7 Challenges faced by Microfinance Institutions - Finezza Blog (2024)

The majority of developing nations are struck with poverty as a leading roadblock to their progress. The main factor that influences the widespread poverty in regions like India is the massive disparity in income distribution. Being an agrarian economy primarily, more than half of the Indian population sustains on agriculture and allied activities.

Both the manufacturing and tertiary sector have been making steady progress since the last two decades, but still, there is a long way before they outgrow the former. The large agrarian sector of the Indian population seems deprived of formal financial services due to the limited functioning of the tertiary industry. It is an important reason why the agricultural industry has suffered from staggering growth in the past.

The concept of microfinance was introduced in the Indian economy with the primary objective of financial inclusion of more impoverished and backward sections, especially the women. The growth trajectory of the Indian microfinance industry has been phenomenal since the time it was introduced.

Factors like the support of the National Bank for Agriculture and Rural Development (NABARD), linkage of the banking system with the self-help groups have further steered the underserved sectors of the Indian economy towards success through microfinance.

However, when it comes down to comparing the plush success of commercial banks, it is only fair to conclude that there are problems of microfinance in India and it has a long way to go. Not only do microfinance institutions lag in structural and operational approach, but also in overall financial processes.

Here are Challenges facing by Microfinance Institutions

In the article ahead, we discuss the problems of microfinance in India.

1. Over-Indebtedness

The microfinance sector deals with marginalised sections of Indian society intending to improve their standard of living, and thus over-indebtedness poses a severe challenge to its growth. The growing trend of multiple borrowing by clients and inefficient risk management are the most significant factors that stress the microfinance industry in India. The microfinance sector gives loans without collateral, which increases the risk of bad debts. Fast-paced growth needs proper infrastructural planning, in which the Indian microfinance sector evidently lacks.

Further, the lack of any apex control over the MFIs in India is also a leading cause of over-indebtedness. These factors also contributed to the Microfinance crisis of 2008 in India. Over-indebtedness makes the MFIs vulnerable to credit risk and increases the cost of monitoring that they have to incur to stay profitable in the long run.

2. Higher Interest Rates in Comparison to Mainstream Banks

The financial success of MFIs is limited when compared to commercial banks in India. The centuries-old banking system has a strong foothold in Indian grounds and is slowly evolving to meet the needs of the times. Most Microfinance Institutions charge a very high rate of interest (12-30%) when compared to commercial banks (8-12%). The regulatory authority RBI issued guidelines to remove the upper limit of 26% interest on MFI loans.

While many MFI sector players benefited from the RBI guideline update, the borrowers were left for the worse. A massive trend of farmer suicide in states like Andhra Pradesh and Maharasthra is the outcome of borrower indebtedness that resulted from the higher interest rates.

3. Widespread Dependence on Indian Banking System

One of the significant problems of microfinance in India is the widespread dependence on the banking system. Because most microfinance institutions function as registered Non-Governmental Organizations (NGOs), they are dependent on financial institutions such as commercial banks for stabilised funding to carry out their own lending activities. Most of these commercial banks are private institutions charging a higher rate of interest. They also sanction loans for shorter periods. The massive dependence of Indian MFIs on banks makes them incompetent as a lending partner.

4. Inadequate Investment Validation

Another problem faced by microfinance institutions in India is inadequate investment validation. Investment valuation is a crucial capability for the healthy functioning of an MFI. However, due to the developing nature of the markets in which MFIs operate, market activity is often limited. This limitation makes it difficult for MFIs to gain access to market data for valuation purposes. The lack of consistent and reliable valuation procedures hinders MFI management teams from obtaining the quality information they need to make investment decisions effectively.

5. Lack of Enough Awareness of Financial Services in the Economy

A developing country in the making, India has a low literacy rate, which is still more moderate in its rural areas. A large chunk of the Indian population fails to understand the basic financial concepts. There is a severe lack of awareness of financial services provided by the microfinance industry among the masses. This lack of adequate knowledge is a significant factor that keeps the rural population from accessing MFIs for easy credit to meet their financial needs.

It also contributes to widespread financial exclusion in the country. The additional task of educating masses and establishing trust before they initiate loans also falls on the shoulders of MFIs. The severe lack of awareness about policies and products offered by MFIs make it difficult for these institutions to sustain in excessively competitive environments that developing nations are home to.

6. Regulatory Issues

Regulatory issues pose a significant problem of microfinance in India. While the Reserve Bank of India (RBI) serves as the premier regulatory body, it tends to cater more to commercial and traditional banks than it does to MFIs. The needs and structure of microfinance institutions are entirely different from those of conventional lending institutions. Some regulations have benefitted MFIs, but others have left numerous issues unaddressed.

The sporadic and unprecedented regulatory changes result in structural and operational changes, but they also lead to ambiguity in norms of conduct. This sub-optimal performance hinders the development of new financial products and services, emphasising the need for a separate regulatory authority for the microfinance industry.

7. Choice of Appropriate Model

The choice of the appropriate lending model is another problem of microfinance institutions in India. Most Indian MFIs follow the Self-Help Group model (SHG model) or the Joint Liability Group model (JLG model) of lending.

However, the selection of the model is often based on random choices rather than scientific reasoning or considering the situation. This increases the risk of borrowings for the weaker section beyond what they can bear, and once the decision is made, it becomes irreversible. The choice of the model significantly affects the long-term sustainability of the MFI organisation.

Conclusion

Although it has come a long way, the microfinance sector in India still faces several challenges. The problems of microfinance in India can be addressed with the help of technological aid, enabling the sector to advance loans to the rural populace more effectively.

Finezza lending management solution is a well-integrated software solution for microfinance institutions and NBFCs. The software solution helps MFI access world-class banking capabilities to match up and compete efficiently with the performance of mainstream commercial banks. The 360-degree suite not only provides the lenders with a wholesome view of the borrower to aid in balanced decision making, but the use of AI and ML technologies also makes the process further risk proof.

The use of alternate data makes it easy to offer loans to the rural population with inadequate credit history and helps reduce over-indebtedness. The software tool can also generate customized product recommendations for borrowers to suit their needs. Finezza also helps with regulatory compliance of processes.