCHAM, 2016).

Credit risk faced by MFI in India

Indian credit market for MFI faces a very fundamental problem of asymmetric information. Asymmetry in financial market can be defined as failures of market decision due to lack of perfect knowledge (Mersland and Strøm, 2011). Due to this, two main problems arise; adverse selection and moral hazard. Adverse selection occurs when the lender has incomplete information about the borrower, therefore there is risk of default. On the other hand, moral hazard occurs when a borrower hides their intention while taking the loan and then engages in undesirable activities, again making it a risky investment (Venu, 2003). Presence of these two problems has led to an increase in non-performing assets (NPA). For this reason, the MFI resort to high rates of interest, sometimes as high as 28%. This is further aggravating the credit risk problem, as customers find themselves unable to repay the loans (Nguyen, 2016).

The factors contributing to credit risk in MFI are (PWC, 2016):

Lack of proper credit screening in case of borrowers from MFI

There are more than 2500 MFI in India but less than 20 are large enough to have proper paraphernalia for assessing the credit screening of the potential borrowers. The lack of proper mechanisms for assessing the credit quality of borrowers leaves the credit risk investigators helpless. The chances of fraud becomes higher as the credit investigators find themselves unable to assess the strengths and weaknesses of the borrowers. The potential borrowers use the money for unproductive use. This is due to the problem of moral hazard. A regular check on the purpose should therefore be done to minimise credit risks.

Lack of credit assessment mechanisms and technological innovation

A robust digital environment solves the problem of asymmetric information and in turn reduces the scope of credit risk. In the lack of adequate credit assessment mechanisms, the investigators fail to identify the appropriateness of the proposed product design for his/her needs. This lack of conformity leads to credit risk.

Business environment for potential borrowers

It is not very supportive which leads to borrowers becoming non-wilful defaulters. Adverse situation of the organizations affect the obligation meeting capacity of the borrowers. Low market share, poor growth and low competition may lead to credit risk. Also, ability, experience and skills of manager and team management skills affect the likelihood of being a defaulter. If the manager fails to resolve the issue related to recovery in a given time frame then credit risk occurs.

Moreover, some borrowers are becoming the middlemen by borrowing the large amount and then distributing it as moneylender. This is an addition to the credit risk.

Future needs of the microfinance industry

It is clear that there is a market potential for MFI in India. However this growth of MFI in India lies in adoption of mechanisms for the dynamic business and economic environment. Therefore, they should adopt several strategies:

  1. Operations innovation: MFI have little or less control over the external stakeholders. So, the growth lies in efficient utilization of internal stakeholders. This requires constant innovation in product, distribution and technology (Ibtissem and Bouri, 2013).
  2. Proper utilization of e-KYC techniques and mobility app in order to get essential information about potential borrower.
  3. Analytics insights: MFI can use analytics at a macro and micro level as a marketing tool for increasing customer base. At the macro level, insights generated through geospatial analytics can be used to estimate population in an area, identifying hotspots for strategic placement of staff or branches and identification of growth areas. At the micro level, customer repayment history and his or her association with partners can provide insights to retain the customer through new products or retain a possible churn (Mersland and Strøm, 2011).

Thus, the future of MFI demands changes in technique of its functioning and becoming more innovative in approach.


Priya Chetty

Partner at Project Guru
Priya Chetty writes frequently about advertising, media, marketing and finance. In addition to posting daily to Project Guru Knowledge Tank, she is currently in the editorial board of Research & Analysis wing of Project Guru. She emphasizes more on refined content for Project Guru's various paid services. She has also reviewed about various insights of the social insider by writing articles about what social media means for the media and marketing industries. She has also worked in outdoor media agencies like MPG and hotel marketing companies like CarePlus.

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