The term "microfinancing" was coined during the growth of Bangladesh's Grameen Bank in the 1970s, founded by Muhammad Yunus.

Microfinance plays a crucial role in providing credit access to rural citizens and small entrepreneurs, promoting balanced and inclusive growth. To address the issues, the government must step in and support the sector.

What is Microfinance?

• Microfinance provides small loans and other financial services to poor and low-income households.
• The definition of "small loans" varies, and in India, loans below Rs. 1 lakh are considered microloans.
• Institutional channels - (i) Scheduled commercial banks (SCBs) (including small finance banks (SFBs) and regional rural banks (RRBs)), (ii) cooperative banks, (iii) non-banking financial companies (NBFCs), and (iv) microfinance institutions (MFIs) registered as NBFCs.
• Components of Microfinance: Microcredit, Micro Insurance, Micro Saving

Microfinance Sector in India- Present Status

• Contribution to GDP: Around 2 % of India’s GVA in 2018-19. 
• Growth: Witnessed growth of over 13 percent in the last quarter of fiscal year 2021-22; year-on-year (YoY) growth stood at 5 percent.
• SHG-Bank Linkage Programme: Covers around 15 crore families through SHGs (around 87% of which are women).
• Employment: to 13 million jobs (direct and indirect). 
• Portfolio: 78 percent coverage in rural areas and 22 percent in urban areas. 

About Microfinance Institutions (MFIs)

• The microfinance sector in India has experienced rapid growth, serving approximately 102 million accounts, including those held by banks and small finance banks.
• Various providers, including NGOs, cooperatives, banks, and telecommunication companies, offer microfinance services.
• NBFC-MFIs in India are regulated by the Non-Banking Financial Company - Micro Finance Institutions (Reserve Bank) Directions, 2011.
• Major Business Models - Joint Liability Group, Self Help Group, Grameen Model Bank, Rural Cooperatives 

Significance of Microfinance in India

• Credit to Low-Income Borrowers
• Collateral-Free Loans
• Financial Inclusion
• Income Generation
• Women Empowerment
• Rural Development
• Encourage Self-Sufficiency and Entrepreneurship

Challenges of Microfinance in India

• Fragmented Data: While loan accounts have increased, data on MFI clients' poverty-level improvement remains fragmented, making it difficult to assess microfinance's impact on poverty reduction.
• Limited outreach - Penetrating remote rural regions with financial services remains a challenge due to inadequate infrastructure, connectivity, and low levels of financial literacy.
• For Ex. MFI outreach in India is extremely low, at only 8%, compared to 65 percent in Bangladesh.
• Higher Rate of Interest than Mainstream Banks – According to a report by the Reserve Bank of India (RBI), average interest rate charged by microfinance institutions (MFIs) in India ranged from 20% to 26%, which is higher than the rates charged by traditional banks (8-12%).
• Impact of Covid-19: The MFI sector has been affected by the pandemic, with collections initially declining and disbursals facing challenges.
• Overlooking social objectives: In pursuit of growth and profitability, some MFIs may overlook their social objective of improving the lives of marginalized communities.
• High operational costs: Study conducted by the Reserve Bank of India, it was found that operational expenses constituted around 25-30% of the total expenses for MFIs.
• Over indebtedness: Borrowers taking loans from multiple microfinance institutions (MFIs) and informal sources can lead to a debt trap. 
• For Ex. Andhra Pradesh microfinance crisis in 2010 occurred due to aggressive lending practices and coercive recovery methods, leading to borrower distress.
• Loans for Non-income generating purposes: Loans used for non-income-generating purposes may exceed the regulatory limit of 30%, trapping borrowers in debt.
• Financial illiteracy: Lack of awareness about various MFIs and their services due to financial illiteracy hampers the participation of the economically disadvantaged.
• Inability to generate funds: MFIs face difficulty raising sufficient funds due to their not-for-profit nature, limiting access to private equity investors and other market-based sources.
• Heavy dependence on banks: Around 80%  of the  Microfinance institution's funds came from commercial banks.

Way Forward

• Regulation: Establishing a comprehensive regulatory framework for the Microfinance sector instead of reactive initiatives is essential due to its significant expansion.
• Strengthen Credit Assessment and Risk Management: To mitigate the risk of over-indebtedness and ensure that loans are provided to borrowers who can repay them.
• Interest Rate Transparency: MFIs should transparently inform borrowers about interest rates and additional charges levied on loans.
• Encourage Microfinance Penetration: Providing financial assistance to MFIs to open new branches in areas with low Microfinance penetration will increase outreach.
• Expand Product Range: MFIs should provide all financial products and non-financial services to underserved populations.
• Use of Technology: Adopting new technologies, IT tools, and applications can help MFIs reduce operational costs.
• Diversify Funding Sources: To finance their loan portfolios, MFIs should consider becoming a for-profit company (NBFC).

Conclusion

Microfinance institutions support marginalised people and inclusive growth. To maximise impact, establish comprehensive regulations, ensure interest rate transparency, encourage expansion in underserved areas, diversify product offerings, leverage technology, and explore diverse funding sources.