India’s microfinance sector needs urgent reforms for sustainability

Source: The post India’s microfinance sector needs urgent reforms for sustainability has been created, based on the article “Why boom and bust in microfinance ” published in “Businessline” on 22nd July 2025

UPSC Syllabus Topic: GS Paper 3 – Indian economy

Context: India’s microfinance sector has grown significantly, serving 15 crore households with ₹6.53 lakh crore in credit. However, rising defaults, over-leveraging, and governance issues have sparked concerns. The discussion is triggered by unsustainable growth practices and declining financial health in the sector, highlighting the need for a fundamental reset. Microfinance sector in India

For detailed information on Microfinance: Status, Benefits, Challenges and Solutions read this article here

Evolution and Reach of Microfinance in India

1. Growth from Modest Beginnings: India’s microfinance journey began in 1992 with a small goal to connect 500 SHGs to banks. Today, SHGs and JLGs together serve 15 crore women borrowers and hold a credit portfolio of ₹6.53 lakh crore.
2. Institutional Structure and Interest Rates: SHGs are mostly funded through public sector banks with low interest rates (about 4%) due to subventions. In contrast, JLGs, serving as the commercial microfinance core, face higher interest rates due to NBFC-MFI borrowing costs.
3. Lender Composition and Delivery Mechanism: NBFC-MFIs dominate the market (39%), followed by banks (33%) and small finance banks (16%). Although banks fund these loans, NBFCs are the primary on-ground delivery agents, often working as business correspondents.

Warning Signs and Unsustainable Practices

1. Cycles of Crisis and Regulation: Microfinance has faced recurring cycles of overexpansion and regulation. Alarming trends include gross NPAs rising from ₹38,000 crore in FY24 to ₹61,000 crore in FY25, and client base shrinking from 4.6 crore to 4.2 crore.
2. Signs of Over-Leveraging: Loan sizes and borrower liabilities are growing faster than the borrower base. Multiple lending and top-up loans are increasing defaults, especially as borrowers struggle to repay larger loans.
3. Market Concentration and Investor Pressure: Top 25 NBFC-MFIs now control 89% of the market. Growth is driven by investor expectations rather than borrower sustainability. MFIs are listing on stock exchanges and using low penetration statistics to justify risky expansion.

Governance and Structural Concerns

1. Differences in Lending Models: SHGs emphasize group bonding, savings, and inter-lending. In contrast, JLGs lack such rigour and are increasingly used for larger loans, shifting from their original purpose.
2. Erosion of Credit Discipline: Earlier, staggered lending based on repayment history ensured discipline. Now, many fintechs and MFIs chase the same borrowers simultaneously, weakening the original model’s strength.
3. Loan Size Shift and Dilution of Norms: Loans under ₹30,000 are reducing while those above ₹80,000 and ₹1 lakh are growing, raising concerns about misuse and inadequate vetting.

Challenges in Recovery and Lending Efficiency

1. Mismatch Between Loans and Enterprise Needs: Large loans may not fund productive enterprises capable of repaying high-interest debts. Smaller vendors can manage quick repayments, but larger loans often lack repayment discipline.
2. Weakening of Peer Pressure Mechanisms: Digital disbursals have eroded the group cohesion and peer accountability that ensured repayment in JLGs.
3. Vulnerabilities of Lenders: NBFC-MFIs depend on PSL funds and ratings but suffer from weak ground-level capacity and high staff attrition. Without PSL support, their sustainability is questionable.

Need for Institutional Responsibility and Reform

1. Regulatory Measures Have Limits: Existing safeguards and SRO norms have limited impact. Institutions must act beyond compliance, upholding long-term responsibility toward clients.
2. Rethinking Profit and Purpose: MFIs must balance commercial goals with the core mission of poverty alleviation. Sustainability and ethical lending must be prioritized over aggressive growth.
3. A Sector in Need of Reset: The sector must realign with its original purpose through internal accountability, better governance, and borrower-centric practices to remain viable.

Question for practice:

Examine the key challenges facing India’s microfinance sector and suggest why a structural reset is necessary.