In today's Finshots, we tell you why the RBI has advised microfinance lenders to ease up on loan approvals in Uttar Pradesh and Bihar.

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The Story

Roopa is a small vegetable vendor in a bustling market. She dreams of expanding her business by buying more stock (not the kind you're thinking about) and perhaps setting up a proper stall.

Her biggest hurdle?

Money.

Traditional banks won’t lend to her because she has no credit history or collateral to offer. And that’s where Microfinance Institutions (MFIs) step in.

MFIs provide small unsecure or collateral-free loans to low-income folks, typically those with annual household earnings of ₹3 lakhs or less. These loans help micro-businesses like Roopa’s, get the capital they need to grow.

While that sounds great, microfinance has been growing at a breakneck speed in the states of Uttar Pradesh (UP) and Bihar of late. For context, these states account for over a quarter of total microfinance loans across the country. And have been among the fastest-growing states in terms of Assets Under Management (AUM) or the total value of loans that MFIs have disbursed since 2019. This makes sense, considering that their combined per capita incomes in FY23 were about 30% lower than the national average of ₹2 lakhs, according to official data for 22 states and union territories.

But this rapid spread has caught the RBI’s (Reserve Bank of India’s) eye. A few days ago, it sounded the alarm about microfinance lenders moving too quickly and advised them to ease up on loan approvals in Bihar and Uttar Pradesh.

Why is it worried, you ask?

Let’s take it from the top.

After India gained independence in 1947, most people worked in informal sectors. And banking services were limited to a privileged few. For decades, those needing capital had to rely on local moneylenders, who often charged exorbitant interest rates, sometimes as high as 100% on small loans.

But things began to take a turn in the late 1980s with the rise of microfinance, thanks to the National Bank for Agriculture and Rural Development (NABARD). NABARD laid the foundation for formal microfinance operations through Self-Help Groups (SHGs). This meant that small groups with similar economic backgrounds would pool their savings together and lend to others in need. This opened doors for people in rural and semi-urban areas previously ignored by traditional banks. In short, it was a game changer.

Soon private players saw microfinance as a lucrative sector and hopped onto the bandwagon. They were backed by private equity investors who poured money into their businesses. Their profit margins were great too. They borrowed from banks at annual interest rates of up to 14% and loaned them out at 24% or more. It was a win-win for banks as well, since it helped them meet their targets for lending to economically disadvantaged sections or what’s known as priority sector lending.

MFIs began spreading across the country, especially in states like Maharashtra, West Bengal, Odisha, UP and Bihar.

But Andhra Pradesh was at the forefront, thanks to strong support from its state government. By 2010, over a third of the 30 million households using microcredit in India, were in Andhra Pradesh. Not just that, SKS Microfinance (later Bharat Financial Inclusion and now merged with IndusInd Bank), which was India’s largest MFI at the time and headquartered in Andhra Pradesh, became the first MFI to conduct an initial public offering in 2010. Its shares were oversubscribed, and prices rose rapidly, signalling the golden age of microfinance.

But beneath all these developments, a storm was brewing.

Reports of people taking their own lives due to predatory loan recovery practices by commercial MFIs emerged in the state. Many borrowers struggled with high interest rates, some as steep as 80-100%. With half of the state’s microfinance portfolio in Krishna district, this became known as the Krishna Crisis.

Since MFIs weren't regulated by the RBI back then, the state government had to step in to fix the damage. It passed something called the AP Microfinance Ordinance to regulate MFIs and protect borrowers. This included mandates on operational transparency and seeking government approval for new loans.

Political opposition encouraged borrowers to stop repayments, causing chaos for MFIs. Their liquidity plummeted, banks stopped lending to them, and loan collection rates dropped from 99% to 20%. Private equity firms lost interest in funding MFIs too.

So, in effect an ordinance meant to protect borrowers, ended up harming both MFIs and those who depended on microloans. With banks requiring substantial earnings and proof of income tax returns, many of them were left with no choice but to return to private lenders, facing high interest rates once again. And it seemed like everything had come full circle.

It was then that the RBI took notice and set up a committee to strengthen regulatory requirements for these MFIs, creating a new category of Non-Banking Financial Companies Microfinance Organisations (NBFC MFIs) to ensure they were within the RBI's purview.

Cut to today, the RBI is worried that microfinance lenders in UP and Bihar might fall into a similar trap of massive lending to subpar borrowers.

And you can't brush off its concerns because it's backed by some scary proof. To put things into perspective, CRIF Highmark's quarterly reports on microlending in India for FY24 showed that, on average, nearly 10% of microfinance borrowers in UP and Bihar had loans from three or more lenders.

So you can imagine why the RBI is concerned.

But yeah, the Andhra Pradesh Crisis happened because of reckless lending by MFIs. And things might be different this time though, as the Microfinance Institutions Network suggests that the bad loan ratio (the ratio of loans unpaid for over 90 days) for FY24 has dropped to about 8% from 9% last year.

However, since this decrease might just be a slight dip, the RBI is keeping a close watch. And you can bet that it'll step in if things start going south again. Don’t you agree?

Until next time…

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