The financial sector in India has been formally serving the economic needs of its urban and rural populations for over three centuries. This sector comprises banking and non-banking network which is present in multiple layers to cater to specific and varied requirements of different customers. The major aim of this network is to mobilize the savings from households to the economy to promote development. The formal lending system includes commercial banks, microfinance institutions (MFIs’) and non-banking financial institutions (NBFC).
The period 1970 – 1990 marked an important turning point for the Indian economy because of events such as nationalization of banks, establishment of regulatory bodies for banks which is RBI (Reserve Bank of India). Scheduled banks (SCB) and regional rural banks (RRB) were also introduced. Commercial banks, which held the largest share in the financial services sector, were able to expand their operations from urban to the rural areas during the 1970’s (Rajan & Pandit 2012). Another major reform, especially in the rural banking segment, was the establishment of MFIs’ in the 1980’s. This included self -help groups (SHG) and joint liability groups (JLG). The focus of this paper is to study the differences between commercial banks and MFIs by examining the different parameters.
The differences between commercial banks and microfinance institutions are explained below by taking into account three major parameters, namely products, operations and regulatory frameworks.
Difference in product offerings
Banks are financial institutions that provide banking and other financial services such as accepting deposits and providing loans to customers. Apart from these, there are number of distinctive facilities provided by banks such as
- demat services,
- locker facility,
- cash withdrawal from ATMs
- provision of credit/ debit cards.
In other words, banks offer cash management services for customers, reporting the transactions of their accounts and portfolios (Dr. Manikyam 2014).
On the other hand, MFIs’ mainly target poor households in rural areas to access financial services such as very small loans (micro credit) to help them to invest in or scale up their small businesses (micro enterprises) (Panda and Mohanty 2006).
Difference in operational processes
‘Process’ refers to the operational process of a company or industry. In case of banks and microfinance instiutions, the common service offered are loans. Therefore, a comparison is drawn between the operational processes of banks and MFIs’ with respect to loan portfolio management which covers sanctioning of loan, disbursement and collection process of loans.
Difference in collateral for loans
The need for collateral as security is considered to be the foremost distinction between commercial banks and MFIs’. While commercial banks require the borrower to pledge loan collateral, there is no such requirement for MFI loans. Banks undertake thorough scrutiny, various processes such as the borrower’s goodwill, financial history and enforcement of collateral. This is done with the help of robust internal applications which fish out risky propositions. If a loan is sanctioned, then the amount is disbursed in one or more installments by the banks (Chilukuri 2014).
On the other hand, MFI loans are generally disbursed to individuals or groups which are geographically diverse, without extensive scrutiny. The monitoring and scrutiny is performed by the peer group members and ‘peer pressure’ acts as collateral as it reduces the chances of default (Korankye 2014; MicroSave 2006). The process of collection by banks is stringent. In case of failure of payment, banks forfeit the collateral and recover the loan amount but this provision is not available for MFIs’. This greatly increases losses occurred due to bad debts.
Difference in deposits and withdraw facility
Another distinguishing process feature of banks and MFIs’ is deposit facility. In case of deposit or savings, commercial banks offer specific products at fixed rates of interest for the depositor. These deposits can be withdrawn anytime. But for MFIs’, a certain amount has to be saved by the group members compulsorily so that they can avail loans. The size of these deposits is also less in comparison with banks (Gateway 2017) .
Different physical and technological infrastructures
Apart from the basic infrastructure, banks mostly integrate state-of-the-art equipment to maintain digital records of client’s information. Commercial banks in India are now largely focusing on class banking, which means there is a wide variety of value added and customized products available for customers. Technology has enabled these banks to serve their customers without having to hire manpower for manual operations. Their customer service is accessible 24 x 7 through tele-banking, ATMs’, E-banking and mobile banking (Nair 2014).
However, microfinance institutions are unable to catch up with this technological pace, mainly due to their capital and funding constraints. Their operations are still confined to the rural areas where lack of infrastructure such as transportation, communication and electric wiring is a major hurdle for MFIs’ attempting sustainability. Also, their clients are spread out in rural areas and remote villages which increase the cost of monitoring for institutions and difficulty in accessibility for customers. There are additional transaction costs, even with the basic infrastructure. This also increases the operational costs for the microfinance institutions (Sravani 2013).
Difference in scale of business and target customers
The scale of operations of commercial banks is not limited to households. In fact, the lending operations of commercial banks are divided into agriculture, micro, small and medium enterprises, export credit, education, housing, social infrastructure and renewable energy. These account for around 40% of their credit (Mohan & Ray 2017).
On the other hand, MFIs’ disburse loans of small amounts to poor households to invest in their small business or for personal use. The basic purpose of MFIs’ is to enable financial inclusion. They seek to empower those sections of society that are not covered by commercial banks and are vulnerable to private money lenders (Singh 2016).
Strong mechanisms for credit in commercial banks
Commercial banks have strong mechanisms for credit appraisal of borrowers. However, the microfinance industry is still at its infancy in risk management. Credit risk is faced by both the institutions. However, the mechanism for handling delinquencies and default is weak in the case of microfinance institutions as there is lack of monitoring. This can lead to fraud by staff as there are geographically diverse clients (PwC 2016). They also have a poor redressal mechanisms in case of wrong doing. Commercial banks have strong risk management because of the diversified portfolio of investments and clients which reduces the chances of loss but there is no such portfolio management in microfinance (Singh 2013; Gateway 2011). This factor is discussed in detail here.
The regulatory framework for the commercial banks and microfinance institutions is decided by the Reserve Bank of India (RBI) and its rural financing arm National Bank for Agriculture and Rural Development (NABARD). The RBI serves as a watchdog for the activities of commercial banks in accordance with the internationally-accepted Basel norms, whereas MFIs’ are governed under different statutory requirements and norms by NABARD. These rules are set according to the nature and functioning of the MFIs.
For instance, the governing rules for small scale MFIs’ are different from those for large scale ones. Recently, after the Andhra Pradesh Crisis, the RBI formed the Malegam committee to study the issues and concerns in the industry (SaDhan 2016).
The table below reviews the differences between banks and MFIs in India.
|1. Products||Deposit, lending, insurance, demat A/c, locker facility, cash withdrawal from ATMs and credit/ debit cards||Deposits, micro-credit, insurance|
|2. Target group||Urban, rural (both above/below poverty line)||Mainly rural (below poverty line)|
|3. Business||Not limited to households and diversified to various sectors||Limited to households|
|4. Physical Infra||Well defined and targets class banking with value added facilities||Struggles with basic wiring, transportation, building|
|5. ICT Infra||Accessible 24 x 7 through tele-banking, ATMs, E banking, and Mobile banking||Minimal to none|
|6. Loan Process||Proper scrutiny and monitoring||Lack of proper scrutiny and monitoring leading to high default|
|7. Collateral Requirement||Collateral required and forfeited in case of default||No collateral required and peer pressure works as collateral|
|8. Mechanism of loan disbursal||Loan disbursed in one or more installments||Loan disbursed to individual/group depending upon savings collected|
|9. Recovery of loan||Less cases of default and collateral forfeited in case of default||Large no. of cases of default/delinquencies due to poor credit appraisal techniques|
|10. Risk Management||Backed by huge capital and to employ state-of-the-art risk management mechanisms||Poor/no mechanisms to manage risk and limited funds provided by National Bank for Agriculture and Rural Development (NABARD), the apex development bank in India.|
|11. Regulatory framework||Governed by Reserve Bank of India and Basel Norms||Governed by NABARD, the rural financing arm of RBI|
Key differences between commercial banks and MFIs’
Microfinance industry is struggling for growth
The historical patterns of banking in India show that conventional banking institutions failed to understand the needs of the rural market. This led to the introduction of the concept of microfinance. The role of MFIs is to provide financial assistance to the rural poor who are unable to access commercial banking products. Both the institutions have similar kind of structure in terms of operations but the degree of complexity is different. It can be said that even though the concept was introduced over 40 years ago in India, these institutions have yet to excel like the commercial banks.
The MFIs are still struggling to sustain themselves in the rural sector. The Andhra Pradesh microfinance crisis, for example, exposed the vulnerability of the MFI ecosystem. On the other hand, commercial banks (both private and public) are reaching out to include the rural and priority sectors.
- Asha Singh, 2013. Credit risk management in Indian commercial banks. International Journal of Marketing, Financial Services & Management Research, 2(7). Available at: http://indianresearchjournals.com/pdf/IJMFSMR/2013/July/6.pdf.
- Dr. K. Ratna Manikyam, 2014. Indian Banking Sector – Challenges and Opportunities. IOSR Journal of Business and Management (IOSR-JBM), 16(2). Available at: http://www.iosrjournals.org/iosr-jbm/papers/Vol16-issue2/Version-1/G016215261.pdf.
- Gateway, M., 2011. Risk Management Fundamentals. , (April), p.31. Available at: http://www.dhs.gov/xlibrary/assets/rma-risk-management-fundamentals.pdf.
- Mohan, R.& & Ray, P., 2017. Indian Financial Sector: Structure, Trends and Turns,
- Panda and Mohanty, 2006. Product Mix and product Innovation of Microfinance in About the Author. Microfinance Gateway. Available at: https://www.microfinancegateway.org/sites/default/files/mfg-en-paper-product-mix-and-product-innovation-of-microfinance-in-india-2006.pdf.
- 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.
- Rajan, S.S. & Pandit, V., 2012. Efficiency and Productivity Growth in Indian Banking. Margin: The Journal of Applied Economic Research, 6(4), pp.467–486. Available at: http://mar.sagepub.com/cgi/doi/10.1177/0973801012462122.
- SaDhan, 2016. Regulatory Framework of Microfinance Institutions. SaDhan. Available at: http://www.sa-dhan.net/Resources/flyer option 1.pdf.
- Singh, P., 2016. Understanding the structure of Micro Finance Institutions in India and suggesting a Regulatory Framework, Available at: http://www.iibf.org.in/documents/reseach-report/Report-24.pdf.