Tuesday, March 15, 2011

Microfinance in India Part 1

I read an article in The Hindu last week about the state of Tamil Nadu shielding its women from exploitative practices of Microfinance institutions. I found the content of the article thought provoking. While, I understand the economics of microfinance, I am only learning about India’s microfinance sector, thus the following post is heavily sourced. At the end of the post you will find sources which I used for this post.

Introduction and History
Some of you may have read about the microfinance credit crisis in India’s state of Andhra Pradesh in 2010 as well as the recent retirement of Mohammad Yunus, a Bangladeshi financier that created one of Asia’s most prominent micro lending institutions – the Grammeen Bank. India’s regulatory authorities, both state and national are working on instituting a package of new regulation which is supposed to both protect the consumers seeking micro loans and create a regulatory environment within which the micro lending industry will thrive.

I felt that to learn more about microfinance in India, I first needed to delve into the modern history of India’s financial institutions and regulatory framework. India’s experiences with establishing and regulating its financial sector created the environment within which social entrepreneurs established India’s micro-lending institutions in the late 1980s.  To understand India’s banking and regulatory legacy, I looked at the Economist Intelligencer Unit, IMF reports and Elizabeth Rhyne’s illuminating article on Huffington Post. Elizabeth Rhyne is the Managing Director at the Center for Financial Inclusion, Vaneet Rai of the Harvard Review Blog and others. 


Since India’s independence in 1947, the country carried out three major initiatives that shaped the country’s banking sector. The first took place in 1955 when India moved towards greater public ownership of banks, when the Imperial Bank of India was taken over by the government and renamed into the State Bank of India. The State Bank of India took over seven banks and its subsidiaries in 1959. In 1969 the Indian government nationalized 14 more private banks. The idea behind nationalizations was prevention of concentration of the financial sector within a few private hands and promotion of a balance of financial development. 

Following in Ghandi’s goal of self sufficiency, the government took steps to ensure that the financial sector provided enough credit to agriculture (especially in underdeveloped rural areas), export and small scale industries. While in 1974 the Reserve Bank of India issued guidelines indicating that both private and public banks must allocate at least one third of its credits to priority sectors indicated above, this requirement was increased to 40% in 1980. Heavy regulation of the banking sector lasted until the liberalization of the 1990s. Liberalizations of the 1990s removed controls on interest rates, liquidity ratios, entry barriers, relaxation of credit controls, and more. 

Microfinance: Background

The idea of micro-lending comes from the broader idea of financial inclusion. In other words, all people rich or poor need access to affordable financial services to conduct daily activities. When we think of banks we think of the types services they provide to customers; such as opening checking and savings accounts, obtaining credit cards, as well as loans to go to university, buy a house or a car. All banking services come at costs which are split between the bank and its customers. To issue a loan, the bank will need a lot of paperwork, including but not limited to establishing the customer’s identity, collateral, creditworthiness and the ability to repay the lent amount. Based on available background on the customer and health of the credit market, the bank will decide how much interest to charge. The amount of charged interest will bring the bank some profit, cover the risk of lending capital and cover the cost of administering the loan.

However, there are customers that both need tiny loans and are high risk borrowers. These potential customers are not likely to be part of the traditional financial system, may not have a credit history, collateral, and may not look like good candidates for a regular bank loan. Additionally, if the loan is small enough a regular bank may have no interest in processing it as administrative costs may turn out to be higher than the return on the loan. 

As a result, these customers tend to obtain loans from informal sources, such as the local moneylender. Micro-lending institutions come in to fill this gap and extend financial services to those customers.  In issuing loans, micro finance institutions use traditional social structures and higher interest rates to mitigate risk from such customers. These institutions lend to groups, which means that both administrative costs are lower per capita and overall loans tend to be larger overall. Microfinance institutions’ interest rates are higher than traditional banks to mitigate higher risk customers who often lack collateral. The majority of beneficiaries are in rural areas, where traditional banking services are far from villages and are part of close knit communities. Lending to a group within a close knit community provides social pressure on individual members of the debtor group to pay on time. Groups that fail to repay communal micro-loans do not get new loans, thus hurting the long-term prosperity of the group. As in the case of Grameen Bank, groups applying for loans go through months of financial planning courses, mitigating non-repayment risk further. 

While this is not the case in India, in some parts of the world, microfinance institutions take bank deposits, thus giving poor communities a way to buy into the success of the micro-lending institution. If groups that borrow from a micro-lending institution also have savings accounts, they give themselves a strong incentive to pay back their loans. Failure to repay a loan will not only mean a denial on the next loan, but also a higher chance that their lender will go out of business. If a micro-lender goes out of business, the community’s savings held at the same bank disappear with the lending institution. From a business development perspective, providing financial services to a group of people previously not part of the financial system, not only gives more income flexibility to this group, but brings a previously untapped source of customers for micro-lending institution – in other words more customers is good for business. This leads to a question, are MFIs in this line of work for the good of the people or business? 

Microfinance: India

After a number of nationalizations of India’s banks, the Bank Penetration and SHG-Bank Linkage Program was created in order to both maximize the increase of the reach of banking services to remote areas and incentivize people to use state banking services instead of more informal traditional financial sources – moneylenders.  The program succeeded in bringing financial services to remote areas and in fostering economic development. 

Andhra Pradesh of the late 1980s emerged as the poster child of success of this government program. This state worked together with the Indian government through SGH-Bank Linkage Program and the National Bank of Agriculture and Rural Development, NGOs, as well as the World Bank towards economic growth. As a result of this success Andhra Pradesh became birthplace of India’s robust microfinance sector. Ultimately, nationalizations and banking policy prior to the reforms of the 1990s resulted in preferential treatment of public sector banks and SHGs. 

In my next post, I plan to cover the development and growth of India’s micro-lending sector and how India’s regulatory framework promoted lending and growth within this sector.


  1. 1.      Gupta, Poonam, Kochhar, Kalpana, and Panth, Sunjaya. “Bank Ownership and the Effects of Financial Liberalization: Evidence in India.” IMF Working Paper. 3 March 2011 <http://www.imf.org/external/pubs/cat/longres.aspx?sk=24695>
  2. “India: Demand for Financial Services.” Economist Intelligencer Unit. Main Report: Finance 2010. <http://www.eiu.com.proxy1.library.jhu.edu/index.asp?layout=displayIssueTOC&issue_id=187333003&publication_id=690002069> 
  3. Kannan, Ramya. “State to Shield Women From Microfinance Institutions,” The Hindu. 8 March 2011 <http://www.thehindu.com/news/states/tamil-nadu/article1518093.ece> 
  4.  Pankaj Kumar and Ramesh Golait, “Bank Penetration and SHG-Bank Linkage Programme: A Critique” Reserve Bank of India. 19 June 2007. <http://www.rbi.org.in/Scripts/bs_viewcontent.aspx?Id=2029> 
  5. Rai, Vineet “India's Microfinance Crisis is a Battle to Monopolize the Poor” Harvard Business Review Blog , 4 November 2010. <http://blogs.hbr.org/cs/2010/11/indias_microfinance_crisis_is.html> 
  6. Rhyne, Elizabeth. “On Microfinance: Who's to Blame for the Crisis in Andhra Pradesh?Huffington Post. 2 November 2010 <http://www.huffingtonpost.com/elisabeth-rhyne/on-microfinance-whos-to-b_b_777911.html >

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