Microfinance: Falling Short Of Its Promise?

Over the years, securing loans has become easier in India, thanks to the growth of the microfinance sector, fuelled by the government’s focus on financial inclusion and empowerment of the underserved. However, this progress has come with the realisation that the sector’s promises have not always resulted in positive outcomes for borrowers and investors. As the microfinance industry faces ongoing challenges, Mandar Wagh examines the financial performance of industry leaders, sectoral headwinds and tailwinds, and provides an outlook for investors to make informed investment decisions 

Microfinance involves providing financial services such as micro loans, savings accounts, insurance, and other banking products to individuals and small businesses that lack access to traditional banking. Its primary objective is to empower low-income populations, particularly in rural and underserved areas, by offering financial tools that help improve their economic standing. The microfinance sector has been a strong contributor to economic growth, especially during the pandemic, when it helped vulnerable communities navigate challenging financial conditions. 

However, after years of success, the sector now faces a slew of challenges that have reversed its fortunes. According to the latest data from the Reserve Bank of India (RBI), stress in the microfinance sector doubled between April and September 2024, with the share of stressed assets in the 31-180 days past due (DPD) category rising from 2.15 per cent to 4.30 per cent. 

The negative sentiment in the microfinance sector has spilled over into the broader market, dragging down stocks of companies with significant exposure to this segment. The microfinance meltdown has become one of the key factors behind the majority of Mid-Cap and Small-Cap losses in 2024, highlighting the interconnected risks within the financial ecosystem. 

Microfinance stocks, which once enjoyed an uninterrupted rally and were among the best performers, have now posted double-digit negative returns over the past six months. This decline raises important questions about the sector’s trajectory. In this story, we will explore what’s going wrong in the microfinance sector, delve into the financial performance of leading microfinance companies, analyse the sector’s headwinds and tailwinds, and provide an outlook to help investors make informed decisions about the future of the microfinance industry. 

Financial Health of Microfinance Sector in Q2FY25
To provide an in-depth analysis of the sector’s performance, we have examined the top 20 BSE-listed microfinance companies by market capitalisation, offering a comprehensive insight into the key players driving India’s microfinance industry. For Q2FY25, the year-on-year performance of the microfinance sector showcased notable strength. However, sequential growth painted a less optimistic picture. While aggregate revenue surged by 25 per cent year-on-year (YoY), the quarter-onquarter (QoQ) growth was limited to around 8 per cent. Aggregate net profit, on the other hand, failed to report any growth, instead registering a slight decline on a year-on-year basis and dropping by around 7 per cent quarter-on-quarter. 

On a sequential basis, the majority of companies reported single-digit revenue growth coupled with either marginal or negative net profit growth. Leading the decline were Poonawalla Fincorp and Spandana Sphoorty Financial, which significantly impacted the sector’s overall performance. Both companies reported triple-digit declines in net profit on both YoY and QoQ basis. The sector’s underperformance was attributed to a combination of interrelated challenges. One of the most pressing issues is the over-indebtedness of borrowers. While microfinance was intended to empower entrepreneurs by offering them the means to improve their lives, in many cases, it has instead led to cycles of debt. 

Micro loans, which were often given to clients without sufficient screening or follow-up, have pushed borrowers into financial distress. In some cases, they were forced to take on multiple loans from different microfinance institutions (MFIs), without fully understanding the terms or their ability to repay. Consequently, the sector experienced a significant surge in non-performing assets (NPAs). For instance, Spandana Sphoorty Financial reported a significant increase in gross Stage 3 assets, which jumped from 1.7 per cent in March 2024 to 5.3 per cent by September 2024. 

This deterioration in asset quality signalled growing stress in borrowers’ repayment capacity, raising alarm about the sector’s overall health. The high interest rates charged by many MFIs are another factor exacerbating the problem. In an effort to maintain profitability, many institutions have resorted to charging interest rates that far exceed those of traditional banks. These rates, which can range from 20 per cent to 50 per cent annually, make it difficult for borrowers to repay their loans, let alone make a profit from their businesses. While some argue that high interest rates are necessary to cover the operational costs of microfinance institutions, others view them as exploitative. 

The rise of predatory lending practices has further damaged the sector’s reputation. Some microfinance institutions, in their bid for rapid growth, have been accused of targeting vulnerable borrowers with aggressive sales tactics, coercing them into taking loans that they cannot afford. This practice has not only hurt the borrowers but also eroded public trust in microfinance as a whole. One of the most significant problems facing the microfinance sector is the lack of adequate regulation. While many countries have enacted microfinance laws, enforcement has often been weak, and regulatory frameworks have failed to keep pace with the rapid growth of the industry. 

Microfinance Sector Woes: A Period of Declines 

The year 2024 proved challenging for Indian markets, with benchmark indices BSE Sensex and Nifty 50 registering modest gains of only 8-9 per cent for the year. Broader indices fared better, surging by 25-30 per cent, though this growth was primarily driven by a strong rally in the first half. The second half of the year, however, saw a largely flat performance, tempering overall returns. Sectoral performance was a mixed bag. The BSE Oil and Gas index emerged as the worst performer, plunging more than 12 per cent in the last six months. 

In contrast, the BSE Healthcare index stood out as a star performer, delivering an impressive 44 per cent gain over the year, reflecting strong investor confidence in the sector. Investors, once enthusiastic about funding microfinance institutions for their blend of high returns and social impact, are now reassessing their involvement in the sector. The initial appeal of microfinance has been overshadowed by mounting challenges, prompting both impact investors and traditional backers to reconsider their strategies. Deteriorating financial performance and heightened regulatory pressures have eroded investor confidence in India’s microfinance sector. This shift in sentiment has been evident in the consistent decline of most microfinance stocks over recent months. 

Our analysis indicates that around 75 per cent of the microfinance stocks examined suffered significant price declines over the past six months, with a few achieving only modest single-digit returns. Among the worst performers, Spandana Sphoorty Financial Ltd. saw its shares plunge nearly 55 per cent, while Arman Financial Services Ltd. and CreditAccess Grameen Ltd. recorded declines of 35-40 per cent each. Only a handful of stocks, including Muthoot Finance Ltd., Piramal Enterprises Ltd. and Edelweiss Financial Services Ltd. managed to defy the trend, delivering double-digit gains over the past six months. 

Government Initiatives 

The Indian government has implemented several initiatives to foster the growth and development of microfinance institutions (MFIs) to enhance financial inclusion, particularly in rural and underserved regions: 

1. Indian Micro Finance Equity Fund (IMEF) - Introduced in the Union Budget of 2011-12, with an initial allocation of ₹100 crore, the IMEF aims to address liquidity challenges faced by smaller MFIs. Managed by the Small Industries Development Bank of India (SIDBI), the fund focuses on strengthening the capitalisation of socially oriented MFIs.
2. NABARD - The National Bank for Agriculture and Rural Development (NABARD) plays a pivotal role in facilitating access to financial services for rural populations through its Micro Credit Innovations Department. NABARD also promotes the Self-Help Group-Bank Linkage Programme (SHG-BLP), a costeffective model connecting poor households to formal financial institutions, empowering them with essential financial tools.
3. Micro Enterprise Development Programmes (MEDPs) - These programmes offer skill training to self help group (SHG) members, enabling them to enhance their production activities and create sustainable livelihoods.
4. E-Shakti Initiative - Launched by NABARD, the E-Shakti initiative is a technological leap for the sector, digitising SHG operations. It facilitates better data access and transparency by mapping SHGs and uploading financial and non-financial information to a dedicated online platform, enhancing the efficiency of financial inclusion efforts.
5. Pradhan Mantri MUDRA Yojana (PMMY) - Launched in 2015, the PMMY aims to improve the flow of credit to small businesses, a critical component of financial inclusion. The initiative provides micro-financing for non-corporate, non-farm small and medium enterprises, further bolstering the growth of the microfinance sector. 

Key Drivers of Microfinance Growth
The self-regulatory organisation for the sector introduced new guidelines on micro-lending in November, including a cap on borrower indebtedness at ₹2 lakh, encompassing both micro and unsecured retail loans, and reducing the number of lenders per borrower from four to three. Initially set to take effect on January 1, 2025, the implementation has been deferred to April 1, 2025. This extension allows lenders more time to address stress and delinquencies, especially during the highly active fourth quarter, while enabling borrowers to better plan their finances, thereby mitigating potential financial strain. 

Considering other factors, rising financial literacy in rural areas is driving the demand for microfinance products, as individuals increasingly recognise the value of formal financial services. With the expansion of mobile phones and internet access, microfinance institutions can reach a broader audience and streamline operations through digital lending platforms. Additionally, the growing rural entrepreneurship and business activities are fuelling the demand for microloans and financial services, contributing to the sector’s growth. 

Private sector participation, including investments from impact funds, is helping microfinance institutions expand their services, innovate, and improve operational efficiency in underserved markets. Microfinance also plays a crucial role in empowering women, providing them with access to financial resources that foster entrepreneurship and social development, ultimately benefiting family incomes and community welfare. 

Investor Strategy
The sorry state of microfinance today is a result of a complex mix of challenges, including irresponsible lending practices, high interest rates, regulatory shortcomings, and the growing realisation that the sector’s promise of financial inclusion has not always translated into positive outcomes for borrowers. However, the potential of microfinance remains intact, provided that it undergoes significant reform. A more responsible, transparent and regulated approach could revitalise the sector and allow it to fulfil its original promise of empowering the world’s most marginalised populations. 

Investors interested in the microfinance sector, especially in the current situation marked by sectoral challenges, should adopt a cautious and informed approach. First, they should thoroughly assess the financial health of microfinance institutions (MFIs) by closely reviewing key metrics such as asset quality, non-performing assets (NPAs), and profitability. Second, diversification is key. Investors should consider spreading their investments across various MFIs rather than concentrating their capital in a single company. This helps mitigate risks associated with individual institutional performance. 

Third, investors should focus on companies with strong governance, transparency, and efficient operational models. These MFIs are likely to navigate challenging times better by maintaining trust and effectively managing credit costs. Fourth, investors should stay updated with regulatory changes in the sector. The increasing scrutiny from the Reserve Bank of India (RBI) has raised concerns in the market, and understanding regulatory updates can help investors make informed decisions. 

Lastly, in the face of sectoral volatility, long-term investors should view the situation from a broader perspective. Despite the current downturn, the microfinance sector has long-term growth potential, driven by rising financial inclusion, technological adoption, and growing rural demand for credit. Patience and a strategic focus on companies with solid fundamentals will be crucial for weathering the sector’s current weakness and capitalising on future opportunities.