Imagine being stuck in a deep hole, desperately trying to climb out but constantly slipping back down.
That's how many low-income individuals feel when they turn to microfinance institutions (MFIs) for financial help. These institutions were created to lift people out of poverty but in many cases, have resulted in pushing them deeper into debt.
In this blog, we'll explore the current state of microfinance in India, its flaws and what needs to be done to fix this system.
What is microfinance?
For all practical purposes, microfinance refers to micro-credit or small loans. Microfinance Institutions (MFIs) provide small loans and financial services to low-income groups, aiming to help them work their way out of poverty and facilitate financial inclusion.
As a category of financial services, MFIs cater to individuals and small businesses who lack access to conventional banking systems. In a way, it is designed to reach people excluded by the formal banking system of India.
The Indian MFI landscape
In principle, a microfinance loan is a collateral-free loan given to a household with an annual income of up to ₹3 lakh or under.
This loan needs to be at an affordable cost to allow rural people to access financial services. However, in a contrasting development, the RBI removed the interest rate cap on MFI loans. This means lenders can charge interest at their own will until it is not usurious though the RBI doesn't give a clear definition of what would be a usurious loan. However, to balance this out, the classification for eligibility to avail of a microfinance loan has been revised to an annual household income level of ₹3 lakhs.
The MFIs charge an average interest rate of 15% to 27% for these loans which itself is very steep compared to the average ROI charged by the Public Sector Banks which varies from 7% to 11% for these small loans.
Microfinance, despite its long journey and initial promise of poverty alleviation and empowerment, has faced numerous challenges that have hindered its effectiveness and raised concerns about its impact. We have shed light on these challenges and prompted a deeper examination of the operating model of Microfinance Institutions (MFIs).
Three key concerns :
Lack of agency for the communities
The lack of agency has inadvertently created a situation where communities become habitual borrowers, often without carefully considering the implications of their borrowing decisions.
In the joint liability group model, borrowers are organized into small groups, and each member is responsible for the repayment of their own loan as well as the loans of their fellow group members.
This system was initially intended to foster peer monitoring and ensure repayment discipline. However, it has resulted in a collective liability that can lead to undue pressure and limited control for individual borrowers.
Under this model, borrowers often find themselves compelled to take out new loans to repay existing ones, looping in a cycle of debt. The pressure to keep up with repayment schedules and maintain their standing within the group can leave borrowers with little choice but to continue borrowing, even when they may not have a clear plan for utilising the funds or the means to repay them.
Moreover, b. Many borrowers may not fully understand the terms and conditions of their loans, including the interest rates and repayment obligations. This lack of understanding further limits their agency and ability to make informed decisions.
The result is that communities become trapped in a cycle of borrowing without critically assessing the long-term consequences. Rather than utilising microfinance as a tool for productive investment or income generation, individuals often borrow simply to meet their immediate needs or to repay previous loans. This lack of agency perpetuates the cycle of indebtedness and hampers the ability of borrowers to break free from the constraints of poverty.
Lack of choice
In the current microfinance model, borrowers are often subjected to predetermined loan cycles and repayment schedules that may not align with their specific needs or financial circumstances. This standardised approach overlooks the diverse and individualised requirements of borrowers, limiting their agency and forcing them into borrowing patterns that may not be optimal for their situations.
This lack of choice hampers their ability to determine their borrowing preferences, resulting in individuals borrowing even when they do not have a genuine need.
It also prevents borrowers from accessing more favourable loan terms or exploring alternative options that may better suit their needs.
MFIs need to offer borrowers the freedom to determine the loan amount based on their specific requirements and repayment capabilities. This approach enables borrowers to borrow only the necessary amount, minimising the risk of overborrowing and potential debt traps.
Furthermore, Borrowers should have the opportunity to align their borrowing activities with their financial goals and obligations. For instance, they should have the freedom to borrow when they truly need the funds and for a duration that suits their repayment capacity.
Harsh Recovery Methods The third criticism of microfinance in India is the harsh recovery methods employed by some lenders. Because microfinance loans are typically unsecured, lenders have few options for recourse if borrowers default on their loans. This has led some MFIs to use aggressive tactics to recover their money, including harassment, intimidation, and even violence. In some cases, borrowers have been driven to suicide as a result of the pressure put on them by debt collectors.
Back in 2012, SKS, - a big microlender in the state of Andhra Pradesh was criticized by human rights groups and lawmakers there in 2010 after local media reported more than 200 suicides linked to over-indebtedness.
While microfinance was originally intended to empower the poor and provide financial inclusion, it has become clear that the current system is far from perfect.
The Rang De way of revolutionising credit for underserved communities
In the context of credit and impact, it is important to recognize that credit itself does not inherently create impact. Instead, credit serves as an enabler or facilitator of impact by providing the necessary financial resources for individuals or businesses to engage in productive activities.
Rang De does not lend money simply for the sake of lending but rather focus on supporting underlying productive activities that have the potential to create positive social and economic impact.
Our Impact Partners who facilitate market linkages, infrastructure and capacity building, ensure that capital is not used as a cash flow instrument by the borrowers but as a means towards generating sustainable income sources.
Often borrowers aren't sure to decide the loan amount they need or the repayment tenure. Our Financial literacy program - ‘Swabhimaan’ enables them to make sound financial decisions which give way to more responsible borrowing. Under this program, not only do first-time borrowers become well-acquainted with using their bank accounts and banking products but also helps them with highly contextual knowledge of how they can use their money better.
In addition to providing financial literacy and promoting responsible borrowing, there's another dimension that we consider - 'Choice Architecture' for the borrowers. This empowers borrowers to design loan products that fit their unique circumstances and livelihood activities.
Instead of fitting into rigid, pre-defined loan structures, Rang De provides borrowers the flexibility to determine how much they want to borrow, for how long, and under what terms.
They could effectively tailor their loans to align with their income cycles, reducing the risk of overborrowing and non-repayment. This customization not only grants greater control to the borrowers but also aids them in leveraging credit for their livelihood activities, acting as a force multiplier.
Rang De's approach aligns with the understanding that credit when channelled towards productive ventures, can create a ripple effect of positive change. The loans provided by Rang De are carefully assessed and directed towards borrowers who have demonstrated their commitment and capacity to utilise the funds effectively, thereby maximising the potential for impact.
To date, more than 8000+ social investors have made it possible for Rang De to disburse more than ₹52 crores in loans to rural entrepreneurs, farmers and artisans since September 2019.
You can invest in rural entrepreneurs at rangde.in and save them from the exploit of MFIs.