In today’s Finshots, we tell you what’s holding MUDRA loans back.

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The Story

We last talked about MUDRA loans a while ago, but let’s get everyone on the same page with a quick refresher.

The Micro Units Development and Refinance Agency (MUDRA) scheme was launched in 2015 with much fanfare. It was meant to be a panacea for India’s small entrepreneurs, the mom-and-pop stores, the small-time traders and the street vendors. The scheme’s goal was simple ― provide collateral-free loans to the underserved. Loans that would help tiny businesses flourish and boost the economy from the grassroots level.

And it seemed like a good plan. It aligned well with the government’s goal of fostering financial inclusion, entrepreneurship and generating employment.

These loans were categorized into three types – Shishu (loans up to ₹50,000), Kishore (₹50,000 to ₹5 lakhs) and Tarun (₹5 lakhs to ₹10 lakhs), each offering different levels of financial assistance.

What has changed since then?

Well, a few things but nothing much, really.

MUDRA loans are definitely getting traction. Disbursements have risen from ₹3.3 lakh crores in FY22 to about ₹4.5 lakh crores in FY23. The number of accounts receiving these loans has also increased by 15%, reaching 6.2 crore. So yeah, people are getting the funds they need.

But these loans are causing headaches for banks, especially public sector banks (PSBs) and regional rural banks, who have been disbursing a large chunk of these loans. By October 2024, most PSBs had disbursed only 42% of their MUDRA loan targets for FY25. That’s a huge shortfall considering the government’s ₹2.3 lakh crore disbursement goal.

And that begs the question – what’s wrong here?

First, there’s the classification issue. Most MUDRA loans fall under the microfinance category, which is in quite a pickle. Non-Performing Assets (NPAs) are on the rise, and profits are declining. For context, in the first half of FY24, gross NPAs rose by 32%, compared to a 32% fall the year before. That’s a lot of loans not being repaid on time.

And it might be scaring the banks simply because the microfinance model works on trust, and MUDRA loans don’t have collateral backing them up. As that trust begins to wobble, the consequences can be dire, with rising NPAs leaving banks holding the bag.

Another issue is the government’s recent move to increase the upper limit for MUDRA loans from ₹10 lakhs to ₹20 lakhs in the Tarun (now TarunPlus) category. While this is great for small entrepreneurs needing more capital, it’s a different story for banks, who take on more risk. And given their past challenges with defaults, banks are understandably hesitant.

Fraud is another big problem. The easy, collateral-free money has attracted dishonest individuals. There have been cases of loans taken for ghost businesses or misused for personal gains. The RBI has even stepped in, debarring some microfinance companies, and cracking down on “evergreening”, where new loans are used to pay off old ones, giving the illusion that everything’s fine even when it’s not.

So, banks are in a tricky position. On one hand, they have government-set targets to meet. On the other, they have shareholders to answer to and balance sheets to keep healthy.

At this point, you’re probably wondering ― why do these concerning situations occur in microfinancing in the first place?

Look, the microfinance model relies on group lending, where members share responsibility for each other’s loans to promote financial inclusion, especially in rural areas. But when the community faces challenges, like a poor harvest or economic downturn, defaults are inevitable. And since these loans are unsecured, lenders have no collateral to recover.

This causes a ripple effect. Microfinance companies struggle, banks take a hit and genuine borrowers find it harder to access credit.

Maybe that explains why the MSME sector pointed out to the RBI that around 300 loan cases, including MUDRA loans, are pending at banks, preventing entrepreneurs from accessing much-needed funds.

So, what’s the way out for MUDRA loans, you ask?

Well, banks are taking notice of these backlogs. And their first suggestion is to reduce the targets set by the government for MUDRA loans. After all, with lower targets, comes lower disbursements, and consequently fewer defaults, yes?

Sure. But here’s the thing. The TarunPlus scheme is moving in the opposite direction. The increasing loan limits could mean bigger loans to be disbursed and eventually higher targets for lenders. So, pushing banks to meet disbursement goals without considering the challenges they face might prove counterproductive. It leads to poor lending practices and ultimately, higher NPAs.

Another suggestion that comes from Finance Minister, Nirmala Sitharaman is looking for better credit risk assessment models. One such model is cash-flow-based lending, which essentially means rolling out loans based on the borrower’s income cash flows.

A somewhat similar suggestion came from a senior official from the largest PSU lender SBI as well — banks need to connect with borrowers at the grassroots level. This means improving financial literacy among borrowers, helping them understand how bank loans, interest and repayments work.

These are solid suggestions, but they don’t hold up great when targets for loans are high and the processing is too easy. In fact, as an article from The Wire puts it:

The finance minister has been giving targets to the government-owned banks which are also forced to lend to non-banking finance companies for on-lending and co-lending. In many places, the ruling party cadres tell the borrowers that this is a gift and not to be repaid. So, NPAs are increasing and banks are writing off 25% and claiming 75% from the Credit Guarantee Fund. But the borrower’s CIBIL score gets affected. Most of them are wilful defaulters. Now they can pay a little, clear the CIBIL score, and borrow again.

This essentially means that the government sets loan targets for banks, pushing them to lend quickly, sometimes without enough checks. Banks also end up lending to non-banking finance companies (NBFCs) to indirectly reach more borrowers. Some borrowers are even told by political leaders that they don’t need to repay, leading to confusion and more unpaid loans (NPAs). When these loans default, banks use a system called the Credit Guarantee Fund to recover their money, writing off 25% of the loan and claiming 75% from the fund. However, the borrower’s credit score (CIBIL score) still gets affected. Many borrowers who intentionally don’t repay (willful defaulters) can game the system. They pay off just enough to clear their credit score, then take out new loans, continuing the cycle of defaults.

And that’s how the banks and the loans end up in the same soup again.

Nevertheless, the cat is out of the bag, and both governments as well as banks know what’s going on with these loans. After all, they’ve disbursed over 50 crore loans worth over ₹31 lakh crores since the scheme’s inception in 2015.

And there’s improvement on the NPA front too, which has declined from 4.7% in FY21 to 3.4% in FY23 for MUDRA loans.

So yeah, banks have been on a learning curve. They’re tightening processes and trying to improve their performance. The government and the RBI are stepping in to provide guidance and oversight too. And who knows, with some promising tweaks and improvements, we might just get MUDRA loans back on track. What do you think?

Until then…

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