Microfinance, Financial Inclusion and Inclusive Growth

Posted in Finance Articles, Total Reads: 8375 , Published on 03 January 2011

Microfinance refers to a broad range of financial services, primarily credit, made available to people who don’t have access to formal banking services. Normally, these services would be required in areas with small population and ‘ticket-size’ entailed would also be relatively smaller (factors making banks’ presence unviable). Therefore, Micro-financial institutions (MFIs) facilitate the reach of financial services at a more ‘micro’ level.

What was being praised for its positive societal impact is today attracting flak for being profit driven.  But is this change of opinion justified? Does Microfinance make a meaningful societal impact or is it a over-hyped phrase? Is the dichotomy between ‘social good’ and ‘profit-motive’ indispensable? In the light of these questions that are all over the place today, this article attempts to provide a perspective.


Why microfinance makes sense?

Cost-effectiveness (Believe it or not!)

o Money lenders charge exorbitant rates (50-100% p.a.) and the lending too is normally secured by land/ property; So if crops fail, the farmer loses his income (crop proceeds) as well as his asset (land)

o Commercial Banks charge much lower officially viz. 6-8% p.a. but the overall cost to the borrower far exceeds this number

o Loans can be rarely availed without kickbacks to credit officers

o Borrower has to make multiples visits to the distantly located bank branches. A normal process would require him to visit the bank, once each for understanding the process, completing the documentation, getting disbursement and subsequently for each drawdown/ repayment

Better monitoring of end-use of funds; Improved Credit Discipline

o MS Swaminathan Committee highlighted that defining end-use of funds was crucial to ensuring farmers’ prosperity.

When a farmer takes a loan to (allegedly) buy seeds/ fertilizers/ tractor, he can still use the credit to fund his daughter’s wedding/ dowry (debt fueling consumption). The SHG model of lending used by MFIs ensures that funds are used for the purpose that they were first availed (debt facilitating creation of productive asset) and therefore foster improved credit discipline.

o More than 99% of the outstanding MFI-generated credit is still categorized under ‘standard’ or performing loans, much higher than corresponding ratios (in food credit) for any banks

Vital tool for Financial Inclusion

o Financial Inclusion is key to inclusive growth and the role played by MFIs in the process leading to employment generation and sustenance cannot be over-emphasized

o Banks lend to MFIs to fulfill their Priority Sector Lending (PSL) targets - 40% for Domestic banks, 32% for Foreign Banks  - and MFIs use those funds for onward lending

o MoF and RBI’s credit policies constantly pressurize as affirmative action has resulted in all banks preparing a 3-year target-driven roadmap for enhancing and strengthening financial inclusion

o This development is also in sync with RBI/ MoF’s views that the banks reach out to the segment which is currently being served by MFIs and the MFIs start targeting those who are now dependant on private money lenders

o Although Micro-credit commands the lion’s share, Micro-finance also includes Micro-savings (generates income for savers and channels savings into productive uses) and Micro-insurance (Crop insurance, cattle insurance, etc.) both of which are vital tools in financial intermediation and consequently financial inclusion

Are For-profit organizations bad?

‘High’ rate of interests

o Although there is a case for capping interest rates and regulating the MFIs (which is likely to happen soon), the high rate of interest is needed to cover

o cost of funds (remember, MFIs don’t have access to low cost CASA funds),

o cost of service (MFI agents visit the borrower for all his requirements and the borrower is required to visit the office only once), and

o higher level of risk (lending in not secured by borrowers’ immovable property)


o Profits are needed to make the model self-reliant and robust and to incentivize innovation, both of which are crucial to a more sustainable (MFI) business model

Why then did MFIs get into trouble?

Possible triggers :

Huge rally in the first few months of SKS Microfinance shares (SKS IPO hit markets in July 2010) perhaps prompted greed which lead to an unpleasant battle in which CEO was ousted and the Chairman returned to executive role. This public display of boardroom battle (in which the outgoing CEO is also reported to have been offered a valuable golden parachute) severely dented the perception of MFIs.

Political maneuvering of Suicides in Andhra Pradesh (by borrowers)

o None of the borrowers who committed suicide had defaulted on their loan payments (as told by Chairman, SKS)

o We have long known that most farmer-suicide cases have been reported in Telangana, Vidarbha and Bundelkhand, mostly due to failed government machinery and wrong-doing on the part of money lenders. Compared to the latter, MFIs were easy scapegoats for Andhra Pradesh politicians

Silver lining

Government and RBI will use this opportunity to bring MFIs under regulatory ambit before they pose any signs of systemic risks

MFIs will be forced to innovate to lower costs for borrowers and what would finally emerge should be a win-win situation

Given the concentration risk involved in banks lending solely to MFIs to fulfill their PSL targets, banks will be forced to use alternative means to disburse credit to the rural household in general and farmers in particular

To be avoided

Statements by legislators and executives provoking borrowers not to repay loans

o This has the potential of undoing the credit discipline that takes years to get fostered

o If MFIs default on their loan, it may cause more than hic-cups in the Indian Banking System

Financial Inclusion is a process which leads to a system wherein every individual has access to financial services (primarily credit and savings); alternatively, a system where no one is excluded from basic financial services. Greater access to financial services enables more effective and efficient availability/ deployment of capital thereby generating livelihood, alleviating poverty, improving access to basic health & education requirements and fostering entrepreneurship – the tenets of sustainable growth. Micro-finance is a significant and sustainable way of bringing greater financial inclusion and, consequently, more inclusive and sustainable growth.

About the Author : Ashwini Kumar is an analyst with a leading ratings, research and policy advisory firm. Views are personal.


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