Banking Central | Pushing credit to borrowers beyond capacity sets off stress alarm on small loans

Microfinance Industry is witnessing early signs of borrower overindebtedness

A big stress is building up in small loans across the country mainly because of aggressive lending and a decline in rural earnings.

Trends from some key small loan markets in India reveal that lenders have been pushing for credit to the same borrowers to inflate their loan books without reviewing their capacity to repay. Microloan market has been hit hardest because of such practices, while cooperative banks are closing in on. A weakness in rural economy and a tepid job market are also driving the borrowers to delay their payments.

Microfinance industry veteran Padmaja Reddy, who is also the managing director of Keertana Finserv Pvt Ltd, openly spoke about this problem in a recent interview. She criticised the industry practice of extending excessive credit to the same borrowers and warned against the high concentration of lenders in specific regions. Reddy believes the current stress in the sector results from borrowers pushing back against MFIs. “They’re frustrated with being treated as tools for profit by MFIs,” she said.

In some cases, Reddy pointed out, that a single borrower carries up to 12 loans with different repayment schedules—weekly, fortnightly, and monthly. Borrowers often don't even know the MFIs involved; they simply refer to "two weekly loans", "four fortnightly loans", and "six monthly loans". This suggests a disturbing trend. "These are warning signals that the regulators and governments must look into," said the veteran.

Microloans are a favourite for all lenders. These are high-margin loans where the demand is always high. It makes both non-banks and big banks aggressive about lending to MFI borrowers. As a result, the MFI loan growth has been high in the recent years. But the overleveraged borrowers are now at their wits' end.

A lot of this credit push comes from the pressure on banks to meet the priority sector lending (PSL) norms. Banks are mandated to lend 40 percent of their credit to economically weaker sections, including agriculture, microcredit and women. To meet this target, they often push money to MFIs. In the interview, Reddy criticised this approach and said PSL norms need to be relooked.

“It is surprising that PSL classification is based on the legal status of the lending entity, rather than the income of the borrower,” Reddy said. For instance, if an NBFC-MFI extends a loan to a BPL (below poverty line) customer, it qualifies as a priority sector loan, whereas if a regular NBFC does the same, it is not priority sector lending, Reddy explained. Additionally, banks follow less stringent criteria when lending to NBFC-MFIs than to other NBFCs, despite being aware of the over-leveraging issues in this sector.

Reddy has a strong point here. Banks often lend to MFIs without stringent rating requirements, primarily driven by the PSL norms, which incentivise lending to MFIs regardless of market saturation or borrower debt levels. In addition to MFIs, banks, cooperative banks, small finance banks, and NBFCs now operate in this segment, which was once considered non-creditworthy. This shift in the landscape calls for an urgent reassessment of PSL norms.

Not so long ago, India Ratings and Research warned about the increasing household leverage of microloan borrowers. The agency said it will monitor the sector over the next 2-3 quarters to see if a planned course correction could contain the risks.

The situation, however, turned more precarious with microlenders becoming over-aggressive in loan growth in the post-pandemic period. The removal of interest rate caps by the RBI in March 2022, the ease of funding from banks to non-banks, and a growing need for priority sector loans substantially orchestrated the growth in disbursement by existing MFI lenders in FY24.

This, coupled with the ease of technology, has improved the reach of credit to the bottom of the pyramid after Covid, also raising a concern on the repayment capability of the MFI borrower.

The lending industry will have to act against the signs of stress. In the first quarter of financial year 2025, the MFI segment saw challenges in the form of lower collections, leading to higher delinquencies as well as a slowdown in assets under management (AUM) growth.

Also, a strong above-industry growth over FY22 to FY24 has led to overheating in some states, India Ratings said. The microlending books in Bihar and Uttar Pradesh grew at a significant pace over the last three-to-four years clocking at a CAGR of 30.5 percent and 35.7 percent over FY22-FY24, as compared to the overall microfinance sector average growth rate of 18.1 percent.

The MFI industry bodies have acknowledged this problem and have given a call to microlenders to cut down on risks by capping the maximum number of microlenders per borrower at four and the maximum MFI indebtedness per borrower. One needs to wait to see how these measures play out.

Banking Central is a weekly column that keeps a close watch on and connects the dots regarding the sector's most important events for readers.