Research Insight
The rise, fall and dynamic revival
of India’s microfinance market
Executive Summery
September 2014
Key findings
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Having fallen further and further behind in its task of providing the country’s vast
population with access to financial services, India’s financial sector is now being shaken
up by the regulator.
The Reserve Bank of India (RBI) – the country’s central bank that is headed by the
eminent economist Raghuram Rajan – has started taking bold decisions aimed at
accelerating the provision of financial services to the 800 million adults living in India.
The demand for financial services is soaring as a result of rising incomes.
In the past, microfinance institutions (MFIs) stepped in where established Indian banks
had failed. Although a combination of inadequate regulatory support and opposition at a
local political level hampered the growth of the sector, microfinance has been more
successful in promoting financial inclusion than any other business model thanks to the
scaling-up of its activities.
Following the 2014 elections, India now has a stable single-party government in power for
the first time in 30 years. The government’s development agenda centres on the private
sector and its ability to deliver essential services such as access to sanitary facilities and
bank accounts.
Meanwhile, the central bank has recognized that MFIs have a key role to play in the
implementation of its financial inclusion strategy and, in 2014, granted a banking license
to an MFI for the first time – thus opening up new perspectives for India’s microfinance
sector.
Dear reader
‘In an efficient financial system, the
playing field is level so that different institutions compete to provide a function,
no institution dominates others because
of the privileges it enjoys, competition
results in resources ­being allocated efficiently, and society gets the maximum
out of its productive ­resources. This is
also equitable for only thus will the interests of consuming masses be emphasized,
instead of the more usual trend of privileged producers being protected.’
India’s financial sector was once described as ‘a ramshackle
engine lovingly maintained by a sect of oil-spattered engineers’1. Over the past few decades, it has fallen further and
further behind in its task of delivering financial services to the
800 million adults living in India. Very few private banks
have thrived and those that have developed mainly cater for
India’s middle class, which is still very limited in numbers.
­Low-income households, which account for the overwhelming
majority of India’s population, would still be reliant on unlicensed moneylenders, were it not for the emergence of two
innovative finance models: publicly administered self-help
groups (SHGs) and private sector-based microfinance institutions (MFIs). Both types of institution provide group loans
at highly competitive interest rates compared to the rates
charged by unlicensed money lenders2. Although both models
have reached tens of millions of clients, MFIs have been able
to scale-up their activities more rapidly and have succeeded
in attracting more funding than SHGs.
This may be one of the reasons why the emerging micro­finance
industry suffered an abrupt, politically-motivated setback
in 2010 – leading to the collapse of several microfinance institutions. These developments threatened to seriously undermine the progress that had been achieved in the area of
finan­cial inclusion – pushing it back 20 years. Fortunately,
over the last three years private sector microfinance has risen
from the ashes, partly thanks to the creation of new business
models. Crucially, this revival has been supervised by the RBI
under the leadership of the progressive economist Raghuram
Rajan. He has made it clear that financial inclusion is a top
priority and that new players should be allowed to enter the
market in order to deliver on this policy:
Raghuram Rajan3
Rajan translated his words into action. In April 2014, the
RBI announced that it would grant a banking license to an
MFI. The licensing round was the most significant since 1993,
when the establishment of private banks was permitted once
again in the wake of India’s balance of payments crisis of
1991. The RBI is thus creating new perspectives for MFIs to
become fully-fledged banks. This incentivizes MFIs to engage
in institutional development, since their success will be rewarded with further operational and financial options, such as
the authorization to take deposits from the public. An important success factor driving sustainable microfinance, which
has already been demonstrated in advanced microfinance
markets such as Peru4 or Cambodia, has therefore now been
adopted by the Indian regulator.
Christian Etzensperger
Senior Research Analyst
1
The Economist, 30 November 2013.
2
achiket Mor: ‘Committee on Comprehensive Financial Services for
N
Small Businesses and Low Income Households Report’, Reserve Bank
of India, December 2013.
3
aghuram Rajan: ‘A Hundred Small Steps: Report of the Committee
R
on Financial Sector Reforms.’ Submitted to the Planning Commission,
Government of India, 2008.
4
‘Peru – Model Market for Microfinance’, responsAbility Investments, 2011.
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The development of
the Indian financial sector
India’s financial sector was subject to strict government con­trols and financial repression from 1947 – the year in which
India gained independence – until 1990, which marked
the start of the liberalization of the sector. During this period,
India was largely isolated from the international financial
system. That period began with the politically motivated
nationalization of major private sector banks in support of the
politico-economic development strategies of the newly independent India. The government subsequently controlled the
sector through its extensive ownership of financial institutions
and the very stringent regulation of banking activities.
The Indian government controlled the flow of credit, channelling
it to favoured economic sectors and enterprises. Interest rates
were administered by the government. Accounting standards
were poor and financial disclosure was minimal. Most financial
intermediaries were required to invest a substantial proportion of their funds in government securities – enabling the
government to refinance its expansive fiscal policies at non-­
market rates. High levels of monetization in the economy forced
the government to impose high reserve requirements and
credit rationing, which further hindered financial sector activity.
Financial intermediaries were plagued by dismal performance,
inadequate capital levels and poor asset quality.
Indian banks: Improving but still falling short of requirements
India’s balance of payments crisis in 1991 led to fundamental
economic and banking reforms, although they were introduced
only gradually. In a carefully planned process, new private
sector banks were licensed and public sector banks reduced
their level of government ownership by raising additional
equity. Today, the India’s banking sector is moderate in size
relative to the scale of the economy and is dominated by
state-owned banks (see figure 1). The ratio of commercial
bank assets to GDP is less than 100% and the credit-to-GDP
ratio is slightly more than 50%.5 The sector is characterized
by strong but declining government involvement. It has
underperformed compared to the banking sectors of other
emerging countries due to low levels of sector profitability,
portfolio growth and outreach. Moreover, India’s banking
sector has not yet experienced a major systemic crisis.
Developments in state-owned banks are dominated by politics,
and privatization is unlikely to happen any time soon. There
are two types of state-owned banks. First, the State Bank
of India (SBI) and its associate banks, which are technically
classed as subsidiaries but operate separately in practice.
Second, there are nationalized banks, consisting of formerly
private banks that became state owned during the two waves
of nationalization in 1969 and 1980.
State-owned Indian banks have comparatively low levels of
capital. The strong growth of their lending activities has led to
a continual need for additional capital as their balance sheets
expand. However, their low profitability limits the proportion of
additional capital that can be generated through the retention
The largest Indian banks
by assets as of 2012
Name
State Bank of India
Total assets
INR million
Assets as % of
total sector assets
Majority
ownership
State
14,687
18.3
Bank of Baroda
5,471
6.8
State
ICICI
5,368
6.7
Private
Punjab National Bank
4,789
6.0
State
Bank of India
4,526
5.6
State
Canara Bank
4,123
5.1
State
HDFC
4,003
5.0
Private
Axis
3,406
4.2
Private
IDBI
Union Bank of India
3,228
3,119
4.0
3.3
State
State
Source: HIS Global Insight Banking Report India
5
The World Bank World Development Indicators, 2012.
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of earnings, meaning they are dependent on rights issues to
close this gap. Since the Indian government is committed to
maintaining majority ownership, the banks have to secure proportional government participation in rights issues to avoid
dilution. Efforts to secure the allocation of government funds
are often subject to delays due to the government’s budgetary
difficulties – leaving banks in a state of limbo as they petition
the government for an uncertain amount of capital.
Stock market listings and the raising of private equity have
reduced the level of government ownership to below 60%
in the case of around half of all public sector banks. The
government has been cautiously pushing for consolidation
among public sector banks. SBI has completed mergers with
two of its original seven associate banks, overcoming opposition from bank unions and left-leaning political parties. SBI
has stated that it plans to acquire the remaining five associate
banks. However, this appears unlikely at present, given the
difficulties it faced with the first two.
Priority sector lending: A blessing or a curse?
Although deposit rates were fully deregulated in 2011 and
few restrictions on lending rates remain, regulations still force
banks to allocate a significant proportion of their loans to
areas of the Indian economy that are classed as, ‘priority
sectors’, by the government. These include the agricultural
sector, micro and small enterprises, education and housing.
Domestic commercial banks are obliged to allocate 40% of
their net bank credit to these sectors.
Indirect lending to these sectors by MFIs qualifies as priority
sector lending (PSL) if certain criteria are met. They include a
maximum annual household income among end-clients of
INR 60,000 (USD 1,000) in rural areas or INR 120,0000
(USD 2,000) in urban areas. The maximum loan size is
INR 35,000 (USD 580) in the first cycle, increasing to
INR 50,000 (USD 825) in subsequent cycles. The total indebtedness of an individual borrower cannot exceed INR 50,000
(USD 825). The loan tenor is capped at 24 months if the loan
The largest microfinance instititutions in India
Bubble size corresponds to gross loan portfolio
7
Number of active borrowers (millions)
SKS
6
5
4
Janalakshmi
Spandana
Bandhan
3
Ujjivan
2
1
Asmitha
Satin
Share
0
Muthoot Equitas
-1
0
500
1,000
1,500
2,000
2,500
Number of branches
Source: MFIN Micrometer, March 2014
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Categories of Indian microfinance institutions
Portfolio size
Large
Vehicle finance institutions
•AU Finance
•Equitas Vehicle Finance
•ESSKAY Finance
•Sakthi Finance
•IKF
Institutions providing group loans
•Bandhan
•Equitas Microfiancne
•Ujjivan
•Janalakshmi
•Grameen Koota
•Satin Creditcare
•Utkarsh
•Suryoday
•Sonata
•ESAF
Medium
Institutions that finance housing
•Aptus Value Housing Finance
•Shubham Housing Development Finance
•Vishwakriya Housing Finance
•Equitas Housing Finance
•Home First Finance
Institutions providing individual loans
•Vistaar Financial Services
•Electronica finance
•Intellegrow
•Five Star Credit
Small
Medium
High
Number of existing institutions
Source: responsAbility Investments
exceeds INR 15,000 (USD 250). No borrower can be served by
more than two providers. Further­more, there is a margin cap
of 12% as well as an interest rate cap of 26% (calculated on a
reducing balance basis) for all MFIs.
While private sector banks understandably take a rather negative view of restrictive PSL practices, MFIs depend on this
refinancing channel to a considerable extent. Since PSL has
been one of the cornerstones of India’s domestic development
strategy for half a century, the sudden abandonment of this
policy appears extremely unlikely. It is, nevertheless, possible
that it may be gradually phased out over the mid to long term
– although no concrete plans have so far been discussed.
Phasing out PSL would not be a problem for MFIs if they had
other domestic refinancing possibilities, hence the importance
of the regulator’s recent step to allow the transformation of
MFIs into deposit-taking banks.
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India’s microfinance
market today
The regulated microfinance market in India today has over
28 million clients – which represents a record figure. They
are served by nearly 50 regulated institutions. The market is
concentrated, since the 10 largest MFIs alone serve a total
of 21.6 million borrowers. This is a clear indication that economies of scale are at work. In the course of the finan­cial year
ending 31 March 2014, the sector attracted 4.7 million new
clients and grew its gross loan portfolio by 35%.6 This mainly
comprises catch-up growth since, even today, only 8% of Indian
adults have a loan from a formal financial institution and only
12% have savings accounts with institutions of this kind, while
only 35% have a bank account (of which more than half are
inactive or semi-active).7 The goal set by the RBI is that 100%
of adults should have a bank account by 1 January, 2016.
The microfinance market in India can be divided into the
following categories:
Institutions that provide group loans: measured in terms
of the number of institutions, the overall portfolio and
client coverage, this represents the largest segment of the
mi­cro­finance market. The vast majority of the 28 million
micro­finance clients in India are served by these lending
­institutions.
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I nstitutions for vehicle financing: A new segment has
emerged comprising institutions that provide loans for the
purchase of commercial vehicles. Although the financing of
commercial vehicles and two-wheeled vehicles has been
common practice in India for a number of years, the focus
was previously on major borrowers (often fleet owners) that
have their own income and tax records. In contrast, the new
institutions active in this area are targeting borrowers with
no credit history or proof of earnings who, in most cases, are
purchasing a vehicle for the first time. These institutions
finance the purchase of either new or second-hand vehicles.
Around 10 –15 institutions operate in this segment and
have credit portfolios of between USD 10 million and
USD 100 million.
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Institutions that finance social housing: A number of insti­
tutions that focus exclusively on financing housing for clients
from low-income households have entered the m
­ arket over
the last three years. Without proper proof of earnings, these
clients are unable to obtain residential m
­ ortgages from banks
and other formal financial institutions.
I nstitutions that provide individual loans: this segment,
which is still in its infancy, comprises institutions that provide group loans and have adapted the scale of their business models, as well as institutions focusing exclusively
on individual loans. Virtually all of the top 10 –15 leading
MFIs have introduced individual loans. However, the port­
folio of individual loans remains small, accounting for less
than 10% of the total loan portfolio. The number of credit
institutions that focus exclusively on providing loans to
indivi­dual borrowers is also limited.
6
Micrometer March 2014.
7
orld Bank Global FINDEX Database 2011; as well as Franklin Allen, Asli DemirgucW
Kunt, Leora Klapper and Maria Soledad Martinez Peria: ‘The Foundations of Financial
Inclusion: Understanding Ownership and Use of Formal Accounts’, Policy Research
Working Paper Series 6290, The World Bank, 2012.
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Individual lending: A revolution from within
India’s microfinance sector is currently experiencing an increa­sing shift towards individual loans. This trend is a natural
consequence of the fact that a large number of clients have
already demonstrated their creditworthiness over several group
loan cycles and are now demanding more flexible terms and
conditions as well as larger loans. At the same time, these
clients cannot access the financial services offered by commercial banks because they are not yet able to provide formal
proof of earnings or physical collateral. This creates significant
market opportunities for MFIs that are in a position to offer individual loans and related financial services.
For MFIs that previously only granted group loans, this trend
towards individual loans poses a significant challenge. The
main pillars of the group loan model are self-selection by
clients, joint liability, small-size loans, short loan terms, standardized processes and strict supervision. In view of these
characteristics, this model can easily be replicated while
maintaining good portfolio quality.
To ensure a successful transition from group loans to individual loans, joint liability – a key element of group lending – has
to be replaced by individual mechanisms. The individual loan
model requires systematic client evaluations by qualified and
experienced loan officers. Both elements are lacking in the
current group lending model. MFIs are responding to these
challenges by setting up their own dedicated departments
(and, in some cases, dedicated branches) to handle individual
loans or by focusing on individual loans that are secured
against collateral – where the assets used as collateral are a
core element of the loan evaluation process. The transition to
individual loans will be facilitated by the presence of properly
functioning credit bureaus (i.e. the privately operated Highmark and Equifax, both licensed by the RBI in 2010).
In the northern states and rural regions of India, the granting
of group loans is continuing to grow at respectable rates. In
the southern states and in urban areas, however, this model
is slowly reaching saturation point. One important reason for
the slower rate of growth in well-developed markets is the new
requirement – stemming from PSL regulations – that a
borrower cannot be offered services by more than two MFIs.
This means that lenders must also adopt a more restrictive
approach to the acquisition of clients, thus promoting a shift
towards individual loans and larger average loan sizes.
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The important
role of the regulator
The RBI is arguably India’s foremost public institution and has
shown itself to be a strong and effective banking regulator. In
recent years, it has taken prudent but decisive action to ensure the sound development of the banking sector without any
apparent and significant government intervention. The RBI has
taken an active approach to evaluating and improving its regulatory framework and has made continuous improvements
to its regulatory and supervisory capabilities since the era of
wide-scale financial repression ended in the early 1990s.
The RBI has a track record of gradually tightening financial
regulations, proactively identifying risk factors and implementing countercyclical regulatory policies. The RBI has introduced
capital adequacy requirements that are based on but go beyond
the Basel III rules prescribed by the Basel Committee on Banking Supervision.
Critics point out that the RBI still lacks formal independence
and that its governance structure reveals a number of inconsistencies. They have also stated that the transparency of its
balance sheet is far from best practice and that it has no experience in handling a banking sector crisis. For the poorest
segments of India’s population who lack access to financial
services, however, the RBI’s most significant failing so far has
been its inability to rigorously pursue an agenda to promote
financial inclusion through the microfinance sector. This shortcoming was addressed in 2013 when a new governor took
over the helm of the RBI.
Focus on financial sector development and financial inclusion
Raghuram Rajan, a former chief economist at the International
Monetary Fund and professor at the University of Chicago, was
appointed Governor of the RBI in September 2013. In his inauguration speech, he announced an agenda that centred on
financial sector development and financial inclusion. The
market was informed of this agenda thanks to a ground-breaking white paper entitled ‘A hundred small steps’ that was
published in 2008 by a committee of the Indian government’s
Planning Commission, chaired by the same Raghuram Rajan.
ed at a rapid rate over the past two decades. It also survived
a severe crisis provoked by politicians in the state of Andhra
Pradesh in 2010.8 Since then, it has emerged stronger and
more innovative than before. The establishment of credit
bureaus and the adoption of lending practices other than the
traditional group lending model have helped to drive this
revival. What had been missing was a consistent regulatory
vision and an agenda to support these positive shifts within
the private sector.
By granting a banking license to MFI Bandhan in April 2014,
the regulator made clear that microfinance institutions can
now aspire to become banks. The RBI also announced that the
application process for banking licenses would become a
continuous one. This will make it easier for MFIs to achieve
strategic growth and institutional development – which are a
pre-condition in order to attract client deposits. For the first
time in India, MFIs now have the option of evolving into
well-regulated institutions than can offer the whole range of
financial services to the vast low-income segment of India’s
population. India is thus well on track to replicate the successful model that led to broad financial inclusion in countries
such as Peru, Cambodia and Kenya.
The general elections 2014:
A strong mandate for private sector growth
India’s private sector was given a rare boost by developments in the
political arena. In May 2014, the results of the world’s biggest elections were announced. 814 million Indians were eligible to vote,
100 million more than in the previous general elections in 2009.
Narendra Modi’s Bharatiya Janata Party (the Indian People’s Party),
whose election manifesto set out pro-business policies and called for
private sector development, won by an absolute m
­ ajority – bringing
an end to 30 years of complex coalition politics in India. This means
that India now has a stable s­ ingle-party government in power that
is pursuing a strong development mandate. These are arguably the
best preconditions for growth in the coming decades.
The ‘Rajan revolution’ has been well timed since it coincides
with a dynamic revival of the microfinance sector. Partly due
to the inertia of Indian banks, this emerging sector has expand-
8
Pooja Yerramilli: ‘The Politics of the Microfinance Crisis in Andhra
Pradesh, India’, 2013.
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Conclusion
India’s financial sector is currently undergoing fundamental
changes, leading to the liberalization and dynamic revival of a
long dormant sector. As the country’s financial regulator, the
RBI has played an important part in driving the development of
the financial sector – taking bold decisions to promote financial
inclusion among India’s adult population of 800 million.
The regulator sent out a strong signal when it granted a rare
new banking license to an MFI, acknowledging that it is MFIs
that have been most successful at scaling up their offering and
reaching low-income segments of the population who lack
access to financial services. With the latest support from the
regulator, leading MFIs now have the option of developing into
fully-fledged banks.
Within the industry, an emerging trend from group loans to
individual loans or loans that are secured against collateral
is creating new business models. As a result, proven lending
approaches used in advanced microfinance markets around the
globe are now being implemented in India. These approaches
reflect the rapid growth of the segment of India’s population
that has to manage cash flows of several dollars a day.
As a result, investors who invest in the development of the
financial sector can now find a host of different investees
that are developing India’s vast market, some of which have
the potential to shape India’s financial sector in the future.
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About the author:
Christian Etzensperger is a Senior Research
Analyst at responsAbility Investments. He holds an MA in Economics and an MSc (Distinction) in Economic Development from the University of Glasgow Adam Smith Bus- iness School. He is also a Chartered Alter- native Investment Analyst. Before joining responsAbility Investments in 2010,
Christian Etzensperger worked as a quantitative analyst at Bank Vontobel and as a macroeconomist and industry analyst at Credit Suisse.
Christian Etzensperger, Senior Research Analyst
[email protected], +41 44 254 32 79
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