SOCIAL COLLATERAL. Microfinance provides doorstep delivery of credit to needy borrowers | Photo Credit: Naturecreator

Widely discussed in the media and other forums, microfinance is often depicted as a villain causing more harm than good to the poor. How true is this?

Microfinance started off in India sometime in the 1990s, as a financial inclusion programme. Prior to that, too, there were some forms of microfinance activities in use. The SEWA bank — started by Ela Bhat in 1974, in Ahmedabad — attempted to provide savings and credit services to self-employed women. Similarly, the cooperative societies and regional rural banks dotting the country are also designed to provide microfinance to the needy sections of society.

However, it was in the 1990s that the informal lending practices of microfinance institutions (MFIs), using social collateral as security, took off. Initially the effort was to link women’s self-help groups (SHG) and banks, and this has grown into a major movement to become the world’s largest microfinance programme.

MFIs, being private entities, need to make profits to sustain and grow. Their services include doorstep delivery, making it more convenient for this segment of borrowers, who are often overwhelmed by the formalities of dealing with banking institutions. Naturally, the cost levied for the services is higher than that of banks, which are constrained from operating at the micro level due to their inherent model.

Funding needs

MFIs in India are not allowed to take deposits from members. To fund their operations, they borrow mostly from banks and other financial institutions at 11-12 per cent interest; sometimes they also borrow from other non-banking financial companies (NBFCs) at rates exceeding 15 per cent.

Since the loaning operation of MFIs is manpower-intensive, the average operational cost is 7-8 per cent. MFIs also need to factor in the risk associated with the unsecured nature of the loan. Finally, they need some returns for their assets to grow. This explains why the cost of MFI loans is 23-24 per cent. Additionally, since the interest charged is on the outstanding balance, the actual cash outflow is low.

MFIs take care to ensure that the repayment obligation does not exceed 50 per cent of the borrower’s monthly income, as per RBI guidelines. But there are entities that are not regulated and whose data is not captured in credit information bureaus, and this may lead to more burden for borrowers.

Course correction

What is the way out? First, the major portion of the interest cost is due to the cost of funds. Can there be a mechanism to provide cost-effective funds? We have seen this in MFIs’ collaboration with the National Scheduled Castes Finance and Development Corporation (NSFDC) to extend credit to SC beneficiaries. NSFDC extended credit to MFIs at 5 per cent, and this was passed on to borrowers at 15 per cent.

MFIs should also reduce operational costs through digitalisation and risk cost through efficient loan assessment and recovery practices.

As for the increasing loan burden, financial education of borrowers is a must. Self-regulatory organisations can take the lead in organising financial education programmes countrywide. The government can support such initiatives and perhaps deploy CSR funding for it. Additionally, the proposed ‘Banning of unregulated Lending Act (BULA)’ can rein in unauthorised entities that cause higher indebtedness.

The solution does not lie in giving microfinance a bad name. It has helped millions of households in getting timely credit. That’s why Prime Minister Narendra Modi has lauded microfinance for its contributions. Even External Affairs Minister S Jaishankar recently appreciated it on the floor of the UN. The only way to make the sector better is to extend support and keep a close watch on its operations.

(The writer is ED and CEO, Sa-Dhan. Views expressed are personal)

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Published on January 19, 2026