Moneycontrol Pro Panorama | Karnataka’s rural debt crisis: A brewing storm

-

Dear Reader,

A report from Incred Equities dated March 24 reaffirms the fears that not all is well in India’s microfinance sector, particularly in states like Karnataka, which is facing a crisis that could potentially disrupt the state’s financial ecosystem.

What was once considered a relatively stable market for microfinance institutions (MFIs) is now showing alarming signs of distress, with a fresh wave of bad loans expected to reach high single-digit to early-teen levels.

This surge is being driven by three key factors: overleveraging, sub-lending, and an arguably ill-conceived state government ordinance that can potentially throw the sector into chaos.

At first glance, Karnataka's MFI sector appeared to be holding steady. In the third quarter of FY25, asset quality in the state was among the best in India, with early-stage delinquencies in the 30-90 days past due (DPD) bucket only creeping up marginally.

However, ground-level assessments by private agencies paint a very different picture.

Lenders turn cautious

Lenders have adopted an extremely cautious approach, limiting fresh disbursements and focusing heavily on collections. Even among existing borrowers, renewal rates have plummeted to 30-40 percent as MFIs enforce stricter eligibility norms.

The latest quarter, Q4 of FY25, is proving to be a turning point, as stress levels have spiked sharply. A surge in overdue accounts suggests that many borrowers—already burdened with multiple loans—are now struggling to meet their repayment obligations.

The most concerning trend is the rise in sub-lending, where borrowers take loans from MFIs, but channel the funds into high-risk informal lending, often at exorbitant interest rates. This practice not only distorts repayment cycles, but also exposes MFIs to systemic risks that are difficult to quantify.

The recent state government ordinance has only made matters worse. Instead of stabilising the sector, it has sowed confusion among borrowers and lenders alike.

Many borrowers are now under the mistaken impression that loan repayments are not mandatory, leading to a sharp decline in collection efficiency. This reflects a dangerous trend: political interventions that undermine financial discipline often have unintended consequences, and Karnataka’s current situation is a textbook example of how poorly conceived policy changes can backfire.

Who is holding up? 

According to the Incred Equities report, while broad-based stress is visible across the board, some players are better positioned than others. CreditAccess Grameen (CREDAG), the largest MFI in Karnataka with a 21 percent market share, has maintained weekly collections and a structured lending approach.

Its customer base consists largely of seasoned borrowers who have weathered previous financial crises, including the Andhra Pradesh MFI collapse, demonetisation, and the COVID-19 pandemic. This experience has instilled a greater sense of financial discipline, helping CREDAG manage risk better than its peers.

On the small finance bank (SFB) front, Ujjivan SFB stands out for its relatively higher ticket sizes and a monthly collection model, which aligns well with borrower preferences. The bank’s strong underwriting framework has kept it somewhat insulated from the worst of the crisis though it is not immune to the broader market stress, as per Incred Equities.

So, what’s next?

With new borrower additions effectively frozen and existing disbursements tightly controlled, the next two quarters will be critical to Karnataka’s MFI sector. If the policy missteps are not corrected quickly, delinquencies will continue to climb, further eroding lender confidence.

The long-term outlook will depend on how well MFIs can navigate the twin challenges of slowing disbursements and rising defaults. While some lenders are bracing for a difficult period, others are looking at this crisis as an opportunity to reinforce stronger credit discipline. One thing is certain—this is not a market for the faint-hearted.

In the coming months, all eyes will be on how MFIs respond to this crisis. The Karnataka experience could serve as a lesson for the rest of India’s microfinance sector, underscoring the need for better risk management, smarter policy interventions, and a more disciplined approach to lending.

Why is this important?

What happens in the MFI loan industry will have a bearing on the larger financial system. MFIs predominantly source money from the banks and have significant interlinkages with other non-banks as well. More than that, any deterioration in credit culture in the MFI space will have a cascading effect on rest of the lending system. Hence, for investors, caution is warranted.

Also, don’t miss this piece today in MC Pro by my colleague Aparna Iyer who raises a valid question-- Are NBFCs back to being reckless in unsecured retail lending?

In her piece, Iyer argues that unsecured lending showed increased growth among NBFCs in the third quarter of FY25 and that especially small ticket loans have begun to rise again.

Investing insights from our research team

Does this mid-sized private bank offer good risk-reward potential?

Control Print: Are all the concerns priced in?

SBFC Finance: How justified is the valuation of this stock?

What else are we reading?

Data at a glance: Who are the market leaders in this rally and why

The key drivers behind March's market rally

Chart of the Day | Will RBI's new priority sector lending guidelines make a difference?

Is a beneficial tariff deal on agriculture with the US possible?

Data at a Glance: Will realty firms achieve pre-sales guidance for FY2025?

Trumponomics is putting lipstick on a policy pig (republished from the FT)

China’s military industrial complex has quality issues. Self-reliance is some way off

It may be premature for India to mandate emissions trading

Salary hike for MPs: A pragmatic move, not an arbitrary decision

The tragedy of Nagpur, a bastion of cosmopolitanism

Markets

Trump Tariff, FIIs Selling Small-cap Correction – What’s next for investors? A star fund manager breaks it down

Tech and Startups

IndiaAI Mission: MeitY invites firms to contribute datasets for AIKosh

Technical Picks: AUBANK, KPITTECH, ONGC, UFLEX, GRASIM